If you type “real estate fraud” into Google and hit search, you may be shocked at the number of recent cases that show up in your results. Stories of criminal real estate developers running Ponzi schemes, fabricating financial records, filing fraudulent lending applications and stealing investor’s money grace the front pages of many major newspapers. But fraud in real estate is not a recent fad. It’s been going on for centuries and cases can be dated all the way back to Ancient Greece. Fraud is ripe in the industry for one simple reason: there’s a lot of money in real estate. Commercial real estate projects often include multiple investors, sizable budgets, numerous service providers and fluctuating timelines. Once a project is complete, property sales, rental income, expense allocation and overall property management become areas where the risk of fraud is high if appropriate controls aren’t in place.
Below, are listed some of the riskier areas within the real estate industry. Consider these areas when reviewing your own investment/real estate portfolio and be sure you understand what is being done (or what may need to be done) to mitigate the risk of fraud for both you and your clients.
Real estate investor fraud
This type of fraud often involves a real estate developer who is soliciting investors to give him/her money in return for shares in a limited liability company (LLC) or a specific ownership percentage in a parcel of real estate. The developer makes material misrepresentations about the use of the funds, the development/construction plans for the parcel, the potential return on investment and/or the timelines for completion. These misrepresentations persuade an investor into handing over large amounts of funds that they may never see again. When investors are continually asked for more money, progress at the construction site is slower than promised, and investors don’t start seeing returns on their investment as promised, the fraud often begins to unravel.
Real estate Ponzi scheme
This type of fraud occurs when a real estate developer has more than one project going on at a time, with multiple sets of investors and full control over investment funds. Moneys are often co-mingled between the various projects, and current project expenses are often left unpaid to pay for past project expenses, debt and prior investors. Money is floated between projects to cover up budget modifications, cost misrepresentations and theft by the developer. Money can also be floated between projects to fatten bank accounts when financial reports are demanded by investors and banks. In many recent cases, developers have used significant investment dollars to fund their own gambling habits and personal expenses and then covered it up by collecting investment dollars on a new project and transferring it back into older projects.
Construction phase fraud
The most common type of fraud that occurs during the construction portion of a real estate transaction is the falsification of invoices. The following are common types of payment manipulation from construction companies:
- Inflating labor or material costs – Any contractor involved with a project may modify or falsify invoices that reflect purchased materials or labor hours to boost their profit margin on the job, but contractors may also falsely represent what they’ve paid to their subcontractors and pocket the difference.
- Budget modifications – Contractors may attempt to add unnecessary work to the original scope or request payment for services never completed in the hopes that developers and investors won’t notice that the additional work wasn’t required and/or completed.
- Improper wage rates – Contractors may charge back-wage rates to the job that are above the rate that is actually being paid to an employee and pocket the difference.
- Material substitution – Contractors may promise the use of a certain grade or brand of material on a job, and then substitute cheaper, subpar materials while still charging for the higher-quality goods.
Property manager fraud
Property managers are often given a significant amount of responsibility when they are selected to handle the day-to-day operations of a commercial or residential rental property. This can include selecting and overseeing service providers, selecting renters, collecting rent, paying property bills and even handling insurance claims. With all this responsibility comes considerable opportunity to embezzle property funds. The following are some of the most common forms of property manager fraud:
- Disbursement Fraud – The property manager often has full access and control of the property’s bank accounts, and can therefore transfer money out, pay themselves absorbent fees, or write fraudulent checks and then cover their tracks by creating accounting entries that make the transactions look like legitimate expenses.
- Kickbacks – This can occur when a property manager hires a vendor that agrees to charge excessive fees for services provided and ‘kickback’ some of the difference to the property manager.
- Co-mingling funds – Property managers often manage more than one property, and therefore have the opportunity to float money between property accounts to hide inappropriate payments, loans or theft.
- Inflated rent costs – Property managers may rent out residential or commercial spaces at rates that are higher than the agreed upon rates known by the property owner, and pocket the difference between actual and expected rental income.
Although there are multiple ways fraud can occur within any organization, proper monitoring and controls will always help mitigate the risks. Review the controls you have in place and ask for help from qualified third parties, such as The Bonadio Group’s real estate experts. Reach out today to learn more.