Flipping is simply buying a house at a discount, adding value in some way, and selling quickly for a higher price. There is nothing illegal or wrong about it, and flippers can do a real estate market a lot of good. But although flipping is perfectly legal, there are illegal flipping schemes out there, and there is a subset of property flippers that is giving good, honest business people a bad name.
Like flippers, floppers look to buy property at a discount. Unlike real flippers, though, who actually add real value to properties, floppers rely on fraudulent representation for their profits – and that’s worse than being illegal: It’s also wrong.
The Origins of Flopping
During the housing boom in the 2000s, appraisers – nearly all independent contractors — were under tremendous pressure from real estate agents and lenders alike to come up with whatever numbers would make the deal go through. The banks didn’t care whether the numbers were accurate: They were selling the loans upstream anyway, to Fannie, Freddie, and any suckers who would take them.
The appraisers who were willing to play ball got lots of business. The honest ones soon found out that their opinion on a deal wasn’t welcome. The lenders stopped calling them, and their business dried up. Only the crooked and spineless – the ones telling the banks and agents only what they wanted to hear, were successful.
Here’s how a typical flop scheme works: A homeowner finds himself significantly underwater on his mortgage and falls behind on payments. The lender eventually initiates foreclosure procedures. Meanwhile the homeowner hooks up with an “investor” (I use the quotes ironically, because floppers aren’t investors – they’re crooks), who offers to put together a short-sale package. Meanwhile, the second crook is in cahoots with a crooked appraiser, who comes up with a low-ball appraisal of the house’s market value.
The lender, relying on information from the crooked appraisal, agrees to the short sale, and the crook buys the house at a sharp discount from market value.
This causes substantial economic harm to the owners of surrounding homes, because the low-ball sales price becomes part of the “comps” that get pulled for the neighborhood. The low-balling therefore causes neighborhood values to drop. It may also make the difference between some surrounding homeowners having to pay extra private mortgage insurance premiums (PMI) and being able to keep that money. This is an important issue to them.
The crook owns the house for a brief period – perhaps a few days, perhaps as long as a year – and then sells the house at the full market value. He may even have gotten a new appraisal by another crooked appraiser at an artificially high price. At the end of the transaction, the flopper and the original seller split the difference between the short-sale price and the final sale: something they planned to do all along.
This eventually mitigates the damage done to neighbors by low comps (though the PMI payments on properties that should have poked above the 80 percent loan-to-value ratio it takes to cancel PMI cannot be gotten back). But it costs lenders as much as $375 million per year, according to CoreLogic, a real estate data clearinghouse that tracks home sale prices and transactions across the country.
What makes a transaction like this an illegal “flop” instead of a flip?
- Collusion between the original homeowner and the flopper. Much of commerce and a lot of tax law assumes that most transactions between unrelated parties are made at “arm’s length.” This means that we assume that both parties are reasonably informed, and that there is no collusion or coercion taking place at any stage of the transaction.
- Collusion between the flopper and the first appraiser. The lender usually relies on the assumption that a professional, licensed appraiser is acting in good faith.
- Lack of disclosure to the lender. The lender is a party, of course, to any short-sale transaction. The lender is relying on the good-faith assumption that no a priori collusion has taken place to deceive them. If the lender were aware of any collusion, clearly, the lender would not agree to the sale. The lender is essentially tricked into selling the property at below market value.
- Collusion between the flopper and the second appraiser. Where the flopper colludes with a second appraiser, after the short-sale, to deliberately inflate the value of the property, they are essentially conspiring to defraud the final buyer, who is also relying on the appraisal to assess the fair market value of the home. Experienced buyers needn’t be taken in by this – real estate professionals should be making their own assessment of property values, or hiring their own appraisal professional. But many homebuyers are neither experienced nor professional. They don’t deserve to be lied to or defrauded.
Lenders Track This Stuff
Understandably, mortgage lenders are getting pretty fed up with this practice, which is becoming all too common. They are getting wise to it, and they are tracking instances where homes are sold very shortly after a short-sale at considerable profit. Simply selling a home after a short-sale at a profit is not in itself illegal – but it is a possible indicator of fraud. According to the CoreLogic study linked to above, the data show that 1 in 6 short-sales are resold within a day, and the the average profit on same-day short-sales is 34 percent, according to the CoreLogic study linked above.
