Detection and prevention of mortgage loan fraud

RMA Journal, The, Sept, 2004 by Vernon Martin

Witness the following comparison of operating expense ratios for garden apartments nationwide in the Institute of Real Estate Management's 2002 Income/Expense Analysis[R]: Conventional Apartments:

1946-1964: 50.6%

1965-1977: 47.6%

1978-2001: 41.3%

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% expense inflation given these operating ratios. If a 12-year-old building was operating at a 41.3% expense ratio and expenses increased at 5% 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% 18 years later. At age 12, the building earns $100 for every $41.30 in expenses. At 5% 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% income growth rate, not 5%. The difference may seem slight, but projecting 10 years out, the difference in income between a 4.17% growth rate and a 5% growth rate would be more than 8%, 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 are often pressured 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 risk management professionals). In a clash of wills, whose do you think would dominate? Physics is on the side of the loan salespeople. This has created an endemic upward bias in the appraisal profession.

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

Consider if there is 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% higher than the market average while fabricating bogus comparable rentals. A review of the borrower's loan file found a resume for the borrower indicating that he was a board member of the appraisal corporation.