Friday, February 15, 2013

Ronan McMahon’s "Real Estate Trend Alert" is Put to the Test in Costa Rica

I’ve been a reader of International Living for a few years now (I only subscribed for one year, but since they have my credit card number, they keep on renewing without my permission), and IL is just one spoke in a real estate advertising and publishing empire that includes such affiliates as Pathfinder International and Real Estate Trend Alert. Many of the IL articles are written by or about ecstatically happy expatriates who escaped dreary lives in RochesterWest Virginia or Minneapolis (December 2012 issue) to find low-cost, gringo-loving paradises without mosquitoes, muggers or muddy roads. A typical testimonial might sound like this: "Every morning we eat fresh tropical fruits on our patio while Juan Valdez roasts our coffee.  Unicorns come to us from out of the jungle -- and we can actually pet them!"

Nothing bad ever happens in Latin America in International Living. Crime? Never heard of it. Try reading expat forums to learn the downsides of living in Latin America.

A subscription to IL gets one signed up for complimentary Pathfinder Alerts, an on-line newsletter featuring foreign real estate deals. A recent e-mail from publisher Margaret Summerfield to a “select group of readers” presented a “For Your Eyes Only” audiovisual presentation from “an international businessman” with a “shockingly powerful wealth-building secret” which we, the "select readers" on their spam list, are urged to keep secret. "Secrets of the wealthy" is getting to be one of the most tired lines of the investment scam business, and this script has all the other standard vernacular of phony get-rich-quick schemes, including the requisite “what would you do with that kind of extra money!” and “You need to be serious about making money – fast!” -- except for the slight Irish accent.

The "international businessman" turns out to be Ronan McMahon, her business partner, promoting a premium IL product, Real Estate Trend Alert, featuring his alleged prowess in spotting amazing real estate deals and sharing “insider information” from his “millionaire friends”, a service normally priced at $999 per year, but temporarily reduced to $499 per year if one “acts now”. The price can even be broken down into quarterly payments of $124.75, and there is a 30-day money-back guarantee if not delighted with his service. I found myself intrigued when he said that his most recent finds are in Costa Rica, a country where I also appraise real estate. 

This presentation has many of the typical features of the Sleazy Investment Promoter's Playbook, such as:

  1. Playing on our dreams.  What would you do with all that extra money?” is a standard investment promoter’s psychological ploy that takes the listener out of the realm of reason and prudence and into the realm of dreams.  
  2. Exaggerated claims of investment expertise.  Mr. McMahon’s own resume shows that he was not employed in the real estate industry prior to being hired as Pathfinder/International Living’s “real estate expert’. If he is indeed a successful real estate investor, he should give us evidence.  As for RETA's claims of profits made my its members, they use the dishonest technique of calculating profit by taking the lowest original purchase price in the development and then comparing it to the highest current listing price in the development, misleading readers into thinking that Ronan McMahon provided 100+% profits for his readers. Aren't there any resales to calculate actual profit?
  3. Claims of “insider secrets” and “millionaire friends” and heavy use of investment promoter buzzwords, such as “confidential” and “insider”. This "fake exclusivity" is how many so-called real estate and advice gurus sell their expensive seminars and publications.  Truly successful investors have no need to sell seminars and publications. Most of today’s real estate and investment gurus, even Rich Dad himself, make their money from marketing books and seminars and not from investment.
  4. Calling us “select”.  This is also a "fake exclusivity" trick. Twenty years ago I often received mass-mailed letters addressed to “Select Area Single” from Great Expectations, an overpriced and scammy dating service.  They didn’t even know my name or marital status.  Likewise, the only thing International Living/Pathfinder knows about me is that I was a sucker who gave them my credit card number.  For that I should be labeled "naïve" rather than "select", unless I've been selected for being stupid.
  5. Special discounts if you “act now”, thus engendering a sense of urgency.

Despite suspecting a hoax, it is to protect and inform all of you, my “select readers”, that I acted as a guinea pig in subscribing to his Real Estate Trend Alert service, authorizing a payment of $124.75 on my credit card and relying on a 30-day money-back guarantee. Little did I know that the scam had already begun.

