In one of our earlier posts we mention the option period. In this, we are going to take a closer look. The articles in this blog are a practical guide to owning and operating your own single family rental property business in the Dallas, Fort Worth, Denton area or the DFW metroplex spanning Collin, Dallas, Denton and Tarrant counties. While the general concepts may apply elsewhere, this is the area that the specifics apply to.
After a contract is executed, which means an offer has been made, the offer has been accepted, all parties have signed and all parties have been notified that all parties have signed, the option period begins. In the promulgated One to Four Residential Resale contract (by the state of Texas), there is a paragraph that offers the buyer an unrestricted option to terminate the contract during what’s called the option period (if an option fee was paid). In many other states, contracts themselves are written subject to inspection findings. In Texas, the right to terminate is broader (at least as stated in the promulgated contract).
When you are buying foreclosures, it is very likely that the contract process includes a “Seller Addenda”. This is usually prepared by the banks and most of them are very similar in content. As far as option period goes, most reduce it to an inspection period. The reduction is in the rights to terminate, not necessarily the period. Normally the banks offer about a 10 day inspection period. The inspection period is different from the option period in that, usually you can terminate only due to inspection findings and sometimes due to inspection findings not apparent at the time of offer. As it is not an option per se, there is no option fee.
Several foreclosed homes, when they are priced right, create a bidding war. Some buyers offer more than what they are truly willing to pay simply to win the bidding war. Then they negotiate in the option period (when the seller is exclusively working with that buyer). It is advantageous to the buyer. However, several properties return to market as contracts are terminated during the option period. The inspection period counters that to an extent by requiring buyers to offer true values during the offer period and only negotiate or terminate for inspection findings. It’s often not stipulated though that who constitutes an inspector? Is an insurance sales person commenting on the condition of a roof an inspector? Is a contractor commenting on a condition an inspector or must the inspector be a licensed inspector in the state? That, the Seller Addendum may stipulate or it may not. Be clear on what your rights to terminate are and what are the limits.
So, now you are in the option/inspection period. In which order must you inspect? Always assume that you may have to exit the deal due to some finding. As an investor you need to keep your inspection costs down. When you are working with your mentor (if you don’t have a mentor – get one; read the blog on Getting a Mentor), your mentor will tell you what’s most suspect with the property. You will get good at “suspecting” based on “evidence” you find when you walk the property. That comes with practice. Staggering inspections from the free ones to the most expensive ones is just common sense. If you detect an incurable or severe objection then you can exit the deal with minimum inspection costs. For example, if you suspect foundation issues, get two to three reputable foundation companies to give you condition reports and bids. Read the blog on finding and keeping good contractors. A Foundation evaluation specialist will take elevation readings at various points inside the house and can tell you where foundation correction/lift is required. He/she will also advice you on what other issues can come up during the lift. The probability of pipes breaking, hard surfaces such as ceramic tile or granite cracking, windows breaking etc. They can’t provide guarantees but use your own knowledge of physics and geometry to make reasonable assumptions about pipe movements and other stresses. Your mentor is invaluable here. The cost of this evaluation is usually $0 as foundation evaluation personnel are sales personnel of the foundation company. When you get multiple reports, you can see if someone is just way off or if all of them pretty much align.
Getting a roofer or your insurance company agent to check and opine on the roof. This is another “free” inspection. You can get other contractors bidding for work to give you reports in this manner.
When it comes to professional inspections, the first inspection that makes most sense (often) is a supply and sewer line leak test. Before we get into this we must take an important detour and discuss turning utilities on. Some sellers have utilities such as water, gas and electric on. Some don’t. So before you get into the option period, you need to know if you can turn it on and if so what the lead time for turning it on is, what fees if any are involved, etc. HUD properties usually don’t have utilities on and sometimes they will not let you turn utilities on if they suspect some defect exists that will cause further damage to the property if utilities are turned on. These matters make inspections more difficult. Your mentor should be able to tell you how to evaluate such deals.
Okay, getting back to the subject: A supply line is under pressure. A pressure test is fairly simple. Usually it is done by connecting a pressure gauge to a convenient supply line tap point like a faucet in the utility room (the one that supplies the washer). Once the faucet is turned on, the pressure gauge will read water pressure, say 40 PSI. Make sure the water heater is in the circuit (that is hot and cold water pipes are connected through the water heater). Now, walk to the curb outside and turn the water supply to the house off. If there is no leak in the supply lines water pressure will hold. Check for 20 minutes or so and if there’s no drop in pressure, there’s no leak. It is a simple test. If the pressure drops, then turn off all the shutoffs (mainly for the toilets) and repeat the test. Toilets are notorious for small leaks that show up in the test. After isolating the toilets if the test passes, the connection supply lines are fine. You may have to fix the toilet leaks. Even without this test, if you have all the faucets shut off, then the water meter dial at the curb should not spin if there is no leak, but that is not a sufficient test.
A sewer test is a bit more involved but essentially the same concept. The sewer line is different in one significant way: The lines are not under pressure. So to check for a leak, you will have to fill the lines up (at least to the first drain level). This is done by using an inflatable ball that blocks the line from the house to the street sewer and then filling the sewer lines up with water (using the garden hose). This is fairly straightforward if the “clean-out” is readily accessible. Clean-out is a tap into the sewer lines meant for “cleaning” or unblocking the sewer lines but it makes checking for sewer line leaks rather simple. Once the lines are filled with water, monitor at the clean-out for a drop in water level. If there is no drop then at least the sewer lines up to the first drain level are fine. Talk to your plumber, inspector or mentor about vertical sewer pipes (risers) and the impact of leaks there. Or, as an experiment, buy a PVC pipe, drill a hole on the side, hold it vertically and pour water into it. How much water exits from the hole? Key is that sewer lines are not under pressure and the pipes are often 2 inches or more in diameter.
If you are not comfortable doing either one of these tests yourself, you should get a licensed plumber (often one who specializes in supply and sewer leak test) to do the tests for you. This is often less expensive than getting a full blown inspection and inspectors may not perform this test (they often do not). Note that at this point you are only interested in finding if there is a leak or not, not where the leak is. That is a more expensive test and your mentor will tell you if it is worth proceeding to that test (if there is that much equity in the deal).
Based on the condition of your property there may be other specific tests that you may have professionals do before you get to a full blown inspection. Often these specific tests are less than half the cost of an inspection and most likely an inspector is only going to recommend that these specific tests be done by licensed professionals if those areas are suspect. So you might as well do them first. Then if you decide you want to exit the property, you can with minimal loss.
When you are getting started, a full inspection is almost indispensable even though by that time you have learned many things you need to know. As you get more comfortable with property conditions and getting isolated areas of concern tested, you’ll forego the full inspection.
If you decide to exit a deal, make sure you are within the option/inspection period and provide clear direction to the selling party. Provide any inspection reports that may be required. If you decide to rather negotiate based on inspection findings make sure that all negotiations are done before the inspection/option period expires. If the seller has not responded to your “negotiation” and the option/inspection period expires, the original contract is in effect (in the state of Texas). If you exit after the inspection/option period you may lose your earnest money.
You will notice the phrase “Time is of the essence” in contract documents when option/inspection periods are addressed, so time is of the essence so make sure that you have accounted for lead times as you work with contractors and inspectors. Do not wait till the last minute and then expect those you need, when you need them are available. Tell your inspectors and contractors that you are in an option/inspection period. Don’t be surprised if you find that the vendors with reasonable costs and not available and the ones available are expensive. That is not a coincidence; it’s cause and effect.