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Real Estate Investing Course - Lesson Nine
Be careful when buying rental property. There are dirty tricks that sellers will sometimes use to get you to pay more. Let me explain with a story.
We stayed at a motel in Arizona for a week one winter. I noticed that the bill showed twice what it should have, but since I had already paid the correct amount, I thought nothing of it. Also, when we noticed that the lobby and swimming pool were unheated, we thought it was frugality. Only a year later, when I read a news story about a new owner struggling to make the motel work, did I realize what was going on.
The owner had been planning to market the property. I suspect she was using the two most basic ways to inflate the appraised value: decrease expenses and increase receipts (on paper). By stopping repairs, turning down the heat, and quietly adding a hundred dollars to the room charges every day (but not collecting it), she could have shown $45,000 more net income for the year.
Of course, she probably paid thousands more at tax time. However, $45,000 more net, at a .08 capitalization rate, means the appraisal would come in $562,000 higher than it should have. Oops! The poor guy who overpaid!
Do you want to avoid a mistake like that when buying rental property? You need to watch for tricks like these. You also have to understand the basics of appraising rental property.
It starts with the capitalization rate, or "cap rate." If real estate investors in an area expect a return of 8% on assets, the cap rate is .08. Net before debt service is divided by this to arrive at the value of a property.
I'll explain this further in the next lesson, but the primary point to remember is that every dol lar added to the net will increase the appraised value by many times as much. By $12.50 with a cap rate of .08, for example, or by $10, if the cap rate is .10.
Sellers Dirty Tricks
If owners of rental properties increase the net by honest means, then a property actually has more value. Unfortunately, there are many dishonest ways that are sometimes used. Unlike sellers of houses, who may cover foundation cracks with plaster, the tricks used by owners of rental properties aren't usually about appearance. They are about expenses and revenues.
The net can be inflated by showing you the "pro forma," or projected figure, instead of the actual rents collected (In other words, an estimate of what it might be.). Ask for the actual figures, and check to see that none of the apartments listed as occupied are actually vacant. Also, be sure that none of the revenue is from one time events, like the sale of something.
Vending machines and laundry machines are a gray area. Smart investors subtract this money from the net before applying the cap rate, then add back the value of the machines themselves. If laundry machines take in $6,000, for example, that would add $75,000 to the appraised value (.08 cap rate), if included. Since they are easily replaceable, adding the $10,000 replacement cost instead makes more sense.
Hiding expenses is the most common tricks. Repairing things "off the books," or just avoiding necessary repairs for a year, can dramatically increase the net. Demand an accounting of all expenditures. If a number in an expense category is suspicious, replace it with your own best guess.
Analyze each of the following, verifying the 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 and any other expenses. This is how you buy rental property safely.
Steve
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