Lenders know that floppers aren’t adding value with a remodeled bathroom and kitchen between sales just minutes apart. Mortgage lenders and their consultants are looking for evidence of fraud – and they’ll start with these cases. If you’re involved in one of these transactions, don’t be surprised if private investigators or law enforcement agents start sniffing around the deal – talking to your counterparties, and ultimately issuing subpoenas for documents.
What, precisely, raises red flags for mortgage companies? CoreLogic defines “suspicious” short-sales as follows:
- A new transaction less than one month after the short sale where the new price is at least 10 percent higher than the short sale price OR
- A new transaction less than three months after the short sale where the new sale price is at least 20 percent higher than the short sale price OR
- A new transaction less than six months after the short sale where the new sale price is at least 40 percent higher than the short sale price.
The scam was common during the run-up, and reached epidemic proportions in the late 2000s, becoming a favorite tactic of real estate crooks by the end of the decade. Consider: According to data from the Mortgage Asset Research Institute, valuation fraud represented just 16 percent of all mortgage fraud cases. That number rose to 22 percent by 2008, and 33 percent by 2009.
A Serious Offense
There’s nothing wrong with buying low and selling high. It’s the American way. But if you rely on fraud to do it, that’s a felony, and the FBI will come after you if they find out. That’s what happened to Sergio Natera and Anna McElany, two real estate agents in Bridgeport, Connecticut.
Here’s how the scam worked, verbatim from the FBI release:
According to court documents and statements made in court, Natera and Anna McElaney, both real estate agents, defrauded Regions Bank, which held two mortgages on a residential property in Bridgeport. On December 5, 2007, McElaney, who was a listing agent for the property, received an offer to purchase the property for a price of $132,500. However, Natera and McElaney informed Regions Bank that the highest offer to purchase the property was for $102,375 and that it was made by BOS Asset Management LLC. Natera and McElaney concealed from Regions Bank that there was a higher offer by another bidder, that Natera owned BOS Asset Management LLC, and that Natera and McElaney planned to keep the difference between the two prices. Based on the false and incomplete information provided to it, Regions Bank agreed to the short sale for the lower price and released its mortgages on the property.
On June 9, 2008, Natera and McElaney arranged for two sales of the property to occur on the same day. The first sale was from the owner of the property to BOS Asset Management LLC for $102,375; the second sale was from BOS Asset Management LLC to the original bidder on the property for $132,500. Natera and McElaney retained the difference between the two sale prices.
In February 2010, Natera and McElaney each pleaded guilty to one count of bank fraud. On July 25, 2011, McElaney was sentenced to eight months of imprisonment and six months of home confinement. [Emphasis added – JVS]
The postscript: Natera received his sentence in April – two months of imprisonment, followed by three years of supervised release, the first six months of which Natera must spend in home confinement.
The best way to defend yourself:
- Have your own appraiser. One you select, who gets paid by you and who works for you. A good appraiser should be able to snuff out or neutralize any work done by a crooked appraiser on the other end.
- Make sure your professional conduct as a flipper is above reproach.
Take a lesson from Warren Buffett, and the Code of Ethics from his company, Berkshire Hathaway:
“… I want employees to ask themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper – to be read by their spouses, children and friends – with the reporting done by an informed and critical reporter.”
Colluding to deceive your business partners and counterparties is never on this list.
The Ethical Flipper
A great chess player never hopes his opponent does not see the best move available to him. The best chess players assume their opponents always see the best move on the board, and play accordingly.
So it is with the ethical flipper. The ethical flipper does not rely on his buyer’s ignorance, never lies, never deceives and never colludes with others to do so. When he buys a home, he is doing a service to a seller who needs to sell quickly. Both parties benefit. When he holds a property, he adds real value. He does not rely on deception to add value, but works in such a way that the more informed the buyer becomes, the more valuable the home is. The value the true flipper adds, whether from repairs, renovations, financing arrangements, or simply doing a great job finding the right buyer for the property, is not dependent on concealment or deceit, but is there even if the buyer knows every detail about how the property was acquired. The true flipper benefits his sellers and buyers alike – and turns them into missionaries for his own business, looking out for opportunities for the flipper to serve their own friends, family, neighbors and co-workers.
Jason Van Steenwyk is a veteran financial industry journalist who has been fighting to make the world safe for the retail investor since 1999. He lives at Ground Zero of the real estate bubble in Fort Lauderdale, Florida.