Evaluating Real Estate Investments -- Identifying Fraud
Antonio Stradivari is the most famous violin maker or luthier of all time. Born in 1644, he worked from a studio in Cremona, Italy until his death in 1737. Besides violins, he made violas, cellos, guitars, and even some harps.
Stradivari was a prolific luthier. He made over 1,100 string instruments during his lifetime, and about 650 survive today. But for every genuine Stradivari violin, there are thousands of fake ones.
Many fake Strads are easy to detect. They may bear a label that reads “Made in Czechoslovakia," obviously a fake, since Stradivari never left Italy, and Czechoslovakia wasn’t created until 1918, nearly 200 years after Stradivari’s death.
But other fakes aren't evident to the average person. For instance, an authentic Stradivari label will have only the first digit (1) of the date. Stradivari filled in the rest of the year (e.g., 1695 or 1713). Many fakes have two digits at the beginning of the year or even the entire year printed.
Luthiers can identify other fakes by the instrument’s age. For example, an authentic Strad will be around 300 years old and show signs of age. Peg holes will have been worn due to years of use and will show signs of peg bushing – adding additional wood to the area so the peg hole is smaller and pegs don’t slip. Also, during Stradivari’s era, violin necks were shorter than those on modern violins. So Stradivari violins will have a neck graft where a longer, modern neck was attached. More scientific methods of detecting fake Strads involve using forestry experts to identify the type and age of wood or chemists to analyze the composition of the varnish.
But good copies of Stradivari violins can fool even the most experienced experts. Nineteenth-century French luthier Jean-Baptiste Vuillaume was a highly-skilled luthier who made copies of Strads. Vuillaume’ s violins now are sought-after on their own merit.
Villaume’s violins were exceptionally good copies, and he didn’t sell them as Strads. But Dietmar Machold, once a world-famous expert in rare violins, passed off fakes as real Strads, sometimes selling them for millions. Machold eventually was convicted of fraud and jailed after his network of businesses, characterized by some as a Ponzi scheme, fell apart.
Unfortunately, violin-making isn’t the only area with fakes and fraud. Although we like to think of real estate as a solid investment (after all, what’s more tangible than land), those investments sometimes aren’t as they appear or are fraudulent. This article discusses warning signs real estate investors should look for before investing to protect themselves from misrepresentations or outright fraud.
Real-Life Case Study
Many years ago, a lovely older couple (I’ll call them Chris and Jamie) came to my office seeking advice about a failed real estate investment. Hoping to improve on the low interest rate offered by their bank, they had invested their $200,000 IRA with a local real estate development company (which I’ll call Affordable Housing Fund or AHF) run by a sponsor, who I’ll call Bill.
Bill was a nice, clean-cut, young man – a real estate agent – Chris said. Bill had invited them and other seniors to a nice restaurant for lunch. He gave a presentation about the Affordable Housing Fund, which provided a low-risk opportunity for investors to receive a 12% annual return. After lunch, the seniors boarded a charter bus and took them to Affordable Housing Fund’s newest real estate development, ABC Homes (ABC).
Bill pointed out features of the investment as the bus drove the seniors past an ABC Homes sign then through newly built streets with vacant lots and partially-constructed homes. Then, the bus stopped at a model home. As the seniors departed the bus, a man wearing a shirt with the ABC Homes logo knew Bill and shook his hand.
Then a pleasant young woman gave the seniors a tour of the model and told them about amenities the development would feature while Bill and the man talked about their families in the living room. Finally, the woman handed out literature with ABC’S name on it. Her business card, identifying her as a real estate agent, was stapled to the front. She encouraged the seniors to call her with questions.
After the seniors returned to the bus, Bill explained that interests in the Affordable Housing Fund were selling like pancakes. If they wanted to get into the deal, they should invest that day.
Chris and Jamie were sold. Bill was a local man putting together an investment to benefit the local community by providing much-needed affordable housing. Since they didn’t want to miss out, they quickly signed up. Bill handed them a one-page form, asking for their names, address, telephone numbers, social security numbers, and how much they wanted to invest. The form said that investments under $5,000 could be made via credit card on PayPal (with the recipient as AffordableHousing@aol.com). Those making more significant investments should write a check payable to Affordable Housing Fund.
The problem: The development was real. But Bill had nothing to do with the new development. Bill had passed himself off to the man and woman who worked ABC as a real estate agent trying to sell homes. The ABC folks were cordial to him because they thought he might help them sell houses to the seniors. AHF didn’t own the land, nor was Bill able to sell shares of ABC. The “investment” in AHF was a Ponzi scheme.
Signs of Fraudulent Investments
According to regulatory agencies and organizations, including FINRA, the North American Securities Administrators Association (NASAA), and the Securities and Exchange Commission (SEC), social isolation resulting from the pandemic has been linked to an uptick in fraud. These agencies list many of these situations as red flags for fraud.
Investors should realize that red flags don't necessarily indicate an investment is fraudulent. Legitimate investments may display one or two of these red flags. But red flags indicate that investors should conduct careful due diligence and verify the sponsor’s claims before investing.
Promises of High Returns with Low Risk
Many scams promise a high return with no risk, which is a red flag that the investment may not be legitimate. With legitimate investments, high rewards seldom come without high risk. Likewise, a low-risk investment will offer a low return.
No Net Worth or Income Requirements
Reputable sponsors will ask questions about investors’ financial situation. Private placement securities limit most offerings to accredited investors with an annual income of $200,000 ($300,000 with a spouse) or $1 Million in net worth, not including their residence. Even where unaccredited investors may invest, sponsors must inquire about the investor’s sophistication.
