What Can Multifamily Buyers Do When Promised Rent Rolls Don’t Match Reality?
Since the value of a multifamily rental property derives primarily from the income it generates, potential buyers must have an accurate understanding of the rents they can expect from acquired properties. That information primarily comes through the diligence process, when the seller provides the buyer with copies of all leases and a rent roll. But what happens when a seller is less than forthcoming, and a buyer finds itself after closing with a building generating less income than expected? Such a buyer is out more than just the nominal difference in rent, because gross rents are a primary input in determining the value of a building. Indeed, aggrieved buyers may have recourse under New York law for the difference in value based on inaccurate rent disclosures by a seller.
A common method for valuing multifamily rentals is the capitalization rate. A cap rate is, in essence, the rate of recovery of the capital spent to purchase the building—i.e., the net operating income of a property divided by the value. In New York City, it is common to have cap rates of approximately 3.5 percent.
During the due diligence process, sellers typically provide copies of leases, a schedule of rents and books and records concerning the property and its operating expenses. Ideally, the information provided to the buyer is complete and accurate. However, even the most careful seller may omit certain information from the rent schedule, especially if leases contain riders, or if incentives were provided at the outset of a lease (such as a free month of rent) but were not carefully recorded. The risk of error is higher in urban areas such as New York, where rent regulations and tax abatements can further complicate rent calculations. As a result, gross rents on the seller-provided schedule may not reflect the actual rents paid by tenants. Perhaps the only way to verify the information would be for the buyer to examine all of the individual leases and riders, or to examine banking records for the building. This additional step is necessary to ensure that the market value calculation is reliable. But that kind of scrutiny it is not always feasible.
The impact of an inaccurate rent roll cannot be overstated. A prospective buyer is not only out the difference in rents for the terms of the leases, but also the portion of the purchase price attributable to the rents disclosed above the actual rent paid by a tenant. For example, if a seller of a 100-unit rental building provides a rent roll reflecting an average of $5,000 monthly rent per unit, but fails to disclose average monthly per-unit rent concessions of $1,000, the impact on the value of the property using a cap rate of 4 percent can be as much as 30 percent or more of the purchase price of the building. In this example, a cap rate of 4 percent would result in the buyer essentially overpaying by $30 million.
While it is preferable that a buyer obtain full and complete disclosure of the actual rents paid by tenants from a seller prior to purchase, an aggrieved buyer may still have recourse against the seller after purchase. The buyer may be able to sue for breach of the purchase and sale agreement (or, alternatively, to rescind or unwind the purchase), though a suit on the agreement depends heavily on the representations and warranties made by the seller concerning the rent. A buyer may also be able to pursue common-law remedies for fraud and negligent misrepresentation (in cases where the seller agreed to accurately disclose rents but, without fraudulent intent, failed to do so). In all cases, given that many multifamily properties are owned by special- and single-purpose entities that may distribute sale proceeds shortly after sale, it is imperative that aggrieved buyers consult counsel promptly after discovering any incorrect or missing rent disclosures.
Eric Sherman is a partner at Pryor Cashman and specializes in real estate and real estate litigation. Bryan Mohler is also a partner at Pryor Cashman, concentrating on real estate litigation and hospitality law. (Marion Harris, an associate at the firm, assisted in the preparation of this column.)