For real estate investors and property managers, net operating income (NOI) is the driving factor to increasing value and generating strong cash flow. In general terms, the NOI is calculated by taking all revenue from the property less all reasonably necessary operating expenses. These expenses include items required to run and maintain the building and its grounds, such as insurance, property management fees, utilities, property taxes, and repairs and maintenance costs. It excludes principal and interest payments on debt, capital expenditures, depreciation and amortization. In the real estate world, fraud could have a significant negative impact on NOI and property valuation.
Fraud could exist in several ways in a property management environment. Here are some common occurrences by employees:
- Allowing a friend to stay in a vacant unit free of charge
- Stealing tenant rent payments by manipulating rent rolls and tenant receivables
- Receiving kick-backs from vendors or contractors (e.g. awarding a contractor the improvement work at the property and receiving a complimentary improvement project at the employee’s personal residence)
- Payments to fictitious vendors for property maintenance work
- Theft of inventory or supplies for tenant units, including food or liquor used for a restaurant located at the property
Why would your employees commit fraud? There are three elements that contribute to the risk of employee fraud (also known as the fraud triangle):
- Pressure or Incentive – The employee may be experiencing personal financial distress, substance abuse, or gambling addiction.
- Opportunity – The employee has access to assets that allows the individual to believe the fraud can be committed and successfully concealed.
- Rationalization – The perpetrator justifies the fraud due to a perceived injustice (e.g. “I deserve this because I did not get a bonus”).
What should you do to prevent or detect fraud at your property? A comprehensive fraud risk assessment should be conducted to protect investors from losses due to fraud. This should include identification of potential risk areas, an assessment of the likelihood and significance of fraud occurrences, and a response to identified risks. This will also include an understanding of the internal control environment, inclusive of preventive controls (designed to prevent fraud from occurring) and detective controls (designed to enable timely detection of fraud).
Fraud can be a significant and pervasive business risk – not only for real estate enterprises, but in most businesses. When fraud exists in a real estate company, the NOI and property valuation are negatively impacted. Mitigating or reducing the risk of fraud is extremely important. Smart investors should consult their business advisor or accounting firm for assistance in conducting a full risk assessment.
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