Passive Participation in a Real Estate Scam

In My Humble Opinion
1

As we know, real estate has tanked over the last few years, and a lot of people in the field have been wiped out or close to it. But as is frequently the case, some investors with high shrewdness-to-scruples ratios are finding money making opportunities on the way down as well. One common one these days is the short sale scam.

Basically it goes something like this. Suppose the seller has negative equity in a property (typically an income producing property). For example, he owes $400K on a property with a current market value of $350K (a few years ago, the property was worth $500K). As soon as the seller decides to go the short sale route, he typically stops making all payments on the property, while continuing to collect any income. (As a certain mobster once observed, “if you don’t pay your bills, your gross income is your net income.”) Then he brings in a friendly appraiser - possibly the same guy who convinced the bank a few years ago that the property was worth 20% more than its true value, except that now his job is to convince the bank that the property is worth less than its true value. By this or other means, the seller convinces the bank that the value of the property is only $300K. At this point, the bank agrees to take $300K for the property - they do not want to be saddled with the property, and would rather focus on banking.

Now he finds a buyer at $320K. But the deal is that the official sale has to be at $300K, and this is the amount that the bank gets. The $20K is paid to the seller “under the table”. And now everyone is happy. The bank got $300K, which is what they think the property is worth, and they don’t have to deal with this headache anymore. The buyer gets a $350K property for $320K (though this will be partially offset by capital gains taxes on the $20K, when he sells). And the seller is happiest of all - he has turned negative equity into $20K, plus whatever income he picked up after stopping to make payments.

There are a lot of variations of this, involving the roles and relationships of the various players, but this is the basic gist. What I’m interested in is the legal and ethical aspects of being the buyer in such a scenario. It feels sort of like being a fence for stolen goods, but I’ve been told that - depending on the details in a specific instance - it’s not always clear that what the sellers are doing is technically illegal, which might make a difference when dealing with the ethics for secondary participants.

And in particular, one variant is where the buyer does not make any under-the-table payments directly to the seller. Instead he pays an “enhanced commission” to a real estate agent/broker, who, after all, got him this really great deal, and deserves some extra compensation. But the buyer is no dummy, and he understands the game, and realizes that some or all of the enhanced commission is being used to pay off the seller. Does this change things?

2

When banks make loans on property that is not a primary residence, they include an assignment of leases and rents in the closing package. The lender gives the mortgagor the license to collect the rents and hold and leases until the event of a default, at which time, that right reverts to the lender.

Now if someone took out a loan on what was supposed to be a primary residence, they signed an affidavit stating so. Investment property loans have a higher rate than primary residence loans. If the lender finds out the property is not being used as a primary residence, they can (and often will) pursue the matter.

Short sales are not so easy. They take months for approval and the seller has to submit tons of documentation. They are also required to be arm’s length transactions, and simply stopping payments on your mortgage won’t automatically get you in the short sale pool. I see a lot of short sales disapproved, and the bank proceeds with a foreclosure. All broker commissions are approved by the lender, and no under the table payments are allowed. The settlement agent cuts the checks. I suppose someone could give a broker a “tip”, but most brokers don’t want to risk their license or jail time for fraud. Banks also have certain approved appraisers that they use for short sales.

While your post sounds like a how-to in theory, in practice, it’s got about a 1% chance of working.

3

All real estate transactions have a HUD form drawn up by the attorneys. It basically states where the money is coming from, how much is coming in, and to whom it is going to be paid to. It must be accurate.

So you are talking about a scheme where both real estate agents, their real estate brokers, at least three attorneys (sellers, buyers and banks, plus additional attorneys if there is more than one mortgagee), the appraiser, and the buyer and seller would be willing to commit illegal fraud and, in the case of the professionals risk losing their licenses and/or facing heavy fines over $20K. I can’t see it happeneing.

4

The opposite is true. While the details that you point to sound like they might preclude this type of scam, as a practical matter I happen to know that it is being done all over the place. And - interestingly, in light of your username - in NJ in particular.

I’m not familiar enough with the nitty gritty details to know how they get around the controls that you mention, but the general concept of having controls that should in theory work but don’t work so well in practice is not unusual. In any event, facts are facts. It’s happening and it’s very common.

