Friday, November 30, 2012

Real Estate Purchase Contract Scams

The appraisal textbooks don’t mention these, so I will.  Real estate purchase contracts are often constructed to mislead lenders and appraisers.  Various ruses are used to inflate stated purchase prices above market value, with the hope of tricking an appraiser into valuing a property at above market value and tricking a lender into offering a loan at an unsafe loan-to-value ratio. Many borrowers don't want to inject cash equity into a deal if they have the ability to purchase with "no money down". Heads, the purchaser makes money; tails, the bank takes back the property with no loss of money to the buyer.

What the buyer and seller are counting on is a phenomenon known as “anchor bias”, the tendency of appraisers to offer an appraised value identical to the purchase price. Various academic studies have indicated that this happens about 86 to 87% of the time, but I notice that some appraisers have been getting wiser lately.

Some ruses that I have recently seen include the following:

1. The “soft second” mortgage loan – forgivable seller financing used to inflate the contract purchase price.

My last appraisal assignment presented such a possibility.  It was an $8 million purchase contract which was contingent upon $4 million in first mortgage financing, supplemented by seller financing of $4 million.  The buyer would have no equity in the property, a situation that presents a high risk for loan default.

I suspected that the seller financing was a “soft second”, a seller concession disguised as a fake loan.  My suspicion was well supported by a contract purchase price which was $1.6 million above the listing price for a property that had been marketed for almost 3 years on LoopNet and updated only 8 days before.

Normally, the term “soft second” in the real estate industry refers to a legitimate second mortgage loan made at a below-market rate, perhaps subsidized by a government agency or a nonprofit entity.  In some cases, though, the seller financing is not meant to be paid back.  It is a price concession in disguise, meant to inflate a contract purchase price.

An appraiser cannot be sure the second mortgage is real or fake, so he must look for clues, the most obvious of which is that the purchase price is not supported by comparable sales or the purchase price is above the asking price.  The lack of equity contributed by the buyer should also make lenders and appraisers think twice. Nothing casts more suspicion on a real estate purchase than that the price cannot be supported by comparable sales.

One would think that some government agency or appraiser association would issue an “all points bulletin” on this deception, but this scam continues to this day.

2. Unsigned purchase agreements in draft form.

I have seen a proliferation of this trick in the last 2 years, and am currently witnessing it happen on a transaction in Puerto Rico.  The buyer just says that the purchase contract has not yet been finalized and submits his own version, usually in MSWord, with a different price.  Very simple, but these deceivers are counting on appraisers or lenders who will believe anything. 

Normally, an application for a purchase mortgage loan comes with an already-signed purchase agreement with contingencies for financing. Why and how could there be a closing without a definitive purchase agreement? An agreement that is not written is not worth the paper it is written on. There is no reason for an appraiser to accept an unsigned, draft purchase agreement as a reliable indication of value.

3. The double escrow

This is when there are two purchase contracts for the same property.  The first purchase contract is the legitimate one, and once closed, the buyer can then sell at a higher price to an entity he controls in a different purchase contract that he will submit to lenders and appraisers.  The latter transaction, however, is a sham "pocket-to-pocket" transaction.

4. Secret partnerships and "transaction facilitators"

In one instance I met with the owners/sellers of swampland intended for development of a marina residential community. The buyer and sellers were old friends, but none had development experience. I was presented with three conflicting purchase contracts, and whenever the story keeps on changing, that is a good sign of deception. After four hours I asked Mr. Seller, who lived in a trailer on the property, where he would be moving to. He seemed surprised and responded, "I'm staying here, of courseI've got a lot of work to do!" which made it clear that he was part of the development team and this was not an arm's length transaction. I looked at his wife, whose facial expression said "How can my husband be so stupid?"

I discovered one company in Arizona that advertised "transaction facilitation" services. Step 1 is that the buyer forms a joint venture partnership with the transaction facilitator in buying the property in the guise of an LLC or Limited Partnership. Step 2 is the shell company (the LLC or LP) sells to the buyer again at a higher price in a sham transaction designed to trick a lender and maximize financing.
I encountered this company in a purchase loan application with a contract price which was twice market value.

