Reading a Claremont Seller's Operating Statement Skeptically

There is a document that arrives with almost every income property listing. It has a title like operating summary or annual expenses, it fits on one page, and it is TYPED BY THE PERSON SELLING THE BUILDING.

That does not make it dishonest. It makes it a claim. Your job in diligence is to treat every line as a claim and to find out which ones are supported by evidence, which ones are estimates, and which ones are missing entirely. The missing lines are usually the expensive part.

This is deal method, not accounting. It belongs with the rest of the underwriting work on the investors hub.

Pro forma versus actual

Learn to spot the difference in the first ten seconds, because it changes everything that follows.

AN ACTUAL statement describes what the building did. It is backed by bills, bank records and tax filings, and it usually looks slightly messy because reality is.

A PRO FORMA describes what the building could do under a set of assumptions the seller chose. It typically shows market rent rather than contracted rent, a tidy vacancy assumption and expenses that have been rounded downward. It is a marketing document and it is entirely legitimate as one, so long as nobody mistakes it for a record.

If the page does not say which it is, assume pro forma and ask. A seller who cannot produce actuals on an income property they have owned for years is telling you something about how the property has been run.

The income side

Test income against the leases, not against the summary. The verification method is set out in estoppel certificates and rent rolls, and it is the only way to know what the building actually collects.

Three specific traps.

MARKET RENT PRESENTED AS INCOME. The summary shows what units could rent for. The leases show what they do rent for. Underwrite the leases. Any gap is upside you should not be paying for today, and on a tenancy subject to statewide rent caps it may not be a gap you can close on your schedule anyway.

PHANTOM LINES. Garage income, storage income, laundry income and pet fees. Some are real, some were true once, and some are an unpermitted space with rent attached, which is a liability rather than income.

NO VACANCY, NO CREDIT LOSS. A statement showing full collection every month for years is describing a lucky building or an optimistic author. Ask for the bank deposits.

The expense side, line by line

Expenses are where the summary is most often incomplete, and the omissions follow a pattern.

PROPERTY TAXES ARE THE BIGGEST ONE. The seller's tax line reflects the seller's assessed value. Under Proposition 13, the California Constitution sets a one percent base levy on assessed value with assessed value increases capped at two percent per year while ownership is unchanged, so a long-held building carries a low basis. On a sale, the property is reassessed. THE SELLER'S TAX NUMBER IS NOT YOUR TAX NUMBER, and on a building held for decades the difference is not small. Rebuild this line yourself with the assessor's methodology and your purchase price, and confirm it with your CPA.

INSURANCE IS THE SECOND. The seller's premium was set by their carrier, their claims history, their coverage and possibly a policy written years ago. Get your own quote early, as described in lender and insurer requirements, and use that number instead.

MANAGEMENT IS OFTEN ABSENT because the seller manages it themselves. Include it whether or not you plan to hire anyone. If you self-manage, you are being paid for labor, and pretending that labor is free hides the real return and makes it impossible to compare deals.

MAINTENANCE IS OFTEN A ROUND NUMBER, and round numbers are estimates. Ask for invoices. A building with almost no maintenance history has either been very well looked after or very neglected, and only one of those is good news.

CAPITAL IS USUALLY MISSING ENTIRELY. Operating statements describe operating costs. They do not fund the roof. Build that separately using the component method in the repair reserve discipline.

UTILITIES DESERVE THEIR OWN LOOK on older small buildings, where shared meters quietly load cost onto the owner. Twelve months of bills settle it.

The documents that settle it

Ask for these, in writing, early in the contingency period: twelve to twenty-four months of bank statements showing deposits, twelve months of every utility bill, the current tax bill, the insurance declarations page, maintenance invoices, every lease and addendum, the deposit ledger, and the relevant portion of the seller's tax filings for the property if they will provide it.

Then rebuild the statement yourself in your own format, with your tax number, your insurance quote, management included, real maintenance history and a separate capital line. What you end up with will not look like the page you were handed, and the distance between the two is the most useful thing diligence produces.

What this does and does not tell you

A rebuilt statement tells you what the building has done and roughly what it will cost you to run. It does not predict the future, it does not account for a vacancy you have not had yet, and it certainly does not promise a return. Real estate can lose money, and a clean set of actuals is a description of the past.

None of this is tax or legal advice. Reassessment mechanics, expense characterization and depreciation are technical questions with real money attached, and they belong with your CPA and a California real estate attorney rather than with a seller summary or an article. Anthony Grynchal has been licensed in California since November 2009.