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I am learning about investing in multifamily real estate (apartments). I understand some of the key figures for evaluating multifamily properties, such as CAP rate and cash-on-cash returns.

All of these calculations rely on historical revenue and expense data provided by the seller. The seller should be motivated to portray their property in the most favorable light possible so they can get the best price/

What's to keep them from fudging these numbers? How do I really know the occupancy rate, rents and expenses are what they say they are?

Expenses in particular seem easy to lowball, either through intentional deception or honestly, just due to different options different owners have.

For example an owner who is also a plumber or contractor, or who has a brother who is an electrician or whatever, could do a lot of work themselves or at discounted rates that result in significantly lower expenses than another owner could, which could lead to more a very favorable CAP rate.

I understand the flip side of this is what makes multifamily investments potentially good opportunities: through better management (including doing things yourself, or making improvements that can justify increased rents), you have better upside than the current owner (you hope).

Do most investors just accept the seller's historical expense and revenue data as the gospel truth?

Is there any recourse if they turn out to be materially different than reality?

For example what if the owner said occupancy was 95% but after the purchase you find this figure was inflated?

Or you find there was a significant hard dollar expense that was not included in the data presented by the seller prior to the sale?

Or you find there was a significant repair the seller did themselves at zero labor cost?

Caveat emptor and all that...but should you believe anything you are told? Is it all stuff you need to really do your own homework on and arrive at your own conclusions...for example if every other property you look at of similar size and age have consistently higher expenses, do you just walk away?

I figure you need to make your own projections of future expenses based on your own (or your paid professional's) inspection of the property. For example if all of the refrigerators and washers/dryers are 20 years old, you can expect to have to replace a lot of them in the near future.

How far back do you typically get data in evaluating a property? If all the appliances were replaced 3 years ago, appliance repair and replacement costs will be very low for the immediate prior 12 months for example, again resulting in a more favorable CAP rate.

Here's an example: http://www.ballard10.com/page2.html While the utilities, taxes, and insurance are probably trustworthy exact figures, that "misc." expense of $1600/year seems suspicious. It must include 100% of the maintenance expenses. Having to replace a couple of appliances, deal with a leak in the roof, or do some painting and that figure will balloon by thousands of dollars.

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    Interesting question but seems to be a little outside of "personal" finance. – Vitalik Nov 14 '10 at 20:54
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    @Vitalik: I'm a person, its about my finances. I'm not running my own REIT or in partnership with anyone else where this is a commercial venture.. The site definition says questions about how to invest wisely are in scope. Seems pretty in scope. – Pat Nov 14 '10 at 23:59
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    I think this is on topic. It is a question of how to evaluate the costs of a purchase when you don't know how accurate all of the information is. @Pat: Well written. – Alex B Nov 15 '10 at 17:48
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Knowledge is power, especially in real estate. Everyone else is out for themselves.

Need to estimate repairs? Pay someone (who won't be in the running to fix any problems) for their time to see what the big gotchas are.

Want to be sure of occupancy rate? Ask for rental agreements and cancelled checks. Get proof, not promises.

All the owner wants to do is sell it to you, at whatever combination of price / terms / speed he needs. Then it's yours, warts and all.

  • I kinda suspected that was the drill. I guess you just take the seller's statements as a starting point for due diligence and trust them to the extent they can be independently verified? – Pat Nov 15 '10 at 0:00
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    @Pat Even independently verified isn't always helpful. I moved into this one house that averaged $100 of heat use for the previous year. We moved in and our heating bill was something like $250. It turns out they had sealed off 2/3 of the house and were only living in a tiny portion of the space. – Alex B Nov 15 '10 at 17:50
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    +1 Get proof, not promises. And, as Alex points out: dig, dig, dig. There may be more to the story than meets the eye. – George Marian Nov 16 '10 at 16:15
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While you may not get these from the seller, you can ask for the Schedule E forms from their prior years' tax returns.

Why will this help? There are two things happening here.

  1. The seller is motivated to show you the property in the most favourable light. This means showing as much profit as possible. They make this choice knowing the purpose of the disclosure documents. This means they're motivated to tweak the numbers a bit.

  2. The seller is motivated to show the IRS the property in the least favourable light. The seller wants to show the IRS a loss so they can minimize their tax burden. This is usually submitted without consideration for potential evaluation by a seller, months or even years before they consider selling the place. No one is really thinking "hey, I should pay more tax this year in case I sell my place, so I can convince a potential buyer it's more profitable than it is". This is the other end of the scale of truthfulness.

If these two sets of numbers are the same, you can feel relatively confident you're not getting tricked.

If they're different, the truth probably lies somewhere in between them. Ideally, I would negotiate the price based on what you see in the Schedule C, unless the seller can convince you that something has materially changed since the return was filed. (repairs, market adjustment, renovations, etc...). Use your judgement here.

Having said this, I think it'll be hard to get the seller to show you their schedule C, because it's likely that it shows their property to be less profitable than their disclosure.

The harder they try to hide it, the more likely it is that the number on the disclosure is misleading. Especially if you offer to let them redact any other info pertaining to other properties of irrelevant items on the filing.

If they show you the Schedule C without a fuss, this would signal to me that they have little to hide.

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