Although I chose the $124.75 (3-month) option, their server automatically upgraded my request to the full $499 subscription. An hour later, my credit card company contacted me about this mysterious $499 charge. I contacted IL and asked for this charge to be corrected.  Four days later I requested a full refund, but only received a credit for $124.75, leaving me with a balance of $374.25.  I have since asked for and received a full refund on March 7, three weeks later, after several dealings with their flaky customer service department (with excuses such as "our computer is programmed to give only one refund, and we can't get it to refund the remainder"). Remember that Pathfinder is an Irish company and might not play by (or even know) the same rules as American companies.

Two days after ordering, I started receiving the daily Real Estate Trend Alerts, which turned out to be recycled (and free) Pathfinder Alerts and International Living classified ads. Nothing secret or "insider" about these, thus contradicting his claim that his selections “truly are insider investments, not available to the public.” Some of these properties are getting shopworn after being repeatedly advertised in these publications for two years or more. And if Mr. McMahon is such a real estate investment genius, why are most of his recommendations his own advertisers? When McMahon uses the word "insider", it really means "advertiser".

Case in point is the last “Alert” I received the morning before I called to cancel my subscription. The title was “Last 2 Lots at this Low Price (Great Views)”. The project was “The Preserve at Lake Arenal”, a Costa Rican project I’m already familiar with as the result of a free Pathfinder Alert. This morning’s alert told of two remaining half-acre lots available to RETA subscribers at the low price of $25,000 each, with 10% cash down and interest-free monthly payments of $187.50 per month for 10 years. McMahon tells us “Arenal is facing an inventory crunch. Land prices have risen,” when the opposite is happening. It always amuses me when I'm told that Costa Rica is running out of land.

I had already recently communicated with owner Greg Coxon, who basically offered the same deal to me: “Our lowest price lots start at 25k.” and “Were [sic] offering no interest financing on short term loans,thus contradicting McMahon’s promise of “off-market deals” and “massive discounts like 50%.” Moreover, the views from these lots are jungle views, not lake views, which makes a difference at Lake Arenal, also known as the "Lake Tahoe of Costa Rica".

A closer look at the sales history of The Preserve might make a buyer cautious. Having been marketed for over 2 years now (as determined from the date of the Facebook page), only 22 out of 57 lots have been sold. The pace of sales has slowed in the last year, with only 6 sales last year and one lot unsold (probably a payment default). Only a model home and a clubhouse have been built. Described as a gated community, the fencing around the gate can easily be stepped over on foot. The lots are not yet graded, and this subdivision is “eco-friendly”, the euphemism for having no public water or sewers. The sewage treatment plant has not yet been built, but there is well water. In other words, this subdivision is still in mostly raw form 2 years later, and the longer development is delayed, the harder it is to sell the remaining lots as prospective buyers become skeptical about the project’s viability. I’ve also never seen slowing lot sales speed up again, as confidence wanes when sales slow down.  Subdivisions are my valuation specialty.

The viability of The Preserve also needs to be judged in the context of its milieu. It is adjacent to another struggling community known as Turtle Cove Lake and Yacht Club. Turtle Cove has a marina, boat storage, and 5 custom homes built so far (two of which are for sale). After 5 years of marketing, only 22 out of 47 lots have been sold, and now their developer is holding a fire sale, with discounts of up to 34%. This spells trouble for the neighborhood. Financing is 20% down and 5% interest. The current price list and site plan can be found via this link: .

When lots get discounted like this, the stage is set for negative lot absorption -- many lots will become “unsold” as buyers who already put 20% down realize that all of their equity is gone and they are now “underwater” on their purchase loans, owing more than the lot is worth. Buyers like this are often litigious, too, but lucky for the developers, they will get nowhere in Costa Rican courts, and neither would you. Vacant lots in distressed subdivisions are among the worst real estate investments that can be made, because the investor could lose his entire investment. Why does Pathfinder and RETA promote them so much? And don't get me started on "Pre-construction pricing" on unbuilt condos.

In summary, this shopworn property is not a suitable investment to be offering to subscribers, is more likely to lose money than make subscribers rich, and Real Estate Trend Alert is no more than a marketing gimmick that repackages paid advertisements into recommendations from a fake expert (a young man who came to IL from the industry) while collecting hefty fees from gullible subscribers.

