Commercial Mortgage Fraud: When Fraudsters Bet the House and Win

It's a volatile combination: high volume of cash-out refinancing loans, declining performance of commercial properties, and relentless production pressures on internal loan officers. The resulting concoction often is fraud. 

Economic conditions are prompting desperate fraudulent property owners to use several tricks to obtain commercial mortgage loans. Following are more schemes.

Misrepresented or Undisclosed Property Conditions  

A lending institution's most important written policy should state that a neutral representative must make a field inspection of the property designated as collateral for the loan. At one bank, a newly hired chief appraiser found in a field inspection that a subdivision in the Sacramento, Calif., area that was represented as 80 percent complete by the appraiser (hired by a loan salesperson) and two loan salesmen had only been rough-graded and appeared to be only 15 percent complete at best.

Recently, a loan broker didn't disclose that the borrower's trailer park was an unremediated U.S. Superfund site (which can be ascertained at www.epa.gov/superfund).

The borrower can't be expected to disclose tax liens and special assessments, and many lenders today are lazy about providing preliminary title reports (which typically disclose such items) to appraisers. A bank recently took a $2 million loss on an incomplete subdivision in Utah when the appraiser didn't know about the special assessments and the loan officer had already taken his commission and left the bank. A bank should make it mandatory to provide a preliminary title report to the appraiser.

Some homebuilders are applying for refinancing on homes they have supposedly completed on the outskirts of many U.S. Western cities, such as Albuquerque, N.M.; Phoenix, Ariz.; Boise, Idaho; Provo, Utah; and Anchorage, Ala. Appraisers are sometimes even instructed by mortgage brokers to appraise the houses as complete even though they aren't. Considering that the main purpose of a builder is to sell homes, a refinance application from a builder indicates trouble in selling his or her product.

In situations like these, appraisers and lenders should throw away the comparable sales data and look at listings instead. An in-depth review of a builder refinance application in Provo, Utah, for instance, revealed 253 listings of similar new homes in the same Zip code, listed at or below the appraised value.

Borrower-provided Comparable Sales Data  

On the residential side, borrower-provided comparable sales data are a favorite technique for property flippers and those who aid them. Appraisers don't typically need instruction in how to do their job, so insistent proffers of free data should be viewed suspiciously as attempts to influence an appraisal assignment. Recently, in Kansas City, Mo., apartment building sales data were found to be tainted by a well-publicized fraud ring that organized limited partnerships to purchase these properties at inflated prices, skim the revenues, and then default on the loans.

If an appraiser's comparable sales data search fails to provide other independent comparable sales, rigorous verification of the borrower's data is essential. Also, the parties in the comparable transaction need to be unrelated and the transaction closed with necessary cash equivalency adjustments made for favorable financing. Developers have fooled appraisers before with "pending sales" that turn out to be "offer" letters written by their relatives or friends.

Inaccurate Operating Statements  

The owner of a strip center/self-storage facility in Texas supplied deceptive operating statements that included "capital infusions" as actual income and included "common area maintenance" (CAM) reimbursements in "base rents" and as a separate line item of income. Also, an unusually high percentage of revenues came from late fees which made me wonder if the owner actually was collecting the fees. As a result of this deception, reported net operating income had been inflated from $67,000 to $178,500. The center was in contract to be purchased by an illiterate immigrant for $1.7 million at a stated cap rate of 10.5 percent.

Don't take client operating statements at face value but compare to operating data for similar properties. National organizations' publications summarize revenues and expenses by reporting members. Some of those groups include Institute for Real Estate Management (IREM), Building Owners and Managers Association (BOMA), and International Council of Shopping Centers (ICSC). Nevertheless, U.S. tax returns (Schedule E for individuals) are the preferred method for verifying revenues and expenses. (Be sure to exclude interest and depreciation expenses.)

Sometimes, of course, submitted tax returns can be forgeries. A Chicago motel owner, for instance, submitted Illinois motel tax returns that understated tax liabilities by 77 percent. The loan applicant declined to provide canceled checks, which is one way of verifying actual tax payments. The borrower's tax evasion opens up the possibility of a tax lien on the property for the amount of all evaded taxes and associated penalties. Because motel taxes are often greater than 10 percent of revenues, this can create substantial losses for both borrower and lender.

Scrutinize the property operating statement for sources of non-realty income and unrelated income. Examples include management fees, legal awards, income from unrelated properties, and the provision of unrelated services. An apartment building owner in Utah applied for refinancing after an unsuccessful condominium conversion; when the scheduled rents didn't add up to the declared income, I suspected that the remaining "rental income" actually consisted of sales of condominium units that year. After we requested the loan applicant's tax returns, we never heard back from him.

Straw Tenants  

Residential property owners, especially multi-family building landlords, can manipulate occupancy. Recall the example of the Oklahoma apartment building (from the first part of this article in the July/August issue) that went from 50 percent to 97 percent occupancy when its owner accepted new residents with poor credit but later had to evict 55 percent of the new residents.

In the early 1990s, a half-vacant apartment building in Riverside, Calif., was quickly filled when the owner offered free rent, no-money-down specials to low-income tenants shortly before he sold it, financed with a Home Savings of America loan, to an unsuspecting investor. As the buyer quickly discovered, many of the new residents had no intention of paying rent, and the loan went into default immediately.

Bank policy should require appraisers to investigate the operating history of the property and try to explain any unusual changes in occupancy.

