Avoid Seller’s Tricks When Buying A Rental Property

Buying rental property can be a fantastic way to invest for the future. Just watch out for these typical tricks that sellers use to inflate the appraised value.

Be careful when purchasing rental property. We stayed at a motel for a week one winter. The bill showed twice what it ought to have, but since I already paid the correct amount in money, I thought nothing of it. When we noticed that the lobby and swimming pool had been 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 recognize what was going on.

The owner had been planning to sell. To prepare, she was using the two most basic techniques to inflate the appraised value: decrease expenses and improve reported income. By stopping repairs and quietly adding $100 in income every day, she might have shown $45,000 much more net income for the year. At a .08 capitalization rate, that means the appraisal would come in $562,000 higher than it must have. Oops! The poor guy who overpaid!

Do you would like to avoid a mistake like that when buying rental property? You’ll want to watch for tricks like these. You also need to understand the basics of appraising income property.

It starts with the capitalization rate, or “cap rate.” If investors in an region expect a return of 8% on assets, the cap rate is .08. Net income prior to debt service is divided by this to arrive at the value of a property. I explain this further in another article, but the primary point here would be to bear in mind that each and every dollar of extra income shown will increase the appraised value by $12.50 with a cap rate of .08, or by $10, if the cap rate is .10.

Sellers Dirty Tricks

If sellers of rental properties increase the net by honest means, then the property must sell for far more. Unfortunately, there are lots of dishonest techniques, both legal and fraudulent, which are sometimes employed. Unlike sellers of houses, who may possibly cover foundation cracks with plaster, the tricks used by sellers of income properties aren’t about appearance. They are about income and expenses.

Income might be inflated by showing you the “pro forma,” or projected income, as opposed to the actual rents collected. Ask for the actual figures, and check to see that none of the apartments listed as occupied are truly vacant. Also, be sure that none of the income is from one time events, like the sale of something.

Income from vending machines is a gray area. Smart investors subtract this from the net income prior to applying the cap rate, then add back the value of the machines themselves. If laundry machines make $6,000, for example, that would add $75,000 to the appraised value (.08 cap rate), if included. Since they’re effortlessly replaceable, adding the $10,000 replacement price instead makes more sense.

Hiding expenses is the most widespread of seller’s tricks. Paying for repairs off the books, or just avoiding essential repairs for a year, can dramatically boost the net income. Demand an accounting of all expenditures. If a number in an expense category is suspicious, replace it together with your own greatest guess.

Analyse each of the following, verifying the figures as much as achievable, 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 make purchasing rental property safe.

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