PS: April 28, 2013, ten weeks later --

Pathfinder Alert has become increasingly desperate to market these shopworn Lake Arenal properties, with almost daily alerts.  Today's alert reads: 

"Once word gets out about this place, and it becomes trendy or hip, it could explode. There's no reason for its low property prices, other than the fact that nobody knows about it....

A lake-view lot for $17,500 - and it's open to offers."

What?  Could Ronan's insider deal at $25,000 ten weeks ago have actually been marked down 30% since then? And still be open to offers? 

PPS: February, 2014, one year later: The Preserve at Lake Arenal now has 36 lots for sale vs. 35 lots one year ago, indicating a net loss of one sale during the past year, and they are still offering "pre-construction" pricing! I seriously doubt if this project will get built.

Nevertheless, I just received this "Pathfinder Alert" from Margaret Summerfield:

"How to make $1.1 million in Costa Rica

Last week, Ronan McMahon told RETA members how they could have made massive profits from a land purchase in Arenal, Costa Rica. If you’re looking for access to “insider deals”, RETA could be your most valuable membership. Join Real Estate Trend Alert to be briefed the next time an opportunity like this crosses Ronan’s desk."

This phantom $1.1 million profit would have supposedly come from subdividing a large residential estate that sold at half its original listing price, but what hasn't been mentioned is that permits are needed to subdivide the land and Costa Rica's rules for approving subdivisions are just as onerous as California's; approvals take years, not months.  Then you have to find buyers for the lots, and buyers have been scarce at Arenal over the last 2 years.  If someone made $1.1 million on this deal, I would like to receive proof.

The style of communication of Pathfinder also presents some concerns. I'm talking about the frequent underlining, highlighting, bolding and exclamation marks!!  Where have I seen this before?  Just about every piece of spam I get, such as ads for miracle weight loss or genital enlargement pills. It's just so transparently sleazy.

11/20/17: I have published an updated article on Ronan McMahon: .

Saturday, February 2, 2013

“Crowdfunding” -- A New Name for an Old and Abused Concept

I’m normally a fan of Bloomberg BusinesWeek, but I found myself baffled by last week’s article, “Crowdfunding for Skyscrapers”, particularly with the idea that this is a revolutionary concept in real estate funding.  Was the writer too young to remember the “syndications” of the 1970s and 1980s, which made general partners richer and limited partners poorer?  Did the writer not notice the TIC (tenants-in-common) scams of last decade and the recent bankruptcies of SCI and DBSI, two of the largest TIC sponsors? ( He even implies that real estate crowdfunding is a concept that originated in – sit down for this one – Colombia, a nation that has given the world so many good ideas.

This concept often changes its name with each new decade as it repeats itself, with the sponsors selling their own properties or unwanted properties to investors, or buying first and then charging a hefty mark-up, all the while charging investors for selling commissions, wholesaling fees, placement fees, reimbursement of offering costs, underwriting fees, and reimbursement of offering and organization expenses. The sponsor is always the winner while investors are usually losers when it comes to "crowdfunding".
It's not the concept of crowdfunding that is the problem, though, so much as the people and the marginal quality of real estate that it attracts.  There is nothing wrong with organizing investors to fund great deals, but crowdfunding, or whatever else you want to call it, often attracts the unscrupulous seeking to exploit the unsophisticated, even if it is just to get rid of their own properties.

The crowdfunding sponsor featured in the BW article, Rodrigo Nino, started his Prodigy Network to sell troubled condo projects, such as Trump SoHo in New York and Sole’in Sunny Isles Beach, Florida.  To his credit, Mr. Nino didn’t cause the problems at these projects, he just solved the problem of selling the condos, something he does very well.  He sells them to foreign investors. And he is an immigrant from Colombia, which makes me suspect that BusinessWeek just let him write his own article.

What's in it for investors in these ventures?  Let’s get some investors to buy condos that Trump can’t sell!” is an investment proposition that does not inspire confidence. It is instead a casting call for suckers.

What was most alarming about this article, though, was the observation that the new JOBS Act “will open new deals to Americans”, as if the Obama Administration is doing our nation a favor in removing SEC (Securities and Exchange Commission) barriers between naïve small investors and fast-talking condo salesmen. 