Another type of "transaction facilitation" is those services which "rent" cash down payment money overnight to buyers while the purchase price is inflated to cover the amount of the phony down payment.  Law enforcement has been shutting down such operations in the United States. Read my post:

5. The missing addendum

Sometimes the purchase contract has a dangling reference to an addendum that suspiciously gets separated from the contract. I am looking right now at a purchase contract with an asterisk by the stated sales price. Below the asterisk is the explanation: “*Sales Price is subject to adjustment based on Special Provision Addendum”. When I requested the missing Special Provision Addendum, it stated that the purchase price could be adjusted to 50% of my appraised value. Knowing that a property will be sold at half my appraised value – now that is a sobering thought.

6. The straw buyer

I recently appraised a parcel of raw land for a purchase money loan to a prospective developer of a hyperscale supercomputing facility along the NLR (National LambdaRail).  The purchase application indicated that the buyer, who supposedly owned a hyperscale computing company, was putting no cash into the transaction; seller financing would fill the funding gap.  At the same time, there was no discernible relationship with the sellers.  The appraisal failed to hit the purchase price, but rather than trying to negotiate the purchase price down, the buyer spent two months arguing that the property should be appraised higher.  Finally, a background check indicated that this man was no computer expert but had a history of legal judgments, bankruptcies, aliases, criminal convictions -- and a degree in political science.  It appeared that he may have been hired to be a fake buyer to bail the sellers out. These types of arrangements are sometimes found offered on LinkedIn.

Straw buyers are more common than you would think.  As I drive around L.A., for instance, I see simple signs stapled to telephone poles advertising "Real Estate Investment Partners Wanted".  What happens when one calls the number is that a fee will be offered to someone with good credit to sign a mortgage loan for someone with impaired credit.  The fee might be $5000 or $10,000 for a residential mortgage, but I've seen a fee of $50,000 offered to sign a commercial mortgage.  In each instance, the real estate partner will be guaranteed to have his name released from the mortgage lien after funding of the loan, but it often does not work out this way, as what starts as mortgage fraud (use of a straw buyer with a high credit score) often continues as a mortgage fraud; the real estate "partner" is not released from the mortgage lien and ends up being pursued by a lender for the full amount of a delinquent mortgage loan. The organizer of the scam has already left town with the funds. Moreover, the "real estate partner" with the high credit score cannot report this fraud to law enforcement because he has already become an accomplice to mortgage fraud.

Other purchase contract deceptions

It is risky, any way, for an appraiser to automatically assume that a contract purchase price is identical to market value.  I have seen fake purchase contracts and purchase contracts which disguise the fact that the buyer and seller are one and the same. I have seen purchase prices inflated by real estate syndicators who are compensated as a percentage of the transaction price.

Many appraisers are so convinced that the purchase price is real that they make the mistake of making unconventional adjustments to sales data to support the stated purchase price. They may choose much newer properties or much smaller properties as comparable sales and fail to make adjustments for age or size.

Questions to ask

The first thing I do in analyzing the purchase transaction is to peruse the Internet to try to find the property listed for sale. LoopNet and are good sources, but sometimes if you just google the address of the property, you can find a more obscure listing. When I find the property listed at a price below the contract purchase price, and the property has already spent a substantial time on the market, that is cause for suspicion.

The next question I ask the buyer and the seller, separately if possible, is "who were the listing broker and the buyer's broker on this transaction?" The reason why I ask is that I see so many purchase loan applications which are not represented by a broker, begging the question of how the buyer and seller found each other in a market with so many properties listed for sale. 

If there was no broker, there was most likely no listing or advertising, meaning the buyer already knew the seller, increasing the odds that the purchase transaction is not arm's length or could even be a "pocket-to-pocket" transaction with the owner buying the property from himself with my client's financing. Past experience has shown me that this is a way to make the lender the unintentional buyer of a hard-to-sell property.

One tell-tale sign of a fraudulent purchase is when the buyer complains that the value is too low. In legitimate purchases, the buyer often uses a low appraisal to negotiate a better price, and they sometimes even thank me for saving them money, but when a buyer starts making phony excuses as to why the appraised value should be higher, it is a signal to me that the buyer is either already affiliated with the seller, a straw buyer, or else the buyer and seller have negotiated a separate purchase agreement and the contract I was given was phony.

