Seller doesn't have Schedule E - shady?

Question

I'm new to investing in multi family units and plan to make my first purchase in a few months. I know the Schedule E is what a landlord should be filing come tax season, and I know my lender will want to see the Schedule E for the property for loan purposes. When a seller says they don't have one or can't provide a Schedule E, is that a red flag?

Cody L. · Answer

I’ve bought + sold 2000+ units. Never once have I asked for a schedule E. Never once have I been asked for one by a lender. Never once have I given one to a buyer (I’ve been asked a few times though. But rarely)

Anthony Wick · Answer

@Nick Colvill In addition to rent rolls and copies of the leases, you could ask for each tenant to fill out estoppel certificates to verify rents/damage deposits, etc.

Cody L. · Answer

The leases will show the rent amount.

What if the guy is a tax cheat and accepts cash and doesn’t report it? Or under reports? Or what if he considers capital improvements to be “repairs” making the property look worse. Or maybe he has no loan so no insurance making his numbers look better than what you’d see. Or maybe he self manages. Or over pays for management. Or keeps a unit for himself + one for storage + one for family so $0 rent income.

There are a million different reasons why someone’s own sche E is worthless. Even if it’s “honest”.

Get a rent roll. Backed up by leases if your worried. Use some common sense to proforma major expense items. Some of the small stuff is rounding errors. Don’t over think it. If it’s a good deal it’ll be obvious. Ditto if it’s a bad deal

Frank Chin · Answer

From my experience, there are many sellers reluctant to furnish schedule E's so for me it's not a red flag. I deal mainly in multi-families and I generally know how much rentals go for in an area. The important thing is to be able to inspect the units to see what shape they are in.

For long time landlords with long term tenants, there's a tendency not to increase rents consistently, especially in areas where the rents had risen sharply. I'm one. I had a tenant with me for over a dozen years, rented an SFR to him below market at $1,300, he took care of the place, did all the repairs, so I haven't raised it the first 8 years. Then a tenant across the street, similar SFR, asked if my house would come up for rent any time soon as his landlord is selling the house. I asked him how much he's paying, and he tells me $1,800 but rentals he looked at are asking for $2,000, but the problem was there's nothing available in town. So even if I showed you my schedule E, it is meaningless, as it does not show what the place should rent for. I was able to rent it so cheap because I got it as a pre-foreclosure some years back, way below market, and it was far enough away that at one time I was looking for a PM. I did raise it by $150.00, but still way below market. In fact if I showed you the schedule E, it would raised even more of red flags. Or would it be really too shady to you that I'm so far below market?

Cody L. · Answer

FYI I'm talking about commercial world (5+ unit).  I could see in 1-4 family where they are trying to qualify YOU more than the property so want to make sure YOUR income can pay the debt by using your tax returns + x% of what's expected from the new units.   Like I always say, I can get a loan on a $20m commercial property easier than a $100k 1-4 family so take my comment in that context.

Dan H. · Answer

I suspect everyone knows this but for 1 to 4 units, comps are the primary cost basis.  Items like cap rate, COC, ROI, etc. would not be the primary basis.  Typically, however, the appraisal does have comparisons that are rent based comparisons.  I believe they used more to qualify the buyer than to set value but it does include a rent based value in that section.

Significantly below market rents present an opportunity (with often a short term hit to cash flow) if the property value was based on cap rate such as for 5 units or more.  In 1 to 4 units I find it often results in a short term hit to the cash flow.  The value was set on comps so the lower rent rates did not lead directly to a reduction in price.  It may have been a reason for the seller to sell (low profits) but the seller's RE agent will strive to get market price.

So you purchase a 4 unit RE at or near market price with rents below market.  Then what?

Do you try to raise all 4 rents to market rent all at once?  That would likely result in significant vacancy.  Vacancy will have turn over costs.  If the tenant is significantly below market rent they have likely lived there a while.  Often turn over rate is a function of length of occupancy (I believe turn over rate is a function of (quality of tenant, thought into minimizing turn over rate (types of flooring have significant different expected life spans), and length of occupancy)).  So it is unlikely to be a 1 day turn over.  The new tenant needs to give 30 days notice (beware of those who do not need to give 30 days notice).  So vacancies have significant impact on cash flow.

Choice 2 is you gradually raise the rents:  If you do this such that it results in 0 turn over it could take years to get to market rent.  During this time you purchased at near market price but are getting less than market rent.  Not smart.

In summary, below market rent in 5+ units is a great opportunity but in 1-4 units mostlt is just a hassle that can impact short term cash flow.

Parker Borofsky · Answer

@Nick Colvill  I am a lender :)  That being said - this is specifically referring to residential conventional lending 4 units or less.

We never ask for or look at the seller's financial data meaning taxes/schedule E etc. except for existing leases IF those tenants will be remaining.

Sometimes you will need the projected rent income to offset your debt to income ratio.  Not all lenders will allow this, but we will.  If there are existing leases, 75% of the value of those leases can be used as rent income in the debt to income calculation.  The appraiser will also complete a fair market rent evaluation and provide the value for that as well.  If the tenants will not remain or if the units are vacant, 75% of the fair market rent value is used.

When you purchase the next investment property, you cannot use the "projected" rent value from the previous properties, however, you can use projected rent income for the new subject property.  Additionally, if you have a schedule E for other rentals, we can calculate the rental income from that schedule.  If you have rental income from properties you have not been renting long enough to have a schedule E from, we can use 75% of a current lease agreement.  This works great except for STR's which you need to wait for a schedule E to determine rent income since there is no lease.  I have not figured out a way around that yet lol.

Hope that helps!

Nick Colvill · Answer

This has all been monumentally helpful and I'm quite sure it has answered my questions perfectly.

James Stinnett · Answer

@Nick Colvill

Hi Nick,

A lot of great information above but I'll give my take on this; anything I repeat from above please take as me 2nd-ing their input!

I was residential loan officer/mortgage broker from 2000 to 2008 and a Realtor since 1993.  2008 and the next few years were difficult times to be in real estate finance so I jumped to bank owned sales during this time, so I have both perspectives.

Both as an LO/mortgage broker and real estate agent I would regularly have banks/lenders ask for a comp-based appraisal and a rental survey on 2-4 units properties; which is Fannie Mae Form 1025/Freddie Mac Form 72.

Also, when a buyer was buying single family home there would ask for a comp-based appraisal and a single family comparable rent schedule Fannie Mae Form 1007/Freddie Mac Form 1000.

Then most lenders would allow for 75% of the projected rents as additional income for the buyer, though they would ask for lease agreements -- and if those were not available or incomplete or several years old they would ask for an estoppel from each of the tenants. The idea behind the 75% was that 25% was estimated to go towards repairs, vacancy, CapEx etc.

Also, as mentioned above 1-4 unit is residential and 5+ is commercial. In 1- 4 underwriting focuses on the buyer in 5+ it focuses on the property.

I don't remember underwriters asking for Sched E from the Seller, but as many stated above I would think that would be difficult to obtain and then would question the validity and thus value of any I did obtain.

Hope this helps, best of luck!

James Stinnett

Seller doesn't have Schedule E - shady?

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