SEC scrutiny of crowdfunding promotions can already be avoided by making “Private Placements” to “Accredited Investors” of 35 or fewer. An accredited investor self-certifies that he or she has at least $1 million in net worth or an annual income of at least $200,000 ($300,000 for couples). The concept of “accredited investor” has been greatly weakened by time and inflation, though, as in the early 1980s, when these thresholds were established, an accredited investor was meant to be in the top 1% of Americans in terms of wealth and presumed sophistication. Today, this category covers about the top 7%, and many accredited investors are ordinary professionals, widows or heirs who are not financially sophisticated. To counteract this weakening of the definition of "accredited investor", the SEC has now eliminated home equity in the computation of net worth.  Nevertheless, this whole system relies upon investors certifying that they meet the definition of an accredited investor and understanding the change in the definition.

As a Certified Fraud Examiner, I have been approached before by groups of aggrieved “accredited investors” who lost most of their money to TIC promoters.  All who I met were senior citizens, and these were people who were counting on a secure retirement after an honest life’s work as, for example, a geologist, a radio engineer, and even a handyman. The DBSI and SCI bankruptcies alone (after the sponsors had received ill-gotten gains) wreaked financial havoc on 22,000 such investors, and the media has ignored the massive predation of the real estate investment industry on unsophisticated senior citizens. 

My neighbor, for instance, invested in the SCI Mezzanine Fund, in which investors paid for the privilege to lend SCI money, unsecured, rather than the usual protocol of the borrower (SCI) paying fees to borrow money from lenders.  His $87,000 investment has disappeared now in the SCI bankruptcy.  We watched the well-tailored SCI co-founder Marc Paul squirm in the bankruptcy court hot seat as he explained how he lost his home as the result of the bankruptcy.  He currently lives in a 4000 square foot Beverly Hills mansion (9661 Wendover Drive) that he deeded, not really "lost", to his children. What suffering he must be going through. Meanwhile, the SCI trustees are now suing my neighbor and his fellow investors for "performance fees" that are somehow owed to these TIC sponsors.

Thanks to the JOBS Act, though, the real estate investment industry will be able to find even more suckers with the new ability to use general advertising and general solicitation to attract accredited investors. Final SEC rules have not been issued yet.
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Monday, January 14, 2013

When Extra Due Diligence on the Borrower Can Pay Off for Appraisers and their Lender Clients

Most of my work is for private lenders, and there are too many scam artists out there who think of private money as stupid money waiting for their taking. They also think of appraisers as stupid, perhaps based on previous experience.

An appraisal purist looks only at the property itself and not who owns it or wants to buy it, which is not relevant when the standard definition of market value is based on the price the property can be sold for on the open market.

Considering, however, that the appraiser or valuer is highly reliant on information from the property owner or buyer, it can help to know the background of the giver of the information. When the information source is known for being untrustworthy, it makes an appraiser revisit all of his assumptions. It also helps the lender-client and can save time for the appraiser.

If and when one of my appraisals comes in too low and a dishonest borrower wants to waste my time with falsehood-filled rebuttals, I used to spend hours reading their rebuttals, researching and attempting to verify their factoids and even reading appraisal reports from their “pet appraisers”.

To save time nowadays, I order a background check on the principal borrower and find enough dirt to stop the deal before more time is wasted. I learn of bankruptcies, legal judgments, criminal convictions and even incarcerations. It’s amazing what types of people are attracted to the commercial real estate business and are allowed to continue to practice in this business.

In my recent post on Puerto Rico I found that the buyer had been convicted of mortgage fraud just one year ago. Coupled with the fact that he could not show me valid, signed purchase contracts, presented me with a misleading appraisal report, and wanted to use his own private escrow company, this made it easy for me to make a judgment call for my client. This was probably a bogus transaction and he was “at it again”.

In another recent instance, the borrower was claiming to buy land in order to develop a 100,000 square foot corporate headquarters for an ultra-high-tech company I could not find any information on. He was paying well above the current list price of the land, putting no cash down and relying on seller financing, which I found suspicious. He had no construction plans and specifications, just artist’s drawings. The background check indicated 2 criminal convictions, 2 bankruptcies, 2 legal judgments against him, several known aliases, as well as no background in technology. He was a political science major.

