Real estate investing can be simple in theory. You buy rental properties for a price and terms that provide positive cash flow, or you buy a home which you can fix up and sell for more. In practice, though, applying these simple principles involves a lot of educated guesses. Nobody really knows precisely what a house will sell for once it is fixed up. You also can’t say for sure how many vacancies you’ll have in an apartment building.
Fortunately, with real estate investing experience your guesses get better. But then there are the tricks and outright lies that some sellers will throw in your way. Bad information makes good guesses difficult to make. How do you protect yourself? Watch for the following dirty tricks that some sellers have been known to use.
The most common tricks involve simply hiding facts about a property. This may be illegal, but only if the seller knows about a problem. How do you prove that a seller knew there were foundation cracks behind the paneling in the basement? You probably can’t. Unless you know a lot about the building trades, you should normally pay for a home inspection – preferably by someone with some building experience.
However, not all sellers are so careful about what they say. If you sense there is a problem with water in the basement, for example, ask about it. If the seller denies there has ever been flooding in the basement, get him to write “There was no standing water in the basement during the time I owned the property.” The point here is that if you later find water, and the carpet cleaner who sucks it out for you mentions doing the same job there a year before, you have evidence that the seller was lying.
Income And Expense Tricks
With rental real estate, the more dangerous tricks are the ones involving the reported income and expenses. You can have a property inspected, after all, for physical problems, and a rotten roof is hard to hide. On the other hand, it is more difficult to prove that a seller paid cash for snow-plowing to keep the expense off the books prior to selling, or didn’t really collect as much in rent as he said.
Why is it so important to watch for this in real estate investing? Naturally, you would be upset if the expenses are higher than they should be on your rental, or the income lower. But this goes beyond your cash-flow problem. Rental real estate is valued according to net income, so if this was reported incorrectly, you may have paid much more than you should have for a property – and much more than you can sell it for.
This gets into the area of capitalization rates, or “cap rates.” A simple explanation: If investors in an area expect a return of 8% on a property before debt service, this is the expected cap rate. So if a property produces net income of $50,000 before debt service, it is worth about $625,000 ($50,000 divided by .08). Now, if expenses are hidden and income exaggerated, so the seller can show a net income of $60,000, you could pay $750,000 ($60,000 divided by .08) – a big mistake, right?
How then, does a seller exaggerate income and reduce the reported expenses? Expenses can be paid for in cash or with a personal check in order to keep them off the books. That’s fairly easy to do, but it does leave clues.
If the property is in a northern area and there is no expense listed for plowing, that is suspicious. Of course it may be that the owner of an apartment building shovels away the snow himself. But since most owners wouldn’t do this, you better add a reasonable expense for this and adjust your projected net income figures before putting a value on the property.
Look carefully at the books and note the expenses shown for maintenance, repairs, advertising, cleaning, management fees, supplies, taxes, insurance, utilities, commissions, legal fees and any other expenses. If any of them seem unusually low, ask about that, or better yet, just estimate a reasonable amount and use that to adjust your net income figures. Also compare the vacancy rates shown to the average for the area and ask questions if it seems too low.
Reported income is also easier to manipulate than you might think. Suppose an owner of a 30-unit apartment building plans to sell it. To show more income, he starts playing with the books a year before the sale. First, he reports income from non-paying and even evicted tenants (watch for those unusually high occupancy rates).
Then, several months prior to putting the property on the market, he raises the rents to $100 per month over the area rents. He knows that people take time to move, so the income spikes up temporarily, and by the time apartments start going vacant you have bought the building. Now you face an exodus of tenants.
Another common trick is to include items that are not part of the normal rental income. This might mean one time income, for example, like the sale of an extra lot or company vehicle. It can also be income from vending machines or laundry facilities. In the latter case, subtract out the income, figure the property value based on the new net income figures, and then add back the replacement cost of the machines. (There is some debate as to whether it is fair to include this type of income when figuring the value of an income property.)
You might think that an owner would hesitate to show extra income or lower expenses. He does have to pay more in taxes after all. But look again at the example above. Showing an extra $10,000 makes his property apparently worth $125,000 more. He might be willing to pay a few thousand in taxes to get that – and you might be stuck with a property that loses money and can’t be sold for anywhere near what you bought it for. Real estate investing can be tricky.