Avoid This Seller's Dirty Trick
When Buying Rental Property
By Steve Gillman - December, 2013
Years ago we stayed at a hotel in Tucson, Arizona for a week,
and when we checked out I noticed that the bill was double what
it should have been. The owner shrugged it off as a mistake and
collected the correct amount from me, but without correcting
the bill on the computer or paper. I thought nothing of it at
the time. While there we noticed that the lobby and swimming
pool were unheated (the owner was wearing a coat as she worked
the desk), and we thought it was frugality. About a year later
we returned to Tucson for a longer stay in an apartment, and
I read a news story about the new owner of that hotel struggling
to make it work. Reading a few details about how business was
worse than expected and expenses were more than anticipated,
I suddenly realized what had probably happened.
My guess is that the owner planned to sell the place so she
used the two most basic ways to inflate the appraised value of
her hotel. They are to decrease expenses and increase reported
income, both designed to boost the net income shown on paper.
Consider the following scenario; she stopped making repairs,
stopped heating the pool and lobby, and quietly added $100 in
false income every day, using tricks like my "mistaken"
bill. By cutting expenses and recording more income she might
have easily inflated the net income shown on paper by $50,000
or more. If a .08 capitalization rate was common for that area
the appraisal would come in $625,000 higher than it should have.
I'll have more on how that works in a moment.
What could the poor guy who overpaid for the hotel do about
it now? If my suspicions were correct this was fraud, but it
would have been a tough case to prove. If you want to avoid mistakes
like this when buying rental property, learn to watch for tricks
like this one. Of course it helps to understand the basics of
income property appraisal and pricing.
Rental property, especially when it is something bigger than
a single-family home, sells according to the capitalization rate,
or "cap rate" that investors expect in a given area.
If they want a return of 8% on assets, the typical cap rate is
.08 for that area. There will always be exceptions for properties
that need more repairs or have more potential for appreciation,
and for different types of properties, but to determine the normal
cap rate you can ask other investors or real estate professionals.
To arrive at an estimate of value or to set a price then, the
net income before debt service is divided by this cap rate. For
example, if a small mobile home park nets $60,000 per year and
the usual cap rate for these properties is 10% (.10), you can
divide $60,000 by 10% to arrive at an estimated value of $600,000
for this particular park.
The point to remember is that any extra income a seller can
show can mean you will pay a higher price. For example, a dollar
of extra income increases the appraised value by $12.50 with
a cap rate of .08, or by $10, if the cap rate is .10. Sellers
of rental properties can certainly increase the net by honest
means. For example, the owner of an apartment building could
add carports or other amenities and raise the rent. He could
find a cheaper pool cleaning company which does just as good
a job. As a result of honest changes that raise income and lower
expenses he can justify a higher price based on the higher net
income shown on the next year's books.
But there are many dishonest ways to inflate the apparent
value as well. Some are legal and some fraudulent. For example,
income is often inflated by showing you the "pro forma,"
or projected income, instead of the actual rents collected.
Be sure to get the actual figures, and check to see that none
of the apartments listed as occupied are actually vacant (really
-- peak in the windows if you have to). Also, be sure none of
the income is from one-time events, like the sale of some assets.
It is somewhat of a gray area when it comes to "extra
income" being added into the mix, like income from vending
machines. Some investors subtract this from net income before
applying the cap rate, and then add back the value of the machines.
If laundry machines take in $6,000 in income, for example, that
would add $75,000 to the appraised value based on a .08 cap rate.
But since they're easily replaceable, it could make sense to
argue for a value based on just the rental income and then add
back the $10,000 replacement cost of the machines themselves.
Naturally some sellers will argue that the extra income sources
are part of the whole package and so the price should be based
on all of the net income. Negotiate!
Perhaps the most common trick is to hide expenses. A seller
could have paid for repairs off the books, or avoided making
necessary repairs for a year before selling, and so dramatically
increased the net income. To determine if this is the case get
an accounting of all expenditures, and if any number in an expense
category is suspicious, replace it with your own best guess,
and subtract that from the net income before figuring the property
Analyze each of the following, verifying figures as much as
possible, and substituting your own guesses if they are too suspect:
Any other expenses
Look for missing expenses as well. I once saw an apartment
building in northern Michigan for which the seller showed no
cost for plowing -- not a realistic scenario in that part of
the country. When I asked he admitted that he was plowing the
parking lot himself. Unless the next investor wants to do that
as well (in which case there still would be expenses), he has
to add in the cost of hiring out the job to see what the net
income will really be.
Notes: If you would like a fuller explanation of how
to find the value of a rental property, you can read our page
using capitalization rates. You might also find it useful
to read our page on what
to look for when buying rental properties. Good luck and
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