Sometimes it’s hard for a property owner to misrepresent occupancy. Retail centers, for instance, tend to have large glass windows and merchants open for business during business hours. With mobile home parks, the unit is either there or not there. On the opposite end of the spectrum are large apartment buildings and hotels. When inspecting these types of properties, the appraiser needs to be much more careful to protect against deception because many units may not be freely accessible or visible from the outside.
Sometimes it’s not practical to fully inspect an apartment complex of several hundred units. In these cases, it is important for the buyer or inspector to be in control of the sample selection of the units to be inspected, so as not to be “steered,” and to select units in different sections of the property. (“Steering” is the practice of preventing access to units that may have been misrepresented as to size, occupancy, or condition.) As you verify that each tenant who is supposed to be there is actually there, you will come to a point at which you can feel confident about the rent roll’s representation of occupancy and tenancy. But wait, there’s more!
Why Verifying Collected Rent Is So Important
It is important to remember that occupancy alone doesn’t bring in revenues; rental income does that. A property inspection should include some elements of rent verification whenever possible and some study of past rent rolls to better understand tenant histories.
For an income-producing property, a non-paying tenant is a worse drag on profit than a vacancy. At least the vacancy may be promptly filled without having to hire a lawyer. One of the costliest mistakes for a client that an appraiser can make is to assume that all occupants are paying rent. It is better to have vacancies than deadbeat tenants. A property that is 25% vacant might be preferable to one that has 25% of its tenants not paying rent, as deadbeat tenants can be difficult to dislodge.
Talk to the Tenants
To guard against relying on a fraudulent rent roll, ask tenants on site how much rent they pay. The responses may surprise you.
The most revealing answers tend to be made out of earshot of the landlord, where some tenants may feel more comfortable divulging embarrassing information. The following are some actual answers I have received from tenants that suggested possible rent collection problems:
Some tenants speak foreign languages, so it pays to learn numbers and simple questions in other common languages. In the Southwest and many major American cities, apartment tenants may speak Spanish. Asking “Cuanto paga para la renta cada mes?” (“How much do you pay in rent each month?”) and learning numbers in Spanish can be helpful. If you cannot memorize numbers in Spanish, supply the tenant with a pad of paper and a pencil to bridge the language barrier. Written numbers are a universal language.
An appraiser should never be afraid to examine leases or call tenants if there is any doubt in the appraiser’s mind about the tenancy.
Verification of Future Tenants
When improvements are only proposed, verifying tenants is trickier. Developers often stretch the truth, representing letters to prospective tenants as lease commitments. Nothing is a substitute for a signed lease with a real tenant. Letters of intent can sometimes be relied upon, but to have any credibility they should come from recognized credit tenants on company letterhead.
In one case, a vacant, former Costco warehouse was purchased for $1.62 million in 2001 and appraised one year later for $21.5 million, resulting in a $14 million funded loan. The property was appraised under the assumption that Federal Express, Walgreen’s, AutoZone, El Pollo Loco, and Global Terratransit would be leasing it, even though there was no documentation of interest from any of these tenants. None of the so-called tenants ever moved in. An appraiser should value a property based on market rents, vacancy rates, and absorption rates if authentic leases cannot be produced.
Case Study: A Loss Incurred on a Fully Occupied Building
In the early 1990s, Home Savings made a purchase loan on a fully occupied apartment building in Riverside, California. The loan went almost immediately into default. As it turned out, the building had been 50% vacant only a short time before. The owner quickly filled it by offering free rent, no-money-down specials to homeless individuals and then sold it to an unsuspecting investor, who financed his purchase with the Home Savings loan. As the buyer quickly discovered, many of the new residents had no intention of paying rent, and as they defaulted on their leases, the borrower defaulted on his loan.
The buyer had performed a property inspection and presumably verified full occupancy. The appraiser was seasoned, respected, and considered to be competent. How could this fiasco have been prevented?
Studying Present and Past Rent Rolls
Most professionally managed properties have standardized rent rolls and management reports that indicate when a tenant moved in and what the tenant paid each month. In addition to requesting the current rent roll, the buyer should also request prior rent rolls. These prior rent rolls could indicate prior periods of high vacancy as well as free-rent specials. It can arouse suspicion when a large, multi-tenanted property goes from 50% occupancy to 100% occupancy in a matter of weeks, and the free-rent specials only add to the suspicions. Good management reports also indicate collection trends.
Just as importantly, one should request and receive complete lease documents, including any amendments, in addition to the rent roll. As tedious as this might be, it is a useful fraud prevention procedure, as rent rolls can sometimes be inaccurate. When inspecting a building, every space and tenant needs to be accounted for within the limits of practicality. Relying only on the rent roll is inadequate due diligence.
