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.