You’ve found an investment property that looks great. Its appearance is one that will attract the quality of tenants you want. It is in a good, relatively safe neighborhood. You see the dollar signs in front of your eyes and imagine the figures in your bank account starting to climb. The good faith estimate from the real estate agent looks good and you have more than enough money to close.
You are excited. That’s your first pitfall. Try to keep emotion out of your buying decision. Buy investment property by the numbers, by how it will perform for you. Never buy it because “It’s so cute!” or “I just love the neighborhood,” though these are both pluses because they mean a property is easier to rent and keep rented.
The day to sign the papers comes and the title company calls you with the amount of money you’ll need to bring to closing. It is far more than what you expected and will all but drain your cash reserves, or even worse is more cash than you have. You have been trapped by one of the pitfalls of buying property.
Several things can happen to mess up what looked originally to be a terrific investment. There is no need for you to get caught in one of these if you know what to look for and you take a few simple precautions to avoid them.
Sloppy real estate agents and sellers
Real estate agents may be good at selling things, but all too often they don’t really understand the importance of accurate numbers. “Close enough” is good enough for them. I have seen many listings for investment properties that have no income or expense figures whatsoever. When you ask them about it, they say, “Oh, do you want them? I’ll have to get them from the seller.” Well, duh, that’s why investors buy investment properties, because they are an investment that they expect to show a good return, not because they look cute or it’s a nice neighborhood, which is what the listing talked about.
Many landlords are the same way. They may be good at fixing up and at managing property, but may be haphazard with their calculations and record keeping. When you ask for specifics you get a reply such as “Oh, I’ve got them here somewhere.”
Usually an inattention to accurate figures is the problem with agents who don’t normally sell rental property, just owner-occupied. The only reason the agent got this listing is because her aunt Sally wanted to sell the property. No one else would have hired this menace. They don’t seem to have a clue that your profit or loss on a property can depend on just a few dollars one way or the other. They don’t own any rental property of their own. Too many times you hear them say, “I did once, but I could never make any money on it.”
When you hear statements like the above, you’ll know you have to be extra careful in all your dealings and will have to check every figure three times. That will mean getting the rent rolls and expense records for the property for at least three years. It will also mean auditing the records by looking at receipts and seeing that repairs were done properly.
That will not be the case with a specialist in the sale of investment property. You will see that every figure is as close as he or she can get it. You will find these folks selling the large apartment complexes and may have the designation CCIM (Certified Commercial Investment Member) after their names. These are the cream of the crop. You will also find them selling small-plexes and small apartment buildings, too. You know that everything will be in order when you deal with these folks. Other specialists in the sale of investment property, those without a CCIM after their names, will also see that everything is in order.
Does that mean you can just rely on what the agent or seller tells you, if you trust their figures? Absolutely not. Real estate is the one investment that allows you to personally verify every operating figure and aspect of your potential investment, and you should, if you expect to come out alive financially.
What figures do sloppy agents and sellers mess up? All of them, of course, but we’ll look at the most common ones here.
If you are assuming an existing loan or land sale contract, you will be paying the difference between the loan balance and the sale price to the seller. The listing agent or seller him or herself give you a figure that has lots of zeros. When you ask about it, you’ll get an answer such as, “Oh, it’s about that much.” Loan balances rarely have lots of zeroes.
Those are words that can cost you thousands of dollars and possibly make the deal fall through. “About that much” could have a $10,000 to $20,000 difference between the stated and actual amounts. The higher the loan balance, the less money you have to bring to closing; the lower the loan balance, the more you have to bring. I know this can cost you a lot, because I fell into this trap. It only ended up costing me about $5,000 extra, though.
Sometimes sellers really don’t have truly accurate figures. But they can get them. You need to know within $100 how much is owed on the property if you are assuming an existing loan or contract. So write into the sales agreement the following language: “Subject to the actual balance of existing loan being no less than $x.”
Operating expenses can use you up and drive you into bankruptcy. I looked at a property once that showed a great gross income, but actually lost money. Fortunately, in this case all the figures were on the listing for potential buyers to see.
You don’t want to rely on the figures in the listing, though. You want to see the actual expenses on the property as reported on the seller’s tax return. But even there the classifications aren’t broken down into enough detail. Possibly the seller paid some operating expenses out of his personal checking account and forgot to include them in his figures.
