Buying Rental Property

Buying Rental Property
Avoiding Seller's Dirty Tricks
Are you considering buying rental property? Let me tell you a story. We stayed a week at a hotel one winter. Our bill showed twice what it should have, but since I already paid the correct amount in cash, I thought nothing of it. We noticed the lobby and swimming pool were unheated, and thought it was frugality. A year later, when I read a news story about a new owner struggling to make the hotel work, I realized what was going on.
The owner was planning to sell, and she was using the two most basic ways to inflate the appraised value: decrease expenses and increase reported income. Just by stopping repairs, not heating the pool, and quietly adding $100 in false income every day, she may have shown $45,000 more net income for the year. With a .08 capitalization rate, that means the appraisal would come in $562,000 higher than it should have. What could the poor guy...
Are you considering buying rental property? Let me tell you a story. We stayed a week at a hotel one winter. Our bill showed twice what it should have, but since I already paid the correct amount in cash, I thought nothing of it. We noticed the lobby and swimming pool were unheated, and thought it was frugality. A year later, when I read a news story about a new owner struggling to make the hotel work, I realized what was going on.
The owner was planning to sell, and she was using the two most basic ways to inflate the appraised value: decrease expenses and increase reported income. Just by stopping repairs, not heating the pool, and quietly adding $100 in false income every day, she may have shown $45,000 more net income for the year. With a .08 capitalization rate, that means the appraisal would come in $562,000 higher than it should have. What could the poor guy who overpaid say? Oops!
Do you want to avoid mistakes like this when buying rental property? Learn to watch for tricks like these. You also need to understand the basics of income property appraisal.
Start with the capitalization rate, or "cap rate." If investors expect a return of 8% on assets, the cap rate is .08 for that area (ask other investors or real estate professionals for the going rate). Net income before debt service is divided by this cap rate to arrive at the value of a property. I explain this in another article, but the point to remember is that extra income equals a higher price for you. 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.
Watch For These Dirty Tricks
When sellers of rental properties increase the net by honest means, the property should sell for more. Unfortunately, there are many dishonest means, some legal and some fraudulent, that are sometimes used. Sellers of houses may cover foundation cracks with plaster, but the tricks used by sellers of income properties aren't about appearance. They're about income and expenses.
Income is often inflated by showing you the "pro forma," or projected income, instead of the actual rents collected. Get the actual figures, and check to see that none of the apartments listed as occupied are actually vacant. Also, be sure none of the income is from one time events, like the sale of something.
The income from vending machines is a gray area. Smart investors subtract this from net income before applying the cap rate, then add back just the value of the machines themselves. If laundry machines make $6,000 in income, for example, that would add $75,000 to the appraised value (.08 cap rate), if included. Since they're easily replaceable, adding the $10,000 replacement cost instead makes more sense.
Hiding expenses is the most common trick. Paying for repairs off the books, or avoiding necessary repairs for a year before selling, can dramatically increase net income. Get an accounting of all expenditures. If any number in an expense category is suspicious, replace it with your own guess, and subtract that from the net income before figuring the property value.

Finally, analyse 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 and any other expenses. Look closely, and understand the usual tricks - this is how you make buying rental property safe.