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Avoid This Seller's Dirty Trick
When Buying Rental Property

By - 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 value.

Analyze each of the following, verifying figures as much as possible, and substituting your own guesses if they are too suspect:

Vacancy rates

Advertising

Cleaning

Maintenance

Repairs

Management fees

Supplies

Taxes

Insurance

Utilities

Commissions

Legal fees

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 on appraisal 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 be careful.


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