A printout from Quicken or Quickbooks or some other software (or, as is the case with most landlords, a copy of a handwritten ledger) is a must. Once you have the printout, start looking for things that don’t make sense or for omissions. Here are items that should appear on a list of expenses:
Property taxes, rental taxes, insurance, electricity, gas, oil, water, garbage, management costs, repairs and maintenance, advertising, telephone. In many cases tenants pay their own utilities, so you wouldn’t find those expenses, but if they don’t appear on the expense report, ask about it.
As an experienced landlord and investor, you also know about how much things should cost. Look for discrepancies in amounts between reported and what you know to be real and for things that the seller did not spend money on that will end up being deferred maintenance and will cost you big time in the future.
You will find things listed as expenses that should not be expenses but rather capital improvements. Those would be non-recurring items such as new carpeting, drapes, roof, and so on. If you see these listed as expenses subtract them from the expenses, because you will not have to spend the money again in the coming year or so. That will increase your bottom line.
Also look for figures that have a lot of zeros. If you see a items such as taxes $1,400, water $100, insurance $200 and so on, it is a signal that those figures are wrong. Had the owner really gone through his books and added up the amounts he actually paid, he would not end up with round numbers.
Here is the language for the sale agreement:
“Subject to buyer’s review, verification and approval of subject property’s expenses within five days of acceptance of this offer.”
You need to know exactly who you are getting, if there are existing tenants in the property. You need to know how much rent they are paying, their payment history, their complaint history; you also need to see copies of all letters and notices sent to tenants.
One of the ways you will be calculating the value of the property is by the amount of rent it fetches. Too many times I have seen notes such as “rents should be higher” in flyers and listings. Hogwash! You must assume that the rents are exactly where they should be.
Look at it this way, if you raise the rents to market rate after you buy the property, many tenants whose rents are below market now (if that’s indeed the case) are going to move, just to get even with you if nothing else. That will mean you have vacancies that will cost you more than the increase in rent you would have gotten. The fact is, you are stuck with the rents the property is getting now, no matter how much the real estate agent or seller protest otherwise. If they should be higher, why didn’t the owner raise them?
This is a lesson for landlords considering selling their properties, as well. Experienced investors will look at current rents, not what the rents “should” be. So get your rents up to market before you put the property up for sale.
Here’s the clause to write into the sales agreement:
“Subject to buyer’s review and approval of existing tenant records and rent schedule within five days of acceptance of this offer.”
Deposits on hand
You might consider this to be a part of the tenant records, and it is, but this is a dollar figure that can be a surprise to the uninitiated. When you are ready to sign all the papers at the title company or lawyer’s office, you will have to, as buyer, pay the seller for all the security and other deposits he is holding. On a large complex that can amount to many thousands of dollars. For a duplex or triplex it could still be $2,000 to $3,000. Factor that into your estimate of closing costs at the beginning of your consideration of a property.
Other things to watch out for:
Liens that may be in the offer
The seller may or may not know about them. Or he may have heard rumors, but nothing else. But the surprise may come six months after you have taken possession when you get a notice that the city is going to put sidewalks in front on your complex and you get to pay.
Impending liens won’t show up on title reports, but they could be common knowledge around the neighborhood. It behooves you to check with the owners of other properties in the area to see if they know of anything in the near future that could cost you a bundle.
Side agreements with tenants
You will find all kinds of side agreements that owners make with tenants that you never see in writing. He might have promised the tenant that he will redecorate the entire apartment if he renews for a year; he might have told the tenant his last month’s rent is free for a one-year renewal. Who knows?
You need to ask the seller to certify that there are no agreements with tenants, orally or in writing, except those he has disclosed.
Language for the sales agreement:
“Seller certifies that he has made not oral or written agreements with tenants that he has not disclosed in writing to the buyer.”
Then take it one step farther: make the seller provide estoppel certificates from each tenant. See the article and form elsewhere in this issue.
Finally, and/or first, because you may want to do it both before you write the offer and after you get the actual figures on the property, run the numbers through some investment analysis software to see where you stand. I suggest Real Estate Investment Analysis Software available through Cain Publications, but there are others out there. Looking at the numbers using that tool can save you thousands of dollars.
There is a lot of money to be made investing in real estate and a lot of money to be lost. How you approach the purchase of it and how well you dodge the pitfalls will determine how well your investment works for you.