Investors should be suspicious of sponsors who don’t ask questions about or require verification of their investors’ financial situations. In the case study, Chris and Jamie invested a significant amount of money without providing any financial information or information about their experience with real estate investments.
Low Minimum Investment
It's expensive to put together and manage a real estate investment. It's rarely economical for a fund to accept an investment of less than $25,000. Although smaller funds might take lower investments, most legitimate sponsors will lose money if they accept very small investments under $2,500 or $1,000. One exception is equity crowdfunding offered through registered crowdfunding platforms -- that's not a common sales method for real estate investments.
Affinity Relationship
Some fraudsters get close to their victims through affinity groups, such as professional, workforce, social, or religious associations. The fraudster then exploits the investor's trust by claiming they have a unique opportunity they are presenting first to members of their group. Occasionally, people intentionally or inadvertently bring their family members into a fake investment. It should be a red flag a casual friend or business colleague suddenly increases their contact to offer an investment opportunity.
That doesn’t mean that every investment that comes by word-of-mouth from an unexpected source is fraudulent. But investors should ensure that a personal relationship with the investment sponsor doesn’t substitute doing proper due diligence.
Few Legal Documents
Real estate investments are complicated. Reputable sponsors will prepare a private placement memorandum (PPM) or similar information describing the investment and its risks. The subscription agreement will usually be several pages long and require both the fund’s and the investor’s signatures. Chris and Jamie should have been concerned when Bill took their money without him signing anything and without their providing more detailed information.
Inconsistencies or Problems with Documents
Chris and Jamie received brochures with ABC’S name on them. AFH and Bill appeared nowhere on the brochures. This inconsistency in branding should have been a red flag that caused Chris and Jamie to ask questions. Had they called the ABC’S number on the brochure or the real estate agent's card, Chris and Jamie likely would have learned that AHF and Bill had no right to sell interests in ABC’S real estate development.
Another sign of fraud might be the absence of documents. For example, a sponsor might claim documents are delayed and suggest the investor send in their money and sign paperwork later. While it's not unusual for a sponsor to require an investor to submit their funds with their paperwork, no one should invest without first seeing legal documents relating to the investment.
Aggressive Sales Tactics Pressure to Buy Quickly
Bill pressured his captive audience to sign up immediately. He also used a form of peer pressure by asking for a raise of hands of those who would invest. Suggesting that investors send money quickly via PayPal was another red flag because it encouraged impulsive investments. Legitimate real estate investments rarely accept payment via PayPal, Venmo, or a similar money transfer service.
Bill’s aggressive sales techniques and pressure to sign up immediately should have been red flags for Chris and Jamie. Real estate investments may have legitimate investment deadlines. For instance, the sponsor may need equity to be invested in time to close on an acquisition. But legitimate sponsors usually won’t pressure an investor to invest without an opportunity for due diligence.
Due Diligence is the Solution
Machold was an expert in rare violins and authenticated the fake Strads himself. There are few such experts in the world, so it was challenging for buyers to verify authenticity. And given Machold’s reputation, they had no reason to do so.
Bill’s tour of ABC’S property was bold and audacious and gave an air of credibility to his investment opportunity. Still, there were red flags. Plus, Bill wasn’t an established real estate sponsor, nor is there a shortage of real estate experts Chris and Jamie could have consulted before investing. Chris and Jamie probably wouldn’t have been in my office seeking advice on how to get their money back if they had done due diligence on Bill, AHF, and ABC.
Had Chris and Jamie come to me before investing, here’s what I would have recommended:
Ask for information about the investment. Larger real estate investment funds usually have a PPM. Smaller funds should provide investors with access to an online data room containing basic information about the property. Had Chris and Jamie asked for this information, Bill probably wouldn't have provided it since AHF didn’t own the development project.
Investors also should receive basic documents explaining their rights and how their distributions will be calculated. This information may be in a limited liability company agreement, corporate documents, or a PPM, but it should be in writing.
Chris and Jamie received no written information about AHF and no documents describing the 12% return Bill promised.
Read documents carefully and ask questions. Chris and Jamie’s big red flag was the ABC branding on the brochures they received. Had they asked Bill about the discrepancy, he probably would have had an excuse. Chris and Jamie should have contacted the real estate agent whose card was attached to the brochure.
Don’t succumb to peer pressure or FOMO, and don't make impulsive decisions you might regret. Chris and Jamie had taught their children these essential concepts but failed to follow them when investing in AHF. Chris and Jamie should have resisted Bill’s attempt to create peer pressure for a quick decision and stepped back to evaluate the investment.
Insist on a contract. Legitimate real estate investments should have a subscription agreement or similar contract. With no written contract, all Chris and Jamie had was Bill’s word that their money would be invested in the real estate development and that they would get their money back with a 12% return. And with no written contract, they could not easily sue Bill or make a claim when he filed for bankruptcy.
Research Bill, AFH, ABC, and the property. A Google search would have shown AFH didn’t appear to exist, that ABC had its own investor portal on its website, and that ABC had purchased the real estate six months ago. While many legitimate real estate investments, a quick search of public government records showed that AFH didn’t exist, that ABC owned the property, and that Bill had several judgments against him for unpaid bills and taxes. Public government records also showed that Bill once had had a real estate license, but it had been revoked for misconduct.
Never invest more than you can afford to lose. Real estate can be a great addition to an investment portfolio, but real estate investments are risky. And investments in a single property are usually riskier than investments in a REIT or a diversified fund invested in many properties. Although the loss of Chris and Jamie’s $200,000 IRA hurt, both had pensions and Social Security, they had paid off their mortgage. Still, loss of their IRA meant they would need to take out a home equity loan to pay for emergencies, such as medical expenses.
© 2022 by Elizabeth A. Whitman
Any references to clients and their legal situations have been modified to protect client confidentiality
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