Commercial Mortgage Fraud: Cash Out, Fraud In (Part One)

There's no shortage of desperate or fraudulent property owners in today's market for commercial mortgage loans. "Cash-out refinancing" is one favorite way to bail out of a troubled property. This primer offers advice to fraud examiners, lenders, and appraisers on spotting and preventing these and other frauds.

Three men claiming to be physicians purchased a New York City walk-up apartment building on a residential street. They then applied at the nation's largest thrift institution for a much larger cash-out refinance loan, stating that they intended to convert the ground floor into a magnetic resonance imaging (MRI) facility. (A cash-out refinance loan provides money needed to repay the first mortgage and additional cash that can be used for any purpose.) MRI space would command a much higher rent than was currently being earned from the rent-controlled ground floor apartment tenants, and this was reflected in the appraisal done by an in-house appraiser. However, once funded, the loan went into immediate default and the borrowers disappeared.

This unfortunate loan default could have been avoided if the appraiser or underwriter at the lending institution had checked with the City of New York to see if such a use was allowable under residential zoning and if permits had been issued for such space; the answer would have been "no" to both questions. Surprisingly, this particular institution didn't have such a written policy.

Unbeknownst to the appraiser and underwriter on this transaction, these same three "physicians" had mortgaged another property at the same lending institution under the pretext that they would be converting hard-to-lease basement space into a natural foods store. This loan also went into immediate default. The lending institution may have prevented this one with a simple in-house database containing names of borrowers and principals of borrowing entities as "key variables."

This is an example of mortgage fraud for profit, the type of fraud that's obvious and associated with early loan payment defaults.

Degrees of Fraudulent Intent 

There are other types of mortgage fraud that are much more common, but less obvious, where the intention is to repay the lender if the property's performance and value increase but to default if the property's performance and value decrease, leaving the lender holding the bag. Such frauds, which are usually accomplished by either misleading or corrupting real estate appraisers, intend to trick the lender into lending more money than is adequately secured by the property and its cash flow. This minimizes the risk of equity loss to the borrower who may not even have any actual equity in the deal.

In these cases, payment defaults occur years after the loan’s origination, and lenders usually don't think to look for fraud at that time. This latter type of fraud is increasing now that more commercial properties are experiencing declining performance. A borrower will know he’s in trouble long before would-be lenders and will use mortgage fraud to mitigate his risk and minimize his equity investment.

So far the low cost of debt has controlled the rate of default on these loans. When debt is at a low fixed rate, the day of reckoning can be postponed for a long time. However, floating-rate debt or short-loan maturities on some problem assets create numerous ticking time bombs that will explode with the next interest-rate shock.

Commercial real estate market conditions today seem reminiscent of 1990 (and the ensuing commercial real estate debacle of the early 1990s), when considering the current volume of applications for cash-out refinancing of commercial properties that are declining in performance.

Complicating the situation is the presence of third-party loan originators (brokers and conduit lenders), some of whom suffer from low ethical standards, and the relentless production pressures put on internal loan officers at financial institutions. Originators who are paid wholly or partly by commissions based on loan volume further exacerbate the problem.

It’s easy to see how pressures to meet loan volume targets provide disincentives to due diligence. However, the biggest lending mistakes are made during these times of deteriorating asset and credit quality.

This article (concluding in the Sept./Oct. issue) highlights some common methods I’ve seen fraudsters use to deceive commercial mortgage lenders in 19 years of reviewing commercial appraisal reports and loans, and the steps that should be taken to avoid such frauds. All examples presented are from firsthand experience.

Deceptive Purchase Contracts and Hidden Seller Concessions

Because so many appraisers and lenders think of the purchase price as prima facie (at first sight) evidence of market value, it has become quite common to see deceptive purchase agreements that inflate contract purchase prices. This is done with hidden or stated concessions, such as “allowances for repair” and “seller financing.” For example, I received a loan application with a purchase contract for $3.2 million for a Houston office building that was listed at that time on www.LoopNet.com (a commercial real estate listing Web site) for $2,350,000. To prevent from being fooled, a lending institution should always have its appraisers and underwriters review the purchase contract for red flags by checking:

1. Seller financing: It’s possible that such a loan could be “forgivable,” particularly if there’s a relationship between the seller and buyer.
2. Allowances for repairs: If the repairs aren’t yet started, this amount should be deducted from the purchase price. All repairs should be verified by inspection before being assigned value.
3. Some comparison of the buyer and seller: If they’re individuals, do they share a surname? If the buyer or seller is a limited partnership, there should be some research into whom the principals are and whether one or more of the principals is on the opposite side of the transaction.