My theory was that he was hired as a straw buyer to bail out the present property owner. (Such opportunities are sometimes offered on LinkedIn, which has sunk as low as Craigslist. A commercial straw buyer can make $50,000 in one transaction.)

I hope this will shorten rebuttal time, although he has complicated matters by ordering an MAI appraisal at a value higher than the inflated purchase price. The appraisal report repeatedly refers to entitlements, but I called several people in the county planning department and not only were there no entitlements, there has never been a development plan submitted for approval. How could there be, when all he has are artist’s drawings?

Some appraisers won’t do due diligence. I do, and my clients thank me.

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Saturday, December 29, 2012

Hong Kong Revisited -- Risks Presented by Low Cap Rates

View of Hong Kong Central from Kowloon, November 2012

Returning to Hong Kong 18 months after my previous post, I found residential prices had increased 23% this year alone as of October, and 87% since 2007, causing the Hong Kong Monetary Authority (Hong Kong's central bank) to worry that “the disconnect between property prices and economic fundamentals” presents “macro-financial risks” to the Hong Kong economy. has reported rental property capitalization rates in Hong Kong have declined to a range between 2.2 and 3.6%, and as low as 2.13% in The Peak neighborhood, and The Economist has reported an estimate that Hong Kong homes are 69% overvalued when compared to the rental income that they can produce.

Ultra-low real estate capitalization rates in Asia, such as in Hong Kong, present a bubble that lasts only until interest rates return to normal levels. Hong Kong already has a history of these bursting bubbles, such as the office market in 2004, declining 30% the following year, or the residential market in the Asian Contagion of 1997, when average prices declined 63% from peak to trough.

The Hong Kong government has already taken measures to discourage speculation, such as lowering loan-to-value ratios on mortgages and imposing stamp duty taxes of 15% on home flippers and foreign buyers, but such measures also send signals that housing prices are still headed upwards.

A Barclay’s report this year shed some light, though, on the gain in housing prices, reporting that the proportion of investor-buyers increasing to 70% and that 60% of homeowners have no mortgage. This points the reason for the price gain in the direction of foreign buyers, particularly the Chinese mainland, who often do not occupy their Hong Kong homes but treat them as “safe haven” assets.

With home affordability in Hong Kong at historic lows, any events that call in to question Hong Kong’s “safe haven” status, such as an interest rate shock, could cause it to suffer the fate of most of the second home markets the world over, although there is always a need for a safe haven somewhere. London, New York and Dubai have been recent popular destinations for foreign buyers with this aim in mind.

Hong Kong benchmark interest rate history -- HK Monetary Authority
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Tuesday, December 25, 2012

Perverse Executive Compensation Schemes Instigated the American Mortgage Crisis

Last month I had the opportunity to watch my former boss on trial. On December 7th, he and his two co-defendants were found liable by a jury for $168.1 million in damages to the FDIC (U.S. Federal Deposit Insurance Corporation) for the failure of IndyMac Bank, the costliest failure to date for the FDIC, causing an estimated cost to taxpayers of $12.8 billion. This case was known as FDIC v. Van Dellen, Koon and Shellem. The basis of this lawsuit was that the defendants departed from safe and sound lending practices in order to score personal bonuses based on loan volume.

IndyMac executives Shellem and Koon

Eleven years ago I was the chief commercial appraiser for IndyMac Bank in Pasadena, California, reporting to the chief credit officer, Ken Shellem, who was one of the defendants in this case. I started my position there with the naïve expectation that this new bank wanted to follow all the rules. It took me 3 months to figure out that IndyMac was in the business of breaking rules to enrich its senior management, and this corruption led to the top of the organization, the Chairman of the Board, David Loeb.

Chairman David Loeb was best known as a co-founder of Countrywide Home Loans than in his other role as a Nevada land developer. While Federal Reserve Board Regulation O severely limits the amount of money that can be loaned to officers of a regulated institution, Mr. Loeb had found what he thought to be a loophole. He pushed through bank loans to developers who were buying his land in Nevada. As the chief commercial appraiser, I was told that I would be fired if I held up any appraisal supporting one of these land loans, and I was prohibited from ordering any appraisals. All appraisals were ordered by loan officers on sales commissions.