I suppose if what you were saying is true, then that gets the buyer in the situation I describe off the hook. If he bought into what you’re saying, then he would be entitled to treat the deal as being on the up-and-up.

[This came up becasue I know an actual person contemplating an actual situation. And he’s basing his assessment of what’s really going on on his own knowledge of how these things work these days, which is as described above.]

5

This is just naïveté. Even before the real estate bust created all this short sale action, there was money being exchanged under the table in all sorts of real estate deals, for a variety of reasons. Besides for the fact that this is widely known in RE circles, I happen to know a person who worked for a RE lawyer and later a title company, and who was present at a lot of big RE closings. She said it was common for certain key people to leave the room at crucial points in the proceedings and conduct some off-the-record side deals of this sort.

6

So your secondhand knowledge of a deal from a friend who is contemplating such a deal trumps my firsthand knowledge of short sales, having worked on many.

I don’t deny that somewhere, somehow, someone is doing a fraudulent short sale, but it’s not very common. I am aware of the schemes you mentioned, as is everyone else who has been in the business for more than five minutes.

You made ridiculous assertions, such as “they do not want to be saddled with the property, and would rather focus on banking” as a reason for a bank taking a loss on an income producing property. Don’t you think the bank took the leases and rents into consideration when they first appraised the property? Don’t you think banks pay management companies 10% to take over receivership of the rents and general management of the property so they aren’t bothered with the daily details? Don’t you think banks are becoming more agressive regarding deficiency judgments?

You also don’t seem to be aware that buyers sign on short sale approvals. They are on the “hook”. They are also on the “hook” for any liens that affect title that aren’t paid or otherwise discharged at closing.

7

Is it common in NJ for the seller and the buyer to have counsel present in a real estate closing? I’ve never seen it happen where I live. I’ve never seen counsel present for the bank either. When I closed on my house, the people present were the sellers, the closing agent, and my real estate agent.

The scenario as presented doesn’t seem very plausible to me. If the bank has approved the listing at 300K then that is what it will be listed for. You’ll either have a bidding war or the property will sell for 300k.

Your scenario also assumes that the buyer in turn doesn’t screw the seller. The only evidence is a contract in the amount of 300k. For seller to argue that he should get the extra 20k, he will have to admit to fraud.

There may be shenanigans going on in NJ real estate, but this particular one doesn’t make sense to me.

ETA- Also, if this does occur, how does the Seller explain the additional $20k in income?

8

No. I don’t know about it from this one case. This has been going on for some time, and is extremely widespread. I know of many people involved in such deals.

My consideration of the buyer’s perspective is what was provoked by this specific deal.

For the most part the banks wrote these loans when controls were fairly loose and when RE seemed to be rising forever. They looked at the properties and what they might do with them as last resorts. They were not prepared to deal with the amount of RE that they would be saddled with if they took a tougher line on short sales.

9

Yes, it’s standard in NJ. In NYC also.

In some states, the attorney for the buyer can also close the loan on behalf of the lender, acting as settlement agent, so the lenders attorney does not need to be present. The title company issues a special letter of protection. Occasionally, a lender will insist that the loan close at their lawyers office or at a bank branch.

10

Realtor here. I’ve heard of this kind of transaction. It’s fraud. Typically, the parties are defrauding a federally insured lender, which carries a huge penalty - 30 years in federal prison and a $1,000,000 fine, IIRC. And oh, by the way, do you know what the number one focus of the FBI’s White Collar Crime unit is these days? Mortgage fraud.

I heard an attorney talking about this kind of thing a few months ago, and she pretty much nailed it. She said that any time you hear the words “outside of escrow”, you should just replace them with “in a dark alley”. It’s the same basic thing.

And yes, there has probably been fraud in real estate transactions since Og sold his cave to Gork.

11

My understanding is that these types of properties generally don’t get “listed” on MLS. The seller goes out and finds a buyer.

I’m not sure how that’s avoided, but unless the buyer is completely clueless, he realizes that he is going to save a lot of money by going along with this deal, and it’s probably not worth rocking the boat just to save some more. Plus, in these types of deals generally the buyer and seller know either each other or some middleman.

I don’t know. The type of people involved in these types of deals are not the “report all your income” types asa rule, but I don’t know the details of how they manage this.

12

Is that fraud on the part of the buyer, or just the seller?