Recent adverse publicity for the appraisal profession

The National Association of Realtors (U.S.) has recently unleashed their well-funded publicity machine to criticize appraisers for failing to "hit" purchase prices. They publicize sob stories of realtors whose purchase deals fell apart.  "I had a bona fide purchase contract and the incompetent appraiser appraised it too low!" Such things could be said about me, too, but nothing is being said about the epidemic of deceptive purchase contracts nowadays.

To appraisers who think they must "hit" the purchase price:

If it was really true that the market value of a property is always the same as the purchase price, there would be no need for appraisals, would there be? 

It doesn't help, though, that some lenders have policies of sanctioning appraisers who don't "hit the purchase price".

Next stop: Puerto Rico

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Sunday, November 18, 2012

Mexico's La Riviera Maya: Ruins from a post-Columbian Race

Storm clouds gather at El Cañón de los Condos, Cozumel

Many tourists are drawn to Mexico's Riviera Maya to visit ruins from a pre-Columbian civilization known as the Mayas, a civilization thought to be the most sophisticated civilization in the western hemisphere prior to the arrival of Columbus, with surprisingly advanced knowledge of astronomy, mathematics, medicine and engineering. Legendary L.A. schoolteacher Jaime Escalante referred to Mayan mastery of mathematics to instill confidence in his Mexican-American students.  

Unlike the Aztecs, the Mayan civilization reached its zenith 6 centuries before the arrival of Columbus and then fell into a mysterious decline. The reason for this decline is not yet understood, and their ruins leave us curious to know more about them.

In my valuation work in Latin America, I have encountered equally interesting ruins from a post-Columbian race of people, a people I label as desarrolladores especulativos (“speculative real estate developers”). Although always present in the indigenous population, their numbers exploded during the first decade of the 21st century, with a significant influx from North America, but this race curiously disappeared after 2008.

One builder's abandoned hommage to the Mayan ancestors, Playa del Carmen

As an appraiser-anthropologist, I have actually met and worked with these people and participated in their beer-drinking  and overeating rituals afterwards. The desarrolladores especulativos were of diverse ethnicity, with some being Latino and others being North American. The one thing they seemed to have in common is that they were all middle-aged and older males. Could this gender imbalance be a biological reason for the disappearance of this race?

No, because this race is not actually extinct, but is instead just hiding from creditors.

Still, there is little left to understand these people other than the ruins they left behind.

La Piscina para los Dioses

As the 21st century began, the desarrolladores greatly increased in numbers. Many came from English-speaking countries. Some called themselves “developers”; others called themselves “renowned developers”. Members of this latter group had sometimes produced only one successful development. (Would Trump need to describe himself as "renowned"?) Some had no actual development experience, and when asked about what other projects they had built, they responded evasively with answers such as “I’ve been in this business 20 years” (most likely in real estate sales).

"La Torre Disponible" peeks out of the jungle much like pre-Columbian ruins in San Miguel.  

Some historians speculate that the Mayan civilization fell due to an unknown cataclysmic event in about 900 A.D. Similar to this theory of Mayan destruction, the desarrolladores especulativos disappeared in an event known as el día en que murió préstamos “the day the lending died”, which can be narrowed down to some time in late 2008.
Here I am surveying an airplane wreck at la Playa del Cid La Ceiba. Could this have been a high-flying developer who found himself "underwater" in his development loans?
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Tuesday, November 6, 2012

Mitsui Fudosan and Shuwa Investments: Then and Now

Mitsui Building in Tokyo's Shinjuku district, Nov. 2, 2012

Some of us still remember a time, about a quarter of a century ago, when rules of valuation of office buildings were completely ignored in an ego-fueled Japanese buying binge.

The competition between Shuwa Investments Corporation and the real estate subsidiaries of Mitsui, Sumitomo and Mitsubishi in overpaying for real estate became insane. (“Mitsui Fudosan”, established in 1941, means “Mitsui Real Estate”)

For instance, the Exxon Building in New York was already listed for sale for $330 million when Mitsui came in and offered $610 million, or 85% above list price in 1986. When Mitsui representatives were later asked (after the deal closed) why they bid 85% above the list price, they said it was because Mitsui’s president wanted to be in the Guinness Book of World Records, and the previous high price for an office building had been $600 million [per Roger Simon Farrell, A Yen for Real Estate: Japanese Real Estate Investment Abroad – from Boom to Bust, 2000, Edward Elgar Publishing, Cheltenham, UK].

