Property Fraud Allegations Snowball as Commercial Real-Estate Values Fall
Length: • 5 mins
Annotated by Nicholas Mills
Drop in values caused by higher interest rates and a rise in defaults exposes more schemes
Fannie Mae’s Washington headquarters. The government-backed mortgage enterprise is cracking down on questionable practices in its rental-apartment lending business. Eric Lee for The Wall Street Journal
July 8, 2024 5:30 am ET
U.S. prosecutors are cracking down on commercial mortgage fraud, a growing push that is sending shudders through the $4.7 trillion industry by raising questions about the numbers underpinning major property loans.
Regulators and federal prosecutors say that property loans based on doctored building financials and valuations have been rising. This type of fraud became more widespread between the mid-2010s and 2021, federal investigators and real-estate brokers say, when commercial property prices surged to new highs and landlords had much to gain from such maneuvers.
“It’s a general trend throughout history that fraud occurs during boom times and is revealed during bust times,” said John Griffin, a professor of finance at the University of Texas’ McCombs School of Business.
In most cases, real-estate fraud is made possible because lenders take a hands-off approach to assessing a building’s value. As long as the numbers look in line with those of similar properties, lenders usually trust that they are accurate, brokers say. Auditing books is expensive and time consuming, and lenders competing for deals may be reluctant to antagonize landlords with onerous due diligence.
Federal prosecutors are ramping up their efforts to root out fraud, often working together with investigators at the Federal Housing Finance Agency, according to court records and people familiar with the matter.
While data on the number of open investigations on real-estate fraud aren’t publicly available, a number of plea deals have been reached in recent months.
Since last fall, at least five different landlords of properties, mostly apartment buildings, in cities including Cincinnati, Hartford, Conn., and Little Rock, Ark., have pleaded guilty to federal fraud charges. Some allegedly doctored building income statements, others allegedly faked property sales at inflated prices, all to get bigger loans.
Fannie and Freddie taking action
Meanwhile, government-backed mortgage enterprises Fannie Mae and Freddie Mac are cracking down on questionable practices in their rental-apartment lending business.
Freddie Mac this year changed its underwriting policies to combat fraud. The agency now requires borrowers to submit rent receipts. It also told lenders to inspect more apartments to ensure they are actually occupied. Fannie Mae has been going through loans to weed out those based on sketchy numbers, according to people familiar with the matter.
In a May earnings call, Ivan Kaufman, CEO of commercial mortgage lender Arbor Realty Trust, listed fraud as one of the unanticipated issues that have “created additional stress” in the market.
“I think there was a lot of elevated fraud in the industry through the brokerage industry,” he said.
At the heart of the problem is the way lenders underwrite commercial mortgages. Borrowers typically submit financial statements called T-12 that show building income and expenses for the past year. Lenders use these documents to estimate the building’s value and calculate how much they are willing to lend. But in most cases they don’t audit these statements to verify that the sums listed in the spreadsheets actually flowed in and out of the landlord’s accounts.
A Michigan landlord pleads guilty
A rental apartment complex in Tallahassee, Fla., financed by JP Morgan Chase, made around $296,000 in profit before mortgage payments in 2018, according to Michigan-based landlord ROCO Real Estate’s internal numbers, federal prosecutors said.
But those weren’t the numbers lenders saw. ROCO told Chetrit Group, the New York firm that was in talks to buy the property, that profit was much higher—$644,000.
ROCO arrived at the higher numbers in part by including rent that wasn’t actually collected and by leaving out concessions such as free-rent periods, an FHFA special agent testified in court.
Chetrit bought the building along with dozens of other properties across the U.S. from ROCO in 2019. JP Morgan Chase funded the deal with a $481 million loan, which it repackaged into bonds and sold to investors. An appraiser hired by the bank used ROCO’s inflated numbers to value the Tallahassee property at $5.78 million. JP Morgan Chase declined to comment.
The mortgage on the Tallahassee property went into default in late 2022, according to data from the company managing the loan.
ROCO’s Tyler Ross last year pleaded guilty to falsifying financial statements at a number of properties. His lawyer told the Journal that while the T-12 statements Ross shared with Chetrit were inaccurate, he supplied the buyer with additional data that showed the building’s true financial state.
In a similar case, a judge in January sentenced New York property manager Jacob Deutsch to more than five years in prison for defrauding lenders in connection with 24 multifamily mortgages in Hartford, Conn. Deutsch and his co-conspirator Aron Deutsch (who was sentenced to probation) overstated the number of renters in their buildings and inflated rental income, the Justice Department said.
Cases of landlords or brokers outright lying to lenders are still rare, brokers say. It’s more common for landlords to make changes to T-12 statements, for example, by leaving out one-time expenses such as renovations, and disclose them as footnotes. These changes are often legitimate and lenders tend to accept them, brokers say.
But Griffin, the finance professor, worries that these alterations have got out of hand and that many loans are based on inflated numbers.
In a 2023 paper published in the Journal of Finance, Griffin and co-author Alex Priest studied more than 39,000 commercial mortgages repackaged into bonds. They found that in nearly one-third of these loans, underwritten building profits exceeded actual building profits by at least 5%.
Landlords have an incentive to come up with inflated building profits so that they can land bigger loans. But lenders also often have an incentive to accept these inflated numbers, especially if they plan to repackage the loan and sell it off to investors, Griffin said. That is because bigger loans mean bigger fees.
“This space is littered with conflicts of interest,” Griffin said.