[I also know some people who have made some pretty good money lending at high interest rates to people who are engaged in these types of transactions. This would be even further at arm’s length.]

13

They can be on or off. The seller and realtor have to put together a short sale offer with an excessive amount of documentation. Them everyone has to wait around for months while the lender reviews and decides what they want to do.

Let’s say the seller owes 400k on a mortgage. The seller submits a 300k short sale package and signed contract After a couple of months, the lender comes back and says I’ll accept 340k, the commission is 3%, not 6%. The bank also caps the sellers costs because they are paying them as part of the deal. The seller doesn’t have any say in the matter at this point. It’s up to the buyer to accept or decline. The bank is paying the commission, not the seller or buyer. The agent can try and convince the lender that the property is worth less than 340k and closer to the 300k using comps, and sometimes the lender will come back and agree to accept less than what they originally asked. Most of the time the bank will stick to their guns. Sometimes it’s for unknown reasons and sometimes it’s because the investors just say no.

Save a lot of money by paying more than they are contractually obligated to pay? Ideal short sale candidates are those with either no or very little equity and no ability to pay. If the bank sees that they can probably get more money for the property, they will. It’s made quite clear in short sale packages that there is to be no cash back to the seller.

14

I am aware that the short sale process is pretty drawn out.

My impression is that the seller first gets the bank to indicate how low they will go - perhaps on an informal basis - and then goes out and finds a buyer willing to pay on the side for that type of deal.

Your final sentence is true. If the bank realizes that they can get a lot more for the property they will. Therefore it’s in the interest of the buyer to avoid letting on that there is any collustion on the price - which is something that’s likely to come out if he renegs on the side deal.

15

That fraud would be on the part of anybody who is intentionally hiding material facts about the transaction from the lien holders. That could include buyer, seller, agents involved, the appraiser, escrow officers, and/or the loan officer making the new loan.

16

Of course if the bank has approved that price, no harm no foul. The thing is, most of the time in short sales, the banks don’t get involved until there is an offer on the table (although that is starting to change in some cases).

As a Realtor, I can tell you that when we see a short sale listing that is priced way below market value, we usually dismiss it and try to steer our clients away from it. Not necessarily because we are afraid of fraud (although that could be a possibility). It’s because when we typically see those things, we know that the likelihood of getting that price approved is very, very low and we don’t want to waste our time and our clients’ time spinning our wheels on stuff like that.

17

I think that may get the lenders I know off the hook. They are private investors unrelated to the specific transaction, other than they provide financing to the buyers in exchange for a mortgage on the (otherwise unencumbered) property.

What about the buyer? Does the buyer get explicitly asked, as part of the process, whether they are making any payments to anyone at all in connection with this deal? If so, it sounds like they’re party to the fraud, as you say (& in the specific case I’m thinking of, I don’t think the guy I know would be willing to do that).

Also, because the process is very drawn out (as someone mentioned above) and because those types of properties are very frequently in poor condition (a lot like buying repo cars).

18

I should add, BTW, that it’s possible that the banks themselves contribute to the problem by the very procedures that they put in place to forstall it. Because no one would ever pay the same price at a foreclosure or short sale as they would pay at an ordinary sale, since the hassle is not worth it. The only reason a person would buy one of these properties and jumpt through the bank’s hoops is to get them at below market value. But once you take leave of market value, you’re creating a situation that’s more open to manipulation. Pricing a custom and illiquid item like real estate is hard enough as it it, but when you’re talking about a unique subset of that with its own rules it becomes even harder.

19

The buyer and sell all sign the short sale agreement provided by the lender.

The first clause of the short sale agreement from the bank is usually along the lines of “(lender) agrees to accept $X.00 in cash or certified funds to release its mortgage loan from the referenced property subject to the following conditions”, then it goes on to name all conditions individually. The conditions include the final sales price and the name of the buyer (as one condition) and that any changes on the estimated HUD that the lender approved must be approved by the lender again or else the deal is off.

If you think the buyer is a “passive participant”, you are very much mistaken.

20

Very possible.

I know a lot of real estate wheeler dealers, so I’m somewhat hip to broader trends in the field, but I’m not familiar with the details of who signs what papers.

To confirm, you’re saying that the HUD settlement statement, which is signed by the buyer, explicitly details all payments that are being made by the buyer in connection with this deal.

Thanks.