Buying Investment Property

Buying Investment Property

Buying Investment Property
First a​ little story about buying investment property .​
My wife and I​ stayed at​ a​ motel in​ Tucson for a​ week one winter .​
Our bill was for twice what it​ should have been, but since I​ already paid the correct amount in​ cash, I​ thought nothing of​ it .​
During our stay, we noticed that the lobby and swimming pool were unheated, and passed it​ off as​ frugality .​
a​ year later, however, when I​ read a​ news story about a​ new owner struggling to​ make the motel work, I​ realized what was really going on.
To prepare the motel for sale, the owner had been using the two most basic ways to​ inflate the appraised value: decrease expenses and increase reported income .​
Stopping repairs, turning down the heat, and quietly adding $100 in​ income to​ the books every day, might have increased the net income for the year by $45,000 more .​
With a​ .08 capitalization rate, that means the appraisal would come in​ $562,000 higher than it​ should have .​
Imagine the the poor guy who overpaid!
To avoid a​ mistake like this when buying investment property, you need to​ watch for tricks like these .​
You also need to​ understand the basics of​ appraising income property.
Valuation of​ income properties start with the capitalization rate, or​ cap rate .​
When investors in​ an​ area expect a​ return of​ 8% on assets, the cap rate is​ .08 .​
The net income before debt service is​ divided by this to​ arrive at​ the value of​ a​ property .​
This is​ expleained further in​ another article, but the primary point to​ remember is​ that every dollar of​ extra income shown will increase the appraised value by $12.50 with a​ cap rate of​ .08 (Or, for example, by $10, if​ the cap rate is​ .10).
Avoid Dirty Tricks When Buying Investment Property
When sellers of​ income properties increase the net income by honest means, the property should sell for more .​
However, there are many dishonest ways, both legal and 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 .​
These tricks are about income and expenses.
One way income can be inflated, is​ by showing you the pro forma, or​ projected income, instead of​ the actual rents collected .​
Demand the actual figures, and check to​ see that none of​ the apartments listed as​ occupied are actually vacant .​
See if​ any of​ the income is​ from one time events, like the sale of​ something.
The income from vending machines is​ a​ gray area .​
Many smart investors subtract this from the net income before applying the cap rate, then add back the value of​ the machines themselves .​
For example, if​ laundry machines make $6,000, that would add $75,000 to​ the appraised value (.08 cap rate), if​ you included it .​
However, since they are easily replaceable, adding the $10,000 replacement cost instead makes more sense.
The other important tricks sellers play involve hiding expenses .​
These can include paying for repairs off the books, or​ just avoiding necessary repairs for a​ year .​
This can dramatically increase the net income, meaning you pay more for the property .​
It also means you have less income than expected, and deferred maintenance to​ catch up on .​
Ask for an​ accounting of​ all expenditures .​
If a​ number in​ an​ expense category is​ suspicious, replace it​ with your own best guess .​
Then re-figure the net income.
Look at​ 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 .​
Do your homework, and avoid seller's tricks when buying investment property.

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