Detection and prevention of mortgage loan fraud

RMA Journal, The, Sept, 2004 by Vernon Martin

Deceptive purchase agreements are now common in the commercial arena, too. An example I witnessed last year was a loan application for a purchase at $3.2 million of a Houston office building still listed on LoopNet (a commercial real estate listing Web site) for $2.35 million.

To avoid being fooled, a lending institution should always have its appraisers and underwriters compare the sales listing with the purchase contract and examine the purchase contract for red flags, including:

1. Seller financing. It is possible that such a loan could be "forgivable," particularly if there is a relationship between the seller and buyer.

2. Allowances for repairs. If the repairs are not yet started, this amount should be deducted from the purchase price. All repairs should be verified by inspection before being assigned value.

3. Comparison of the buyer and seller. If they are individuals, do they share a surname? If the buyer or seller is a limited partnership, there should be some research on the principals. Know your client, and know whether one or more of the principals is on the opposite side of the transaction.

Most of all, appraisers should not be harassed by the lender for failing to appraise a property, for its purchase price. In a refinance application last year, an appraiser valued an apartment property in Oklahoma for $1.575 million, with the understanding that the purchase price several months previously had been $1.4 million and occupancy had increased from 50% to 97%. 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, as all units still had original appliances and carpets from the early 1970s. As for the 97% occupancy this was being achieved with low tenant quality--so low that 55% of the 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 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. The owner's space seemed to be vacant. The appraiser relied on this lease for occupancy and market rent information to arrive at a value estimate of $4.25 million. The building was subsequently valued at $1.55 million seven months after the original appraisal, based on market rents for such space. A lending institution's appraisal policy should call for a property to be appraised at market rents if contract rents seem too high. In addition, any above-market lease in which the tenant has not vet moved into the space should be viewed quite skeptically.