Thursday, May 03, 2007

What Is Due Diligence When Buying a House?

"Tom Stone", a reader and frequent commenter on this and other housing bubble blogs and someone who is extremely knowledgeable about buying property, shared with me what he considers due diligence when buying a house. As it would benefit readers, here's what he had to say (gently edited):
Hello Marinite,

Here are my thoughts, please feel free to edit in any way you see fit.

I would like to emphasize that I do not think it is a good idea to buy a home at this time, and probably won't be for a year, or more.

"Due Diligence" is defined as the kind and amount of research a "Prudent Person" would undertake when borrowing hundreds of thousands of dollars to buy a home.

First, determine your price range by considering the amount of your down payment, and a reasonable percentage of your income for debt service. I will assume 25% of your gross income is available to cover principle, interest, taxes and insurance. (Yes I can get you a loan at 55% DTI to 95% cltv, if that sounds good, call 1-800-273-TALK.)*

I go online to OFHEO and check the information for the Metropolitan Statistical Area (MSA) I am interested in. I go to the Census Bureau to see how the Demographics look, I Google "Economic studies, Oz MSA" and read them, I Google "Demographic Studies, Narnia MSA" and read them, I check school ratings, crime statistics, and the "megan's law" site on line. I check online for Geological hazards such as flood zones or earthquake faults, unstable hillsides or the presence of Levees. USGS has a helpful site for much of this, state and county information may also be available online. I Google "superfund sites". These basic steps should give you a neighborhood or two to look at closely. GET OUT OF YOUR CAR AND WALK THE NEIGHBORHOOD! Preferably on a Saturday afternoon or evening around dinner time...drive through the neighborhood with your windows open, on a weeknight, on Friday, and on Saturday, about 10 PM. If you can, drive through late morning on a weekday as well. Go to Open houses in the area. If there is a property that looks right, check Trulia, Domania and Zillow, and print out the information you get. Look at recent comparable sales, ring the doorbells, tell the folks you are thinking about buying on "x" St, and ask their advice. "Can you tell me anything about the neighborhood, I'm afraid of making an expensive mistake".

So far, it is looking good, and I'm in love with the big redwood and rhododendrons in the yard. So, off to the county recorder's office to see what there is to see. I check the address, and I check the owner's name as well for other properties in the county. I look at the date purchased the type of note, any refi's, notices of default, different mailing addresses, etc. If there is a different mailing address, I check to see who owns it. I do the same for any other properties owned by the same person(s). I check by name as well for such things as a DBA, a divorce, etc. I then either do a lexis/nexis search, or go to an online info broker such as "detective search" and buy a report on the seller. If the seller is self-employed I would buy a dun&bradstreet report on the business. I would look for any signs of distress, particularly if the seller is in a housing related business, and would tailor my offer accordingly. My offer would be contingent upon a THOROUGH inspection of the property, and modified by any problems encountered by the inspectors.

Some may quibble with my assumption that 25% is an appropriate percentage of gross income to spend on your home. It is conservative. Others may feel that using an information broker to gain insight into the sellers financial situation is invasive. Fair enough, don't do it. My position is that ANY and ALL publicly available information on the property and the seller(s) should be part of my due diligence, whether buying for myself, or acting as an agent.

Tom Stone

*PS the 800#, above, is the national suicide prevention hotline...
The great thing is that all of those excellent recommendations by Tom do not require a real estate agent. You can do them all on your own for very little money compared to what you would pay a commission-based agent. But if you still insist on using an agent, then make sure that when you settle on a commission you aren't paying the agent for the work you did yourself.

11 Comments:

Blogger vfsv said...

Don't forget those helpful bloggers like Marinite.

There's also a new slice of data "Median $ Value" for Santa Clara County charted at:
http://www.viewfromsiliconvalley.com/id326.html

Thanks!

May 3, 2007, 9:04:00 PM  
Anonymous waiting For Sanity said...

Wow!