Most of all, appraisers shouldn’t be harassed by the lender for failing to appraise a property for its purchase price. Many lending institutions currently do so, with the effect of appraisers generally tending to “rubber stamp” the stated purchase price (said to occur 98 percent of the time). Worse yet, residential lenders often don’t even supply appraisers with purchase contracts under the philosophy that it would take too much time to do so.

In a recent refinance application, an appraiser valued an apartment property in Oklahoma for $1,575,000 with the understanding that the purchase price several months before had been $1.4 million and occupancy had increased from 50 percent to 97 percent.

The previous closing statement indicated that the seller had provided a $350,000 allowance for repairs (equal to $6,000 per unit) and $50,000 in seller financing with undisclosed terms. An inspection of the property yielded no evidence that $350,000 had been spent on renovation; all units still had original appliances and carpets from the early 1970s. As for the 97 percent occupancy, this was being achieved with low tenant quality – so low that 55 percent of new tenants had been evicted before their six-month leases had expired.

An independent local real estate broker stated that he and his peers were already aware that this property had been effectively purchased for $1 million, but the appraiser was nevertheless unduly influenced by the misrepresentation of the effective purchase price.

The ‘Pocket-to-pocket’ Lease

A renovated, century-old warehouse building on a dirt road near the Denver, Colo., central business district was appraised as a fully occupied, class-A downtown office building. A knowledgeable broker informed me that the owner had signed a high-rent lease to an entity he controlled to make the building appear fully leased at high rents, which were actually moving from one “pocket” to another “pocket” of the same owner. After re-inspection, the owner’s space was found to be “dark” or vacant.

The appraiser relied on this lease for occupancy and market rent information to arrive at a value estimate of $4,250,000. The building was subsequently valued at $1,550,000 seven months after the original appraisal, relying on market rents for such space. It should be a lending institution’s appraisal policy to insist that a property be appraised at market rents if contract rents seem too high. Also, any above-market lease in which the tenant hasn’t yet moved into the space should be viewed quite skeptically.

Bogus Construction Plans

The lead-in case of this article is an example of this scheme. Here’s another: a real estate developer wished to acquire and hold a piece of land for eventual development as an industrial park. He admitted in a newspaper interview that he would temporarily use the site for airport parking only until the industrial park development became feasible again. Wishing to purchase the land for $24 million he persuaded a bank to lend $30 million to build a permanent, state-of-the-art airport parking lot with parcels leased to McDonalds, Denny’s, Hertz, Budget Rent-a-Car, Chevron, and a national taco chain. Colluding with an inside loan officer, the appraisal was made to order and valued the completed property at more than $67 million, assuming parking rates of up to $20 per day at a time when most daily rates were $9, although the proposed lot would increase parking inventory by more than 40 percent at an airport that was already at maximum legal flight capacity. Although the parking lot was completed, none of the ground leases to any of the above retailers were executed, probably because any ground lease would interfere with the developer’s eventual intention to develop an industrial park on the entire site. Because the oversupply of parking created a price war, daily rates at this parking lot are now only $7 uncovered to $10 covered and the property is operating at a loss after debt service on a $30 million loan. This loan was then sold to other financial institutions under the misrepresentation that the airport itself planned to lease the parking lot although the airport had been suing the developer for the two years and had erected a fence around the parking lot to prevent pedestrian access to terminals.

This $30 million loan fraud could have been prevented with these policies:

1. Commissioned loan agents shouldn’t be allowed to order appraisals. A neutral party, (having no stake in the outcome of the loan application), such as a chief appraiser or chief credit officer, should do the ordering.
2. The bank should have insisted that only appraisers from its approved list be used. This appraiser wasn’t approved and was also linked to a $250 million loan default at another institution.
3. An examination of the date of the inspection, the date of the appraisal order, and the date of the report should be compared. In this case, the inspection had been done before the appraisal was ordered, which suggested that the appraisal had already been done for another party, possibly the developer. The delivery of the appraisal of such a complex property one week after ordering it also seemed suspect. Most commercial appraisals of much less complicated properties arrive in three to four weeks.

Bogus Offers to Lease

Nothing substitutes for signed leases with real tenants. Letters of intent are generally non-binding, and if they are to have any credibility should come from recognized credit tenants on company letterhead. Despite these intuitively obvious precautions, a vacant, former Costco warehouse was purchased for $1,620,000 in 2001 and was appraised one year later for $21.5 million – resulting in a $14 million funded loan – with the assumption that Federal Express, Walgreen’s, AutoZone, El Pollo Loco, and Global Terratransit would be leasing it, although there was no documentation of any interest from any of these tenants. Federal Express, which was to occupy 40 percent of the space, had chosen a nearby building instead. Two years later, the only tenant is an ethnic supermarket. A lending institution’s appraisal policy should insist the property be valued based on market rents, vacancy rates and absorption until a bona fide lease can be produced.

