Commercial Real-Estate Fraud Soars Amid Plunging Property Values

As report by The Wall Street Journal

What's happening: U.S. prosecutors are ramping up efforts to combat commercial mortgage fraud, sending shockwaves through the $4.7 trillion industry by scrutinizing the numbers behind major property loans.

Why it matters: Fraudulent property loans, based on doctored financials and valuations, have surged since the mid-2010s. This wave of deception was fueled by skyrocketing commercial property prices, providing landlords ample motivation to inflate their numbers.

• Current crisis: Higher interest rates and a spike in defaults are now exposing these fraudulent schemes, adding strain to a commercial real estate market already suffering its worst downturn since the 2008-09 financial crisis.

What they're saying: “It’s a general trend throughout history that fraud occurs during boom times and is revealed during bust times,” says John Griffin, finance professor at the University of Texas’ McCombs School of Business.

The loophole: Real-estate fraud often thrives because lenders typically take a hands-off approach when assessing a building’s value. If the numbers appear consistent with similar properties, they usually pass without rigorous verification. Auditing is both costly and time-consuming, and lenders eager for deals may avoid antagonizing landlords with stringent due diligence.

The crackdown: Federal prosecutors, often collaborating with the Federal Housing Finance Agency’s Office of Inspector General, are intensifying their efforts to root out fraud. While exact figures on open investigations aren't public, numerous plea deals have surfaced recently.

• Recent cases: Since last fall, landlords of properties in cities like Cincinnati, Hartford, and Little Rock have pleaded guilty to federal fraud charges. Some inflated building income statements, while others faked property sales at higher prices to secure larger loans.

Fannie Mae and Freddie Mac respond: Government-backed mortgage giants Fannie Mae and Freddie Mac are cracking down on dubious practices in their rental-apartment lending business.

• Blacklisting brokers: Both agencies effectively blacklisted mortgage brokerage Meridian Capital Group and brokers from other firms due to allegations of doctored financial statements.
• Policy changes: Freddie Mac now requires rent receipts and more thorough inspections to ensure apartments are occupied. Fannie Mae is scrutinizing loans to weed out those based on dubious numbers.

The fallout: In a recent earnings call, Ivan Kaufman, CEO of Arbor Realty Trust, highlighted fraud as an unanticipated issue creating additional market stress. “There was a lot of elevated fraud in the industry through the brokerage industry,” he said.

How it works: Fraudulent schemes often revolve around T-12 financial statements, which detail a building’s income and expenses over the past year. These documents are pivotal for lenders in estimating property value and loan amounts but are rarely audited for accuracy.

Case in point:

• ROCO Real Estate: This Michigan-based landlord inflated profits for a Tallahassee, FL, apartment complex to secure a larger loan from JP Morgan Chase, which was later repackaged into bonds and sold to investors. The mortgage defaulted in late 2022.

• Guilty plea: ROCO’s Tyler Ross admitted to falsifying financial statements for several properties. In another case, New York property manager Jacob Deutsch received a five-year prison sentence for defrauding lenders on 24 multifamily mortgages in Hartford, Conn.

The big picture: While outright lying to lenders is rare, altering T-12 statements by omitting one-time expenses or other tweaks is common and often accepted by lenders. However, Griffin warns that these alterations have escalated, leading to many loans based on inflated numbers.

• Study findings: In a 2023 paper, Griffin and co-author Alex Priest analyzed over 39,000 commercial mortgages and found that nearly one-third had underwritten building profits exceeding actual profits by at least 5%.

The bottom line: Both landlords and lenders have incentives to inflate building profits, leading to bigger loans and fees. “This space is littered with conflicts of interest,” Griffin said.

Be smart: Stay vigilant about commercial real estate investments.