I worked mainly with the Bank’s Home Builders Division and was surprised to find that its own senior credit officer was on commission. As a result, there was no loan proposal that he didn’t like. After 3 months, it was made plain to me that my job was to approve every salesman-ordered appraisal report with a review report bearing my signature. This concerned me, because I found a few of the reports to be biased with false inspection reports, absurdly optimistic income projections, or appraised values well above the simultaneous purchase prices.

I tried to hold on to my job as long as possible without approving the fraudulent reports. I certainly did not want to be fired, but neither did I want to be prosecuted or sued some day for participating in loan fraud. It would be better to be unemployed. I was fired roughly 6 months after I started.

I blew the whistle to the regulators (OTS), and shortly afterwards there were some personnel changes at IndyMac, including the sudden retirement of Chairman Loeb and the termination of the COO and Senior Credit Officer of the Home Builders Division. Loeb died five months later, the Kenneth Lay of the banking industry. Most of the ringleaders kept their jobs, however, including the defendants named above.

I launched a wrongful termination lawsuit against the bank and two of the same defendants named above – Ken Shellem, my boss and chief credit officer, and Richard Koon, the chief loan sales officer, who worked hard to persuade the bank to fire me. At a court-ordered mediation the case was “settled to the mutual satisfaction of both parties.” A non-disclosure agreement prevents me from saying more.

The problem with the whole mortgage industry

In the mortgage industry meltdown of 2007-2008 it could be asked why so many of the best and brightest financial minds were so wrong again so soon after the savings and loan fiasco of two decades ago?

It’s the compensation

One explanation is that financial executives were gaming the system in response to unsound executive compensation systems commonly used by public companies.

Earnings can often be booked at loan origination, regardless of loan soundness. During the good times, these unsound loans can be sold off to sit in mortgage pools or portfolios as ticking time bombs, to be dealt with long after the senior executives have received their bonuses and exercised their stock options. Many mortgage industry executives succumbed to such a compelling enrichment scheme.

IndyMac Bank and Washington Mutual

Two of the largest savings and loan institutions in the U.S., IndyMac and Washington Mutual, were respectively seized by the FDIC in July and September of 2008.

Both were fast-growers who were rewarded by Wall Street with high price-earnings multiples and soaring stock prices. Those in the mortgage lending business know, however, that such rapid growth is inconsistent with prudent lending.

Many mortgage-lending institutions rewarded their CEOs and COOs with incentive-based compensation that dwarfed their annual base salaries and encouraged them to do whatever was necessary to increase the stock prices of those institutions. Stock prices moved in tandem with reported earnings.

IndyMac CEO Mike Perry, for instance, had an annual salary of one million dollars per year, but his incentive-based compensation (bonuses and stock options) was many times as high. Perry earned over $32 million by selling IndyMac stock from 2003 to 2007, in addition to performance bonuses which were typically 75 to 100% of his base salary.

An IndyMac press release on September 22, 2006, “IndyMac Signs Long-Term Contract with High-Performing CEO, Michael Perry,” plainly explains the radical difference in future (year 2007) compensation to Perry under various scenarios, with his total compensation limited to $1,250,000 for EPS growth of less than 5%, but compensation of $8,943,000 for EPS growth of 17%. With a compensation structure like this, it was no wonder why rapid growth was pursued at all costs. Making and selling unsound loans would be the easiest way of meeting such a financial goal.

Kerry Killinger, CEO of Washington Mutual (WAMU), was also paid a base salary of $1,000,000 in Washington Mutual’s last full year of existence, and he was incentivized with stock options that brought his total pay package to more than $14 million. The New York Times reported that he received $38.2 million in performance pay ($7.6 million in cash and the remainder in stock) between 2005 and 2008. WAMU”s mortgage-related losses of $8 billion in 2007 and 2008 wiped out all of its earnings in 2005 and 2006.

World Savings

As reported on CBS’s Sixty Minutes, Herb and Marion Sandler safely and soundly managed World Savings for years before finally succumbing to such temptation, receiving millions of dollars in the sale of their doomed institution to Wachovia Bank, so badly damaged that the federal government had to force its sale to Wells Fargo.