Bogus Offers to Purchase

One of the oldest and most transparent scams is to provide written “offers to purchase” in applications for refinance at unjustifiably high amounts. These obviously cannot be accepted as indicators of market value. A recent loan applicant claimed an offer to purchase his 11-unit apartment property in a low-income neighborhood for $1.8 million, when similarly sized properties were trading at $750,000 to $800,000.

Owners of a 33-year-old apartment building in El Centro, Calif., a low-income desert community, applied for refinancing and supplied two expired sales contracts, the first for $2.3 million and the second for $2.6 million, from five months before. They claimed scheduled rents well above market rents. All the comparable sales located in El Centro were more modern buildings and had sold in the range of $33,000 to $38,000 per unit, which would indicate a value for the subject of $1.4 million to $1.6 million, but the appraiser relied on these expired sales contracts and above-market rents to estimate the value of the apartment building at $2.5 million.

A lending institution should instruct its appraisers and underwriters to ignore offers and expired sales contracts for refinance transactions.

Illegal Improvements

An owner of two mixed-use buildings on Lombard Street in San Francisco applied for refinancing; the owner demonstrated signed contracts for billboard leases on these buildings at rental rates exceeding rents from the space inside these buildings. A major car manufacturer had just signed a contract to lease the larger sign at a net rate of $32,000 per month, verified by a company representative. The owner also produced permits from the California Department of Transportation (CalTrans) for these signs; Lombard Street is part of Highway 101, a California state highway. Nevertheless, there was no historical record of sign rental income prior to the summer of 2003. A fortuitous phone call to San Francisco’s Planning Enforcement Department found that the signs were illegally erected without permits from the city and a letter to the owner was being sent out that same day with an order to remove the signs. A CalTrans permit doesn’t negate the need for a permit from the city of San Francisco, which highly regulates and limits billboard advertising. Income from illegally erected improvements can’t necessarily be considered permanent income, particularly in communities with reputations for vigorous code enforcement.

Extraordinary Appraisal Assumptions

It’s comforting to see that appraisers are more commonly disclosing “extraordinary assumptions” in prominent locations in their reports rather than burying them in the “assumptions and limiting conditions” section as in years past. This new trend is also a cryptic cry for help: “Look at what the loan salesperson is making me do!”

A recent example was the appraisal of a proposed subdivision outside Sacramento, Calif., in which the appraiser was asked to assume the existence of a street providing access to the proposed subdivision when no such street existed. His “as-is value assuming completion of the street at no expense to the developer” would appear ludicrous to any review appraiser, but a chief lending officer saw it as credible. There’s only one definition of “as is,” and it’s “as is.” It should be bank policy to reject “hypothetical appraisals” or appraisals containing “extraordinary assumptions” that assume conditions which don’t exist or can’t reasonably be expected to exist.

One of the most misused extraordinary assumptions of the 1980s was that market demand would exist for proposed projects. Instead, the Texas prairies were bejeweled with empty office buildings.

From a lending viewpoint, one must be very careful with appraisal reports with the catchphrase “per client’s instructions.” While this could be the hallmark of a conservative lender wary of inflated pro formas, it could also be a warning sign of possible manipulation by self-interested parties such as commissioned loan agents. Assumptions dictated by commissioned loan agents can have major effects on estimates of value.

All bank officers relying on appraisal reports should read the “assumptions and limiting conditions” sections. Office of Thrift Supervision (the federal regulator of savings and loans) examiner Glen Sanders presented these unreasonable assumptions in a 1989 speech to the National Association of Review Appraisers:

• The site will be rezoned.
• Undeveloped land has utilities.
• There’s effective demand for the proposed development.
• There will be 95 percent occupancy.
• The land is stable.
• The land has valuable oil assets beneath it.
• The client’s statements are correct.

The last statement is a common appraiser’s cop-out. The lending institution should always instruct the appraiser to alert it to any borrower dishonesty immediately.

Another egregious extraordinary assumption seen in appraisals of environmentally contaminated sites is the assumption that contaminated land isn’t contaminated.

(In the Sept./Oct. issue: misrepresented or undisclosed property conditions, borrower-provided comparable sales data, inaccurate operating statements, straw tenants, phantom renovations, and more. Read the second part of the article here.)

Vernon Martin, an Associate member of the ACFE, is the Western region review appraiser for an East Coast investment bank where he focuses on loan acquisition, due diligence and loan originations. Also, he’s an instructor at California State University, Los Angeles, and has published several articles in mortgage, real estate, and banking journals. He welcomes stories and questions about commercial mortgage fraud from readers as he builds a Web site clearinghouse for information on the subject.