Phantom Renovations  

Many of today's requests for cash-out refinances contend that major renovations have occurred since the date the original loan was made, yet property inspections indicate that no work was done. This was the case with the Oklahoma apartment property described earlier.

In another instance, an appraiser estimated market rent for a rental cottage in Laguna Beach, Calif., at $3,125 per month based on representations from the borrowers that they spent $150 to $200 per square foot in renovating the cottage -- renovations that didn't seem evident in photographs. The appraiser wasn't permitted to see inside the cottage for reasons of tenant privacy. A quick check of the multiple listing service (MLS) indicated that the cottage was vacant and offered for rent at $1,500 per month.

A bank's property inspection policy needs to include visual verification of all stated renovations and capital improvements but, more importantly, it should be understood that not every dollar in expenditures necessarily adds one dollar of value. For instance, swimming pools may not add as much value as they cost to build depending upon geographic location.

Misleading or Erroneous Statistics  

Sellers of a non-performing shopping center loan represented impressive trade area statistics for a shopping center located in a blue-collar town of 7,000 residents in Michigan. Average annual household income was $72,000 within a three-mile radius and $60,000 within a one-mile radius. This seemed hard to believe when witnessing the town residents washing their rusty pickup trucks across the street from this mostly vacant center, which had lost its supermarket, drugstore, and Kmart.

These trade area statistics didn't correspond with the 2000 U.S. Census for the town, which indicated an average household income of $44,000 per year. The three-mile radius estimate of household income, if accurate, was most probably influenced by the close proximity of Gross Isle, a wealthy island suburb of Detroit, to which there were no direct roads from the shopping center. (See the U.S. Census Bureau Web site, www.census.gov, for checking the accuracy of such data.)

The Pro Forma  

Few lenders take long-term income projections from borrowers seriously, yet they'll accept projections of revenues increasing at the same rate as expenses. Nevertheless, in the life of almost every commercial building, expenses will increase faster than revenues because this is the reality of the economic obsolescence process. That is why expense ratios are higher for older buildings than newer buildings.

Witness the following comparison of operating expense ratios for garden apartments nationwide in the 2002 edition of the Institute of Real Estate Management (IREM) Income/Expense Analysis: Conventional Apartments.

1946-1964: 50.6 percent
1965-1977: 47.6 percent
1978-2001: 41.3 percent

Take the midpoint of each range, such as 1955, 1971, and 1990, to calculate respective average building ages in 2001 (when the data was collected) of 12, 30, and 46 years. Then algebraically derive a revenue growth rate that would correspond to a 5 percent expense inflation given these operating ratios.

If a 12-year-old building was operating at a 41.3 percent expense ratio and expenses increased at 5 percent per year, use a financial calculator to solve for the revenue growth rate that would result in this building operating at an expense ratio of 47.6 percent 18 years later. At age 12, the building earns $100 for every $41.30 in expenses. At 5 percent inflation, expenses are $99.391 18 years later. Divide by 0.476, and the corresponding income would then be $208.81. Then solve for the rate of return that would turn $100 into $208.81 18 years later. The solution is a 4.17 percent income growth rate, not 5 percent.

The difference may seem slight, but projecting 10 years out, the difference in income between a 4.17 percent growth rate and a 5 percent growth rate would be more than 8 percent, and the difference in net operating income could be twice as great or more.

Be Skeptical of Appraisals  

Imagine the pressures put on self-employed fee appraisers. They are rarely criticized for value estimates being too high (until after foreclosure) but often harassed for value conclusions thought to be too low.

Consider the personalities of those attracted to the real estate development and sales professions; the successful ones are the equivalents of human steamrollers. By contrast, appraisers, as the old joke goes, lack the charisma it takes to be accountants (or fraud examiners). In a clash of wills, whose do you think will dominate? Physics is on the side of the loan salespeople. This has created an endemic upward bias in the appraisal profession.

It's easy for the fee appraiser to ignore or minimize negative effects on value when borrowers have snappy explanations. I've encountered numerous foreclosure situations where a property flaw -- such as a lack of visibility -- was obvious, yet the appraiser didn't discount it. Office space without windows falls into this category, as does commercial space without road frontage. "Noxious neighbors," such as dog kennels, oil refineries, and liquor stores need to be considered in reaching a value conclusion. Traffic noise is a noxious neighbor for residential properties.

Discover if there's any relationship between the appraiser and the borrower or broker, which is often the case in small communities. Did the borrower or loan agent actually request this particular appraiser? Several years ago, in an appraisal of a failed Texas subdivision being converted into rental housing near oil refineries, the appraiser reconciled at rents and prices 50 percent higher than the market average while fabricating bogus comparable rentals. A review of the borrower's loan file found a résumé for the borrower indicating that he was a board member of the appraisal corporation.

Also, bear in mind that mortgage fraud often has willing accomplices in the loan sales department of the lending institution making the loans; so exercise the same tests of veracity with loan salespersons. Don't consider them the most objective sources of truth.

This primer is intended to help detect and prevent possible mortgage fraud. To prevent fraud, a lender must consider the possibility of bias or inaccuracy in any information submitted by interested parties and must take the appropriate steps to verify the facts.

Vernon Martin, an Associate member of the ACFE, is a fraud solutions product manager at First American Real Estate Solutions in Anaheim, Calif. He also teaches real estate valuation 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.