When Investing in Real Estate, Be Aware of Games that Sellers Play to Inflate NOI

By Eric Tyson, Robert S. Griswold

Copyright © 2015 Eric Tyson and Robert S. Griswold. All rights reserved.

The Net Operating Income (NOI) used when calculating IRV should be the projected NOI. However, sellers often price the real estate property based on the historic or most recent NOI for the past 12 months because they can support that number with their financial records. As a buyer, you should be aware that some sellers plan the sale of their property only after operating it in a soon-to-be-for-sale mode for at least 12 months — making sure that they maximize income and minimize operating expenses. Although maximizing the NOI is common sense and something that all owners should do all the time, some owners can be very sneaky about the numbers they report in the period before they make the property available for sale.

For example, they may defer income or collect lump sum payments that artificially inflate the income; they may make considerable improvements to the physical aspects of the property so they can defer normal ongoing maintenance and report abnormally low operating expenses for the 12 months leading up to the sale. They can do this by simply stockpiling the most commonly used parts and supplies and then using the excess inventory so it looks like they didn’t have these expenses during the past year. Or they may claim that many of the normal operating expenses of the property are capital items and not part of the NOI calculation.

Use the zero-based budget method of projecting the income and operating expenses to arrive at a realistic NOI for your first year of ownership. Developing your own numbers minimizes the possibility that you will make your investment decision on artificial numbers. And don’t stop with the NOI. Especially if the property operations have been manipulated by deferring maintenance and repairs, you want to formulate a detailed and thorough capital expense budget from what you observe during your due diligence walk-through(s). Remember that the only numbers you should trust are the ones that you have independently verified yourself.