Not to be outdone, Shuwa Corporation acquired the Arco Plaza in downtown Los Angeles for $650 million in 1986, only to spend tens of millions more on asbestos abatement. Many of us who worked in L.A. in the late 1980s sat by our phones hoping for a call from Shuwa’s headhunter, because working for Shuwa meant being welcomed anywhere like a binge-shopping Arab sheik or Elizabeth Taylor at a jewelry store. 

By the end of the 1980s, though, Shuwa had lost its luster and even attracted local consternation in L.A. when local employees sued for being physically beaten at work. Finally, in 2002, the troubled loan from the Bank of Tokyo for all of Shuwa’s downtown L.A. office buildings was bought for $255 million.

"Yoshi-san just spent $650 million for Asbestos Plaza ! Hit him !"

[Disclaimer: Not an actual photo of employee beatings at Shuwa Corporation]

The causes

There was a perfect storm of causes that resulted in this legendary period of Japanese misinvestment:

a. The appreciation of the yen, starting in the mid-1980s. The Japanese manufacturing miracle suddenly elevated the yen to a status in which the rest of the world looked cheap.

b. Japan’s extraordinarily low cost of capital, which allowed borrowers to settle on lower returns from foreign real estate.

c. Japanese bank regulations which were favorable to real estate because real estate inflation was a fact of life at that time in Japan.

d. Rivalry for prestige among Japanese companies such as Mitsubishi, Shuwa, Mitsui and Sumitomo, which created a competitive haste to acquire trophy properties without adequate due diligence.

e. The Guinness Book of World Records.

f. The use of domestic investment criteria to evaluate overseas investments. In Japan at that time, real estate investors were being enriched by capital gains, and investors looking overseas were so convinced that capital gains would continue that they overlooked current financial performance. Japanese investors did not use DCF models or current rates of return in evaluating their foreign purchase decisions, as they assumed that capital gains would take care of everything.

Mitsui Fudosan today

As a publicly owned company, Mitsui Fudosan was forced to become run in a more sensible manner, and pursued a course as a savvy, diversified real estate developer involved in office, retail, and housing, with new initiatives in logistics facilities, solar power development and private REITs. It is not a J-REIT (Japanese REIT), but a development company focused on growth through value-added projects, and it had a good record in the last decade by increasing revenues by 21% and increasing the dividend from 14 yen per share in 2007 to 22 yen per share in 2009, where it has remained since, equivalent to a current dividend rate of 1.3%. The most recent annual report, however, indicated 4% slippage in revenues, down to 1.338 trillion yen, due mainly to the falloff in the property sales business.

One of Mitsui's most interesting recent projects has been DiverCity Tokyo Plaza, a grand mixed use project on Odaiba Island in Tokyo Bay with an office tower and 154store, "theater-oriented" retail center. Just as New York Harbor has the Statue of Liberty, Mitsui has now given Tokyo Bay a statue of Gundam, a popular Japanese anime character.

Both Jones Lang LaSalle and Cushman & Wakefield have recently published reports that Tokyo now ranks third in the world for new real estate investment, trailing only New York and London, and some of these Tokyo investments are of the "flight to safety" type that also define the New York and London markets.

Part of this "flight to safety", however, is a flight to seismic safety after last year's 9.0 earthquake, creating an interest in new, safer office structures and also causing more functional obsolescence for high-rise structures built before 1981, when seismic standards were considerably strengthened.  The above-depicted Mitsui Building in Shinjuku, for instance, was completed in 1974, although one can observe that the entire east-facing wall of the building is dominated by seismic cross-bracing.

Although the U.S. hasn't had a major destructive earthquake since 1994, there is currently a flight to building safety after Hurrican Sandy caused such unexpected destruction in New Jersey and New York. In this case, tenants are seeking buildings more resistant to wind and water damage. It is not a good time to sell a beach house.

Last year, Mitsui Fudosan had a 25th year anniversary celebration of their acquisition of the Exxon Building, now known as 1251 Avenue of the Americas, in the building lobby.

Shuwa Investments Corporation was dissolved some time during the turn of the century. Being a privately held corporation, they did not have angry shareholders to keep them in line.

Per Jones Lang LaSalle and Cushman & Wakefield, the Tokyo office vacancy rate was last measured at 8.9%, down from over 10% the year before.
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