Excellent info.

It ought to be obvious that we should do that kind of research on the biggest investment most of us make.

Thanks for making it obvious.

May 4, 2007, 1:02:00 AM  
Anonymous Anonymous said...

Indeed. Very thorough information. The only thing that I'm a little curious about is what Tom admitted was very conservative: 25% of income going towards the principal.

Let's pare that 25% to a below Bay Area price of say- 600k for a home. If you put down a healthy 20% on the home, now we're down to 450k or so.

The payment would still be roughly $2,626.08 a month on the mortgage. That doesn't include property tax: $6,500 annually, Insurance: $2,500 annually, and the inevitable repairs, which I'll leave blank just for argument's sake.

The bare minimum required payment annually on a 600k home with a 20% down payment would be: $49,500 per year. That assumes that you don't eat or own a car. Nothing else. Just "da-howse"

So what does $49,000 translate to income wise? Well, since California takes roughly 30-35% of your income in taxes, that'd mean that someone making around $57,000 a year would have just barely enough to cover the mortgage. But this is unrealistic because this amount assumes that the person making the payments would not be eating. Plus 100% of their income is going to the mortgage,which is very far from the 25% target.

How much would someone need to make in order to only be putting down 25% of their income on a mortgage such as the above example?Well, my math is probably rough here, but if the above person making 57k is putting 100% of their pay into the house, then you could just stupidly assume they make 1/3 the necessary funds to do so. So... 57k times 3 equals $171,000 annually.

Again, that assumes that the payee is not eating out or using any of the money for luxuries. Someone making 171k would surely want more than a Chevy Cobalt or Ford Escort to drive... right? But let' assume that they're frugal little spenders and eat out twice a week and buy new shoes and so on. They say that the average US citizen spends roughly 30% of their income on luxuries. But out hero here is thrifty. Let's assume they only spend 15%. 171,000 plus an additional 15% equals $222,000 annually.

Folks... I don't know many people making that kind of money. In fact, that is around 4 times the supposed median income level.

I'm not disagreeing with Tom at all.25- 30% MAX is what people SHOULD be spending. But the truth is that I'd be willing to bet that some in the area are spending close to 80%.

I've been doing the simple math on housing here for years and the numbers are so far off the mark that I think one year in VERY wishful thinking. Anything over 400k and I'm not biting.Trust me. I make a decent 6 figure income and I see little use in wasting it all on a house.

May 4, 2007, 8:57:00 AM  
Anonymous Bob said...

I just read an article in which a day laborer and his friend, who combined made 30k qualified for a 720k mortgage. This is what did change -- underwriting.

So the question remains. Will there continue to be enough of this type of underwriting to keep this type of suicide loans going forward (since quite frankly I think there is an endless supply of dumb americans willing to take these types of loans) or will this stop. So far I am not convinced that this type of underwriting has ceased to the level that would force this to stop. Has anyone seen anthing different? Anyone have good information on when this type of lending will truely cease and we will once again be back in a place where fundamentals will rule the day?

May 4, 2007, 9:37:00 AM  
Anonymous Anonymous said...

My take: Removal of the suicide loans pulls the rug out from under the market. California will be hurt the worst as our high prices are not offset by wages and the runup here was financed by cheap lending. As the first-time buyer disapears, the move up chain breaks.

One of two things will happen:

1. The people who have to sell will sell for a discount thereby repricing all homes, even the ones by people who want to sell but don't.

2. Nothing sells because no one wants to sell for a perceived "loss". So the market is dead for some period of time.

Also, keep in mind that the current downturn has NOT been accompanied by a recession, lower wages, natural disasters, increased inflation, increased interest rates, etc. Since the likelihood of some of those bad things happening is higher than not, when they do happen the weakness in the housing market will convert to an utter crumbling in the market.

Thus, if you are planning to sell or think you might want to in the next 10 years or so, you should do it now while you still have a chance. Pass the overwhelming risk on to some other fool if you can.

