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Would the Real Income Property Expert Please Stand

Would the Real Income Property Expert Please Stand

Posted: 22 Jul 2008 10:19 AM CDT

Heisenberg the German physicist said “An expert is someone who knows some of the worst mistakes that can be made in his subject and manages to avoid them.”

Recently, NetGain received an attractive four-color brochure editorializing the investment merits of a property. Among the pictures and maps was a description of the immediate area plus a brief financial summary. It was a partisan presentation for what was proposed to be an attractive income property investment opportunity.

Since the listing agent had already described why this was a wonderful investment, NetGain’s instincts were directed to what was wrong with the picture. The focus of attention always begins with the math. Two numbers stood out: The capitalization rate (cap rate) was 5.6% and the income was predicated on market rents. These numbers call for further investigation and the question Heisenberg might ask from this brochure is “Who’s the expert?” Is it (1) the broker, (2) the seller, (3 ) the buyer’s money manager, or (4) the buyer?

1. The Broker

The broker should be designated an expert because there is no worst mistake(s) to be made from his presentation. A broker takes a listing and recommends a price to the seller based on the sale prices of comparable properties. The seller decides the price.

The intelligent broker knows that people who manage other people’s money are under pressure to invest. This broker further knows that the compensation of people who manage other people’s money increases when properties are bought. That motivation can drive a money manager to recommend the purchase of an income property with a 5.6% cap rate based on market rents. Consequently, the broker prepares an attractive four-color brochure highlighting the investment merits of the property and sends it out to the money managers.

2. The Seller

The seller should be designated as an expert because there is no worst mistake(s) to be made from this narrative. The seller has decided on a sales price based on information by the broker and his own prejudices. If the price is unrealistic, the seller changes the price.

3. The Money Manager

The buyer’s representative (money manager) should be designated with the opposite of expert (incompetent), the reason being he is about to make one of those worst mistakes. He’s going to recommend a property for purchase that he should pass over. NetGain’s own National Income Property Index (NIPI) currently recommends a 7% cap rate, based upon an objective formula that considers the mortgage market rate, the unemployment rate, and the consumer confidence index. The subject property is at a premium of 25% over NIPI’s recommended cap rate. To make matters worse the net operating income (NOI) was calculated on market rents, not collected rents. The operating expenses give no consideration for turnover vacancy, leasing commissions, increased marketing costs, and so forth. In other words, the already strained 5.6% cap rate is an inflated number. Of course, the catch-all justification is that the property’s good looks give it bragging rights.

Bragging rights aren’t enough for a pretty property that is materially overpriced, especially when the economy is trying to live through a credit crunch, record high gasoline prices, increasing unemployment, consumer confidence at record lows, fighting a war on two fronts, and a weak dollar (meaning higher interest rates).

4. The Buyer

The buyer should be designated with the opposite of expert (incompetent). The buyer made a worst mistake by hiring a money manager who put self-interest above his client when he recommended the purchase of an income property with foul numbers.

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