Real Property Investment

How To Use Security Deposits To Increase Value

The value of a commercial real property investment is typically tied directly to its net operating income. Of course this is not the case with raw land or even buildings that may be sitting empty for example, but in general I believe this is a fair assumption.

Every dollar that you can add to your bottom line will roughly add $10 to the value of an apartment building or other commercial property. Therefore, every penny counts when it comes to the income of your building. Or to be more precise, every penny counts tenfold!

When security deposits are forfeited by tenants, the money moves from the balance sheet to the income section of your profit and loss statement. When this happens the net operating income of the building increases. Not only does this improve your cash flow, it increases the value of your investment property.

When it is time to sell your real property investment, security deposit forfeitures are a legitimate income source to include on a pro forma income statement. Some people may argue this or say that a sophisticated buyer would never include such income when calculating the value of a building. I say bologna (or is that bologna?).

I recently sold a building to a REIT (real estate investment trust). I think it is fair to say that in this game, buyers don't come much more sophisticated. Most REITs are interested in cash flow, period. If the building fits their acquisition criteria, they will apply a cap rate to the income, and that is how they determine what they will pay. For this particular commercial building I had included income from security deposit forfeits on the pro forma that was prepared to market the property. As part of their negotiating tactics the REIT originally balked at the income. I then explained why it was a legitimate income and they eventually agreed. Here was my argument.

All of the security deposits were seized legally. If a tenant failed to give proper notice, they forfeited their deposit. If they owed money or damaged the suite, I kept the appropriate amount. If a suite is left damaged in any way (beyond regular wear and tear), the owner of the apartment complex has to pay to repair the damage. That expense shows up on the profit and loss statement. It is only logical to offset that expense by the amount of the security deposit that was seized.

It is just smart business. That income arises from the day-to-day operation of any multi family real property investment. You have to include it as income when you file your tax return. It's income. Period.

In this particular instance, the security deposit represented approximately $100,000 in additional property value. No small amount, and certainly worth negotiating over.

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