For example, a field review of a struggling shopping center in Henderson, Nevada, revealed that the appraiser failed to notice that the highest-paying tenant on the rent roll, a Baptist church, was not actually occupying any space at the center. Based on the square footage claimed for the church on the rent roll, it was apparent that the church was supposed to be occupying a vacant Blockbuster Video store, but anyone could see through the plate glass windows of this vacant store that there was no provided seating, a prerequisite for holding most religious services (including Baptist services).
According to the rent roll for this shopping center, a Baptist church was occupying this former video store.
What If the Tenant Is Not There?
If the tenant is obviously not occupying the property, it may be because 1) the tenant has vacated the premises prematurely, or 2) a new tenant has not moved in and might not actually intend to.
One should be skeptical of vacancies that are not described as vacancies. If the tenant has left, for instance, it may be claimed that the tenant is still making rent payments. These payments should be documented with copies of rent checks. “Credit tenants,” such as financially sound national retailers, often continue making their contractually obligated rental payments, but lesser tenants cannot necessarily be expected to do the same.
Likewise, the landlord can claim that a lease has “just been signed” for a vacant space, but one should be skeptical of tenants who have not yet moved in. For instance, a large, older medical office building in south Phoenix was described as being fully leased but found to be half vacant, with every vacant suite having a sign announcing the upcoming arrival of a new tenant. Half-vacant, older, multi-tenanted buildings in low-income areas do not typically increase from 50% to 100% occupancy overnight.
In another case, an inspection of a multi-tenanted industrial building in Connecticut revealed that the tenant paying the highest rent, a nightclub, had still not moved in after supposedly paying rent for 15 months.
The rent roll for this building in Connecticut stated that the property’s highest-paying tenant was a nightclub. An inspection revealed that the tenant still had yet to move in after allegedly paying rent for 15 months.
When in doubt, request copies of checks or bank statements establishing that the tenant actually paid rent. As the Internal Revenue Service has known for a long time, bank statements can be a powerful auditing tool.
When the Landlord Pretends to Be a Tenant
A “pocket-to-pocket” lease is what results when a landlord pretends to be a tenant. For example, two developers of a speculative new office building in Phoenix were having trouble leasing out enough space to satisfy the occupancy requirements of most takeout lenders, so they wrote leases to themselves creating company names from their initials. Using this strategy, John Doe could write a lease to JD Development, Inc., and move some used office furniture into a vacant space.
One clue in detecting “pocket-to-pocket” leases are unknown tenants signing leases at rental rates that are obviously above market rates. Walgreen’s may pay above-market rates because of the specialized tenant improvements they require, but unknown tenants occupying generic office space would not have a reason to sign a lease at an above-market rate. This should motivate the appraiser to find out what the market rental rates are.
For example, a loan made on a renovated, century-old warehouse building on a dirt road near downtown Denver was based on an appraisal report that described the building as a fully occupied, Class A downtown office building. The appraised value was $4,250,000. A knowledgeable broker revealed that the owner had signed a high-rent lease to an entity he controlled in order to make the building appear fully leased at high rents. Upon reinspection, the owner’s space was found to be vacant. Seven months after the original appraisal, the building was valued at $1,550,000, relying on market rents for such space.
Any above-market lease with a tenant who has not yet moved into the space should also be viewed skeptically. During the inspection, it is useful to ask, “What does this tenant do?” to sort out possible straw tenants, relatives, in-laws, or John Doe Developments, Inc.
The Best Way to Verify Occupancy and Rents
The person who is often in the best position to provide accurate and objective information is often lower on the totem pole and closer to the action than the property owner or developer. Try to interview the property manager before the owner shows up and puts words in his or her mouth. You may be able to do this if you show up at least half an hour before your scheduled appointment with the owner. Managers are more likely to have objective reports and may not have yet been instructed to mislead you, so one-on-one time with the manager can be time well spent.
Estoppel Agreements
Estoppel agreements signed by tenants are intended to verify lease obligations, advance payments, renewal options, options to purchase, defaults by the tenants or landlord, and any claims against the landlord. Estoppels can be counterfeited, though, by desperate landlords, particularly if they are so bankrupt as to be considered judgment-proof.
Conclusion
The central theme of this chapter is the need to verify that the full, obligated amount of rent is being received from the tenants that are supposed to be occupying the space. Occupancy and/or lease documents should not necessarily be considered proof that rent is being paid. An appraiser should also be skeptical of vacant space that is represented as being paid for by an absentee tenant. An examination of historical rent rolls can alert the appraiser to suspicious changes in occupancy or phantom tenants. Lastly, a well-planned inspection of a property will go far in spotting misrepresentations about occupancy, rent, unit sizes, and habitability.