GUEST AUTHOR: Vernon Martin, the founding principal of American Property Research, performs paid research, due diligence and valuations regarding commercial real estate
throughout the world. He has 28 years of commercial appraisal experience and has
worked in 20 countries, 39 U.S. states, and four Canadian provinces. He was previously the chief commercial appraiser at 3 national (U.S.) lending institutions, formerly taught Real Estate Valuation at California State University, Los Angeles and has authored many professional journal articles and two books.
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 imprudent loan-to-value ratio.
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 96 to 97% of the time, although some appraisers seem to 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. I found the listing on the Internet.
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. 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.
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.
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. 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 where he would be moving to. He seemed surprised and responded, "I'm staying here, of course. I've got a lot of work to do!" which made it clear that he was part of the development team. 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.
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.
Other purchase contract deceptions
syndicators who are compensated as a percentage of the transaction price.
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 realtor.com 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 even 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, 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 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?
AUTHOR: Vernon Martin, the founding principal of American Property Research, performs paid research, due diligence and valuations regarding commercial real estate throughout the world. He has 28 years of commercial appraisal experience and has worked in 20 countries, 39 U.S. states, and four Canadian provinces. He was previously the chief commercial appraiser at 3 national (U.S.) lending institutions. Full profile: click here
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