Finding the First Corner

Fable of the Day

An old man watched a young boy tease a bear that was tied to a tree with a rope. Each time the bear would rise, the boy would back off. Each time the bear would sink back down, the boy would poke it with a long stick. The old man asked, "Sonny, what do you think you are doing? If that bear gets loose, it will tear you and everybody else in the neighborhood to shreds."

"No worry, old man." says the boy. "I'm just playing the stock market."

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We proceed with my underlying claim that an investment whose value is based solely on the ability to "flip" an asset is on shaky ground.

The Fannie Mae Form 216 (Aug '88), Operating Income Statement, is a frequently neglected tool that should be included with any appraisal of a 1-4 family income residence and critically scrutinized. The biggest problems (at least from my perspective) center around the facts that:

• most appraisers have no real-world experience or training in the maintenance and operation of a residential rental
• most appraisers lack the experience to adequately address the need for periodic repairs to real property, and,
• as a result, appraisers using the 216 generally accept borrower estimates or simply PFA to fill in the blanks.

When this is followed by a reviewer or an underwriter who may not have been adequately trained to spot inconsistencies between the appraisal report and the 216, the Monthly Operating Income developed on the 216 will provide an unrealistic or even fraudulent indication of the property's net income generation potential. Fannie Mae requires this form to be properly filled out and submitted with every Fannie Mae 1025, Small Residential Income Property Appraisal.

The 216 should also be completed for every single-family appraisal (Fannie Mae Form 1004) where the home is to be used as a rental. It usually is not, however, because loan officers do not want to pay the additional fee most appraisers charge to do extra work, and in any event, it is easy to get around by simply claiming that the home is to be owner occupied. Unfortunately, there is no space on the forms to indicate whether the borrower already owns a dozen single-family homes within the county. (Such information is embarrassingly easy to find and is sometimes very difficult to hide, but has nothing to do with the valuation of the subject property. The amount of fraud seen by the average appraiser is incredible, but reporting it can be hazardous to his business. Maybe I should post a few war stories?)

If the subject property is a single-family residence that will be used as a rental, the Fannie Mae 1007 (8/88), Single Family Comparable Rent Schedule should also be filled out. This will provide an estimate of the subject's gross income potential, as of the appraisal date. In general, the rent comparables used in the Fannie Mae 1025 will be used for the same purpose if the property is a 2-4 family rental.

The front of the 216 is used to project the anticipated income and expenses for the next 12 months. It is sometimes necessary to survey income property owners to get a feel for what is typical in a given neighborhood; quite often the subject property's owner will underestimate his actual expenses. The form carries this statement :

"If the appraiser is retained to complete the form instead of the applicant, the lender must provide to the appraiser the aforementioned operating statements (n.b ' actual year-end operating statements for the past two years'), mortgage insurance premium, HOA dues, leasehold payments, subordinate financing, and/or any other relevant information as to the income and expenses of the subject property received from the applicant to substantiate the projections."

In over 20 years of residential appraisal practice, I have never had a lender provide that information. I always had to acquire it from the applicant, the property owner (if it was a sale), or market surveys. Many borrowers treat a request for such information with an attitude of offense, and market surveys are time-consuming because the competition in the rental market makes landlords treat such information as proprietary. It is, nevertheless, critical data, and on more than one occasion I have had to conclude that the projected Net Operating Income shows that the landlord's business is not viable. Once that happens, you have a very unhappy investor, who will never again willingly give you data about his investment plan. You also will have a very unhappy loan officer, who will try to guarantee that you never again get an appraisal order from his company.

So, what is so difficult about this Form 216? For one thing, is asks for items like projected vacancy and the "customary expenses that a professional management company would charge to manage the property". Those two items alone can sink the NOI. The second page, though, is the real killer. On page 2 is the Replacement Reserve Schedule. Many investors will ask, "What is THAT?". THAT is what causes many of the investors in my market to lose their investment.

Even assuming that the rental is unfurnished, and the tenant must supply stove and refrigerator, items like dishwashers, furnaces, central air units, and water heaters need periodic replacement. It is not unusual to see an appraiser indicate on a form that a home has a Remaining Economic Life of 40-50 years (hey - would you make a 30 year loan if the REL was 30 years or less?). Let us suppose you are talking about a duplex, with two of each. Assuming the equipment is brand spanking new the day of the appraisal, in a 50 year period the investor will need to buy and install two furnaces, four central air units, eight water heaters, and eight dishwashers. That is based on average life expectancies for those items. He will also need to re-roof the building at least once, and, based on my experience and the experiences related to me by local investors, will need to totally replace the flooring -- carpet and vinyl -- about nine times. Assuming he sells it at the end of the fifty year period, on that schedule, all of the replacement items would be needing to be replaced at that point, and he would be selling a building in need of updating.

The Replacement Reserve Schedule provides an amount that should be set aside each month to have money in reserve to complete the repairs that will be required over time. A wise lender would require an escrow account for those items, but using that criterion, I have never done business with a wise lender. Those figures are totaled and transferred to page 1 and added to all the other expenses to give the Total Operating Expenses. The numbers are then reconciled: the Total Operating Expenses are subtracted from the Effective Gross Income and divided by 12 to give a Monthly Operating Income. The Monthly Operating Income is then reduced by the Monthly Housing Expense (P & I on the mortgage, hazard insurance, property taxes, MIP, etc) to give a Net Cash Flow. If this form were completed honestly and properly, the percentage of loans made on residential rental real estate would plummet. In most cases, the only way to generate a positive cash flow is to reduce the amount that is to be borrowed, since that is usually the largest single monthly expense. This calls for a bigger down payment, and would spell the end of cash-out refinancing of most rental properties.

Next time we will look into the case of the honest investor who wants to actually get an income from real estate rental property, and expects to hold the property for a lengthy period of time.