Fannie Mae

Franklin Raines, the CEO at Fannie Mae, received $52 million in compensation between 1999 and 2004, with $32 million from an incentive plan generating big bonuses for Fannie Mae achieving certain performance yardsticks, such as 15% annual growth in earnings. Mr. Raines was accused of falsifying the reported earnings to gain his bonuses and was therefore terminated, leading to a $9 billion profit restatement covering years 2001-2004.

These CEOs have faced multiple lawsuits, some of which have not yet been resolved. Mike Perry, IndyMac CEO, settled with the FDIC (last week) and the SEC and faces class action lawsuits from investors.

Renowned law professor and former regulator William Black has recently made similar comments as follows:
Widespread appraisal fraud by mortgage lenders optimizes accounting control fraud.  The fraud “recipe” for a mortgage lender (purchaser) has four “ingredients.”
  1. Grow like crazy by
  2. Making (purchasing) really crappy loans at a premium yield (interest rate) while
  3. Employing extreme leverage (very high debt to equity ratios), and
  4. Providing only grossly inadequate allowances for loan and lease losses (ALLL)
George Akerlof and Paul Romer wrote a famous article in 1993 entitled “Looting: The Economic Underworld of for Profit.”  They agreed with the central finding of competent financial regulators and white-collar criminologists: following this recipe produces a “sure thing.”  More precisely, following the recipe produces three sure things.  The lender (purchaser) will report record (albeit fictional) profits in the near term, the controlling officers will promptly be made wealthy by modern executive compensation schemes, and the lender (purchaser) will suffer severe losses in the longer term. 
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Thursday, December 13, 2012

The “Colonias” at the Mexico-Texas Border

Colonia in Cameron County, Texas

While working on an assignment near Brownsville, Texas, which was a proposed subdivision with no entitlements or development plan, it reminded me of a different type of illegal subdivision which has been a scourge in the Texas Rio Grande Valley.

The word “colonia” has an often undesirable connotation in Texas, unlike other areas of Latin America, where it generally refers to suburbs or other human settlements. In Texas it refers to illegal residential subdivisions lacking the basic utilities (water and sewage treatment) needed for human habitation. Residents also sometimes have to poach electricity from the closest power line, as often done in India. These colonias are some of the poorest communities in the U.S. (60% of households earn less than $1600 per month and average household size is 4.1) and are estimated to contain as many as 500,000 residents in Texas. A University of Texas study indicates their greatest prevalence in the border counties of Webb (Laredo) and Maverick (Eagle Pass) and the Central Texas counties of Travis (Austin) and Bastrop.

Photo from P.A. Lassiter

When one crosses north from Mexico to Texas, the landscape and culture have a less defined boundary than the border itself, as the Texas border is porous and the border fence has unguarded openings for vehicles (although vehicles can’t cross the Rio Grande at those points). Extended families sometimes live on both sides of the border and cross freely, and the vast majority of residents on the immediate Texas side of the border are ethnically Mexican.

Texas governments have traditionally had a laissez-faire (“anything goes”) attitude towards real estate development. There are no zoning laws governing land outside city limits, and even the city of Houston has no zoning code.

Some unscrupulous land developers have previously taken advantage of this laxity by subdividing rural land, building or allowing substandard housing on it, and failing to install water or sewers. This was done illegally, and per Texas Local Government Code section 232, all residential subdivisions must now be approved by county government and show that they have water and wastewater removal prior to development. Lack of zoning is not the same as having approval to build. The law allows almost any piece of rural land to be subdivided and developed, but the development has to meet local standards, which include water and sanitation.

Because these communities live outside the conventions of the modern American financial system, colonia residents cannot obtain mortgage financing for their land or homes. Instead, their home purchases are typically financed through “contracts for deed” issued by the original property owner as “pay-to-own” contracts, and are often informal and handwritten, charging interest rates as high as 20% per year. This leaves homeowners without proper title to their properties, not being recorded in official land registries, and burdens homeowners with tremendous risk that they cannot claim or sell their ownership rights.

In 1995, the Texas state government was becoming increasingly concerned about living conditions and exploitation of poor homeowners in colonias and enacted legislation to discourage “contract for deed” transactions and assure that all residents have water, sanitation, and electricity. This will prevent future colonias from being developed, but has not necessarily corrected existing colonias, as there has been no budget for enforcement.