Granted, California is expensive for other reasons that have nothing to do with easy credit...like the cost to build, the permits, etc. So CA will still remain the most expensive state even after prices retreat. And Marin will remain the most expensive county in the BA. It's all relative. The bubble floated all boats equally and when the flood receeds, the boats will come back to rest to where they were before this insanity began.

May 4, 2007, 9:51:00 AM  
Blogger Chuck Ponzi said...

Anon 8:57 AM.

I agree that 25% should be the a rule of thumb... but you also need to be realistic. Being conservative for conservative's sake does not translate into a reasonable home for your family.

In most cases, new buyers have agreed to 50% DTI, so we can throw that right out the window, but we can consider 25% of gross salary to be fairly reasonable for a person in their mid-30's which was originally about the time a person bought their family home.

One would assume from this that you are not yet in peak earning years, and frankly, that you'll be getting a regular annual raise to cushion the purchase over time. That's fairly conservative. That may not be realistic for any profession now due to global competition and the move to production-based compensation.

If you're a salesperson who relies on commissions, or work in a volatile industry, less than 25% is a going to be a good rule of thumb. There is no way to handle fluctuations in income without a good savings account of at least 6 months of income (not just living expenses, but income). A conservative approach would be 12 months of income. Most americans are too stretched to even consider saving this amount, which is a scary prospect and increases the likelihood of default and bankruptcy.

On the other hand, many of these 25% of gross income suggestions were before the bubble and also before AMT was a significant problem for middle-income americans.

I think it's time to do away with the 25% in favor of something more suited to a person's point in life... maybe more for some circumstances, and maybe much less for others.

Chuck Ponzi
www.socalbubble.com

May 4, 2007, 10:17:00 AM  
Anonymous Anonymous said...

"I think it's time to do away with the 25% in favor of something more suited to a person's point in life... maybe more for some circumstances, and maybe much less for others."

I think the question should be more like how "hard-core" are you for the Bay Area? How much pain and money is it worth for you to live here? Do you really think that paying 3 and 4 times the amount to live in the BA versus- say Dallas TX is worth it? I feel like the only person who isn't exactly thrilled with this area even if it was affordable. So naturally to me I don't have the same urgency to buy something.

I'm sure the BA mentality will assure prices will stay nice-N-high for those would-be home buyers even after the crash.

May 4, 2007, 10:56:00 AM  
Blogger Graeme said...

"How much pain and money is it worth for you to live here?"

Low pain, and not that much money - I rent!

May 4, 2007, 11:56:00 AM  
Anonymous Anonymous said...

It seems like all the best places are going to be bought and hoarded by rich people. In some ways I think I understand how native American Indians or Native Hawaiians must feel. It's really a rip....and we have to move to the reservation.

May 4, 2007, 7:50:00 PM  
Anonymous Anonymous said...

Marinite / Tom..

Great stuff.. thanks for the research and posting.. I'm sure this info will come in handy in 2010 (or later) when it's time to buy again..

Matt

May 5, 2007, 7:38:00 AM  
Anonymous tom stone said...

Chuck,your points about the percentage of income that is appropriate to allot to a mortgage are entirely valid,as are your comments on saving.i picked a conservative number as a benchmark,one that i believe to be generally valid.for those interested in how the mortgage market works,i highly recommend the "ubernerd" series of posts by "TANTA" at calculated risk,Marinite links there.I work in the field,and CR has taught me more about how RE finance works than anything else.as far as not needing an agent,some still will.they just don't have the time and energy to do the work if they have kids and full time jobs.if you are in that position,get a good buyers agent,require that they do all the due diligence mentioned (yes you will have to pay for some of the background searches,so what)and offer your agent 2.5% commission on fsbo homes...if they can get you a GOOD price.now i'm almost famous i'm hoping to get a table at "D's Diner" in sebastopol without a wait.Thank you Marinite!

May 6, 2007, 8:26:00 PM  

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