Monday, October 24, 2011

Real Estate Investor Mistake # 3 - Vacancy Mis-Reads & Cash

You're reading an advertisement for a property that you want to buy and you see a stellar's 100% occupied!  Great you say, and you are so enthusiastic that you put an offer immediately after looking at the financials because you're convinced you have a good deal......

HOLD ON!  Did you determine what the Economic Occupancy is?  What's the average vacancy in the area you're looking in?  How does this property compare with the average for the area?  There is a very big difference between Physical Occupancy (that which is almost always advertised by the realtor or the seller), and Economic Occupancy.

Economic Occupancy is the % of your tenants that pay their rent.  Physical Occupancy is the % of tenants that are inhabiting the property.  There is a very big difference between the meaning of these terms.  You could have a 100% full building but if a large percentage of tenants are paying late, or not paying, that is going to impact your cash flow and the value of your building.

Find out what the Economic Occupancy is in the property by looking at the P&L and verifying that the numbers that you are being given are in fact true.  You can do this by asking for the portion of the tax return that the seller sent to the government for the property and comparing this with the P&L statements provided to you for the past two years, rent rolls, invoices for utilities, bank statements, copies of leases, cancelled checks etc.  The figures for the tax return and the P&L / rent rolls should match.  If they don't, then you must determine why because you now do have a problem, and that's either major or minor depending on the discrepancies.

You have to protect yourself from sellers that are potentially trying to mislead you with false and/or incorrect numbers.  I'm not saying that all sellers are doing this potential activity, but what I am saying is that you should follow what Ronald Reagan said...."Trust....but verify".  The only way to verify is to work with documentation and never, ever accept documentation where the seller says, he/she accepted cash payments for rent unless this is a very small portion of overall revenue.  You will have to be the judge of how small a portion is acceptable to you.  The best is that no cash is exchanged.  You can never verify this type of activity and you are setting yourself up for trouble if you accept this.  You may luck out if cash payments were being taken, but you may also get burned.  Why take the risk?  No cash exchanges are the best situation to start with.

So once again, make sure that you can verify the "Economic Occupancy" of the property by doing your proper due diligence and please do yourself a big favor:  Don't accept Pro Forma financials.  The risk is not worth it.  You want to buy a property based on how it's performing now, not on possible or improbable future numbers that you probably won't hit.  It's better to be conservative and protect yourself.  Also, out for "cash payments" for rent.  There is no way to verify where the cash came from.

Until next time, have a fantastic week.

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