Colonias may undergo similar life cycles to conventional neighborhoods, starting simple and uncrowded, than densifying to horrific proportions, and then finally being recognized and brought under the control of local authorities and even provided with modern infrastructure. The top 2 photos are colonias I saw in Cameron County, which has made progress in getting colonias under control. I searched in vain in Cameron County for a horrificly overcrowded colonia, so I turned to another blogger for the third photo, one of many on her own blog.
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Friday, December 7, 2012

Waterfront Land Appraisal in Puerto Rico

This was a 1000+acre combination of fee simple (freehold) and leasehold interests in land around a scenic bay in Puerto Rico, and the lease agreement also had an option to purchase. A developer was acquiring these interests for an already approved project to build hotels, villas, and a cruise ship port. This mixture of interests meant that I had three tasks to do:

1. Determine the market value of the fee simple parcel, whose purchase price had been set in year 2000,
2. Determine the market rental rate for the remaining parcels and compare to the contractual rental rate to determine if there is a positive leasehold value, and
3. Determine if the option price was above or below market value in order to determine if the option had any value.

In my background check on the borrower, I found that he had pled guilty a year ago to a criminal charge of mortgage fraud and was also being sued by the FDIC. This became troubling to me as he required a quick closing on the loan and was using an unknown escrow company, yet had no signed, valid contracts as of my visit or several days afterward. What was also suspicious was that the price kept on changing with each new contract version he sent, all of which were in MSWord and easily alterable.

The ground lease was to another unaffiliated LLC who was supposedly going to assign its interest to the borrower after the lease was signed, but despite my requests, I never received a document of this assignment of leasehold interest. Moreover, the lease had a clause which rendered it null and void if anyone in the tenant’s company had had a criminal conviction.

The fee simple parcel had an abandoned sugar mill, and there was no environmental report to inform me about possible contaminants. Common sugar mill contaminants include bagasse (from boiler fuel), pesticides from the sugar liquid and residue, and metal oxides from the rotting of the structures. This site had an estimated 50,000 tons of scrap metal, much of it rusting, placing iron and zinc oxides into the soil.

The bay’s water was as turbid as New York Harbor and unlike the clear blue water one would normally expect in the Caribbean. The problem was agricultural runoff from the farms upstream, making the bay very silty, compounded by incoming wave action from the Caribbean Sea. The waterfront of the fee simple site, moreover, consisted mainly of bulkhead and mangroves, making it unsuitable for a beach. Beaches are one of the principal attractions of Caribbean resorts.

Moreover, the bay’s maximum depth was only 29 feet, whereas most cruise ships have drafts (distance from waterline to bottom of keel) of more than 25 feet and need another 6 feet of depth for clearance. The bay would have to be dredged first and periodically thereafter until the continuing river silt deposits were under control.

Sales of large parcels of entitled land had not occurred in several years in this part of Puerto Rico, but a look at listings of property for sale indicated asking prices below the sales prices of several years ago. An adjacent, waterview parcel entitled for 100 hotel rooms and 50 villas is listed for sale at just $35,000 per acre or $10,000 per UBV (“unidad basica de vivienda” or “unidad de vivienda basica”, meaning “basic housing unit”, a unit of measure uniquely created by the Reglamento de Zonificacion de Puerto Rico, the zoning regulation for Puerto Rico). One UBV is equivalent to a 3-bedroom dwelling. A 2-bedroom dwelling counts for .8 UBV. A one-bedroom dwelling counts for .6 UBV, and a hotel room counts for .4 UBV.)

The purchase option was based on a price close to $100,000 per UBV, ten times as high as the neighboring property, so the purchase option was considered to have no value.

Because the ground rent was in steps leading up to a stabilized rent equivalent to 8% of the purchase option price, and no ground leases were found as high as 8% of value, the leasehold interest itself was also considered to have no value.

The only parcel that was considered to have value was the fee simple brownfield parcel, so there was insufficient collateral to support the large development loan requested by the borrower. Furthermore, he never showed the ratified, valid contracts that would show that he was really closing these transactions (with my client's funds) on the day he specified, with his chosen escrow company. (I always advise my clients to use nationally known escrow companies.) I suspected a scam.

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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