Let the Buyer Beware! Reducing Risk as a Real Estate Investor
Investing in real estate is just that—INVESTING. Risk comes with the territory. The key to successful real estate investing lies in the analysis and due diligence of a potential income property. When done prudently and methodically, the investor’s risk is not only greatly mitigated, but he or she should have clear line of sight as to the property’s return potential. Sounds relatively straightforward, right? Well, this task becomes much harder when the seller tries to make a monetary gain by feeding on the inexperienced investor’s lack of knowledge or inadequate due diligence. Luckily, we’re all savvy investors at BiggerPockets.com and we know how to spot these seller exaggerations and fallacies. Let’s examine some of the common ones.
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Common Real Estate Seller Exaggerations and Fallicies
In commercial real estate, a property’s value is determined by dividing its Net Operating Income by it is market Cap Rate. Since a higher Net Operating Income means higher building value, it’s only natural that a seller would want to overstate his buildings income. Many times, for instance, a seller will try to convince an unsuspecting buyer that laundry income, storage income, or some other miscellaneous type of income is higher than it actually is. A prudent investor knows to obtain some sort of valid documentation to prove such claims or, at the very least, make educated assumptions if documentation is unavailable.
Actual Income vs. Projected Income
Too often, listing agents will follow a column labeled “Actual Income” with pro forma, market, or projected income. This is especially misleading when this column is placed next to a “Projected Income” column. While a property’s potential is certainly a heavy consideration for any investor, the bottom line is that a property’s value is determined by how it operates TODAY! Why pay somebody else for work that they themselves will do (making projected performance actual)?
Miscalculation of Cap Rates
The equation for sales cap rate is Cap Rate = Net Operating Income / Price. While this seems academic, be sure to double check a listing agent's cap rate calculation. For example, one listing I know of advertised a sales cap rate of 6.5%. I determined that the seller had erroneously calculated the cap rate based upon Gross Operating Income instead of Net Operating Income. Taking into account expenses, I found that the seller was actually trying to sell the building at a cap rate closer to 4%!
Regardless of whether or not a property is self-managed, there is always a cost to management—whether it’s in time or in dollars. If a seller fails to do so, include a reasonable management fee when performing your analysis.
I know this is obvious, but you would be surprised to see how often a listing includes incorrect math. Sometimes a listed property’s Gross Scheduled Income and rent roll don’t equal. Sometimes the sales cap rate is miscalculated (as described earlier). Be sure to double-check the math on any listing. Interestingly enough, I’ve never found any math errors that would benefit the buyer…
In real estate investing, there are many things out of control: interest rates, water prices, market conditions, etc. Keeping this in mind, we owe it to ourselves to avoid unnecessary risks that we CAN look out for.