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Real Estate Syndication Fraud

     By American Property Research Expert in Commercial Mortgage Fraud and Commercial Real Estate Appraisal

PhoneCall Vernon Martin, M.S.R.E., CFE at (323) 788 1605

Real estate syndicates often have agendas that do not align with the interests of the limited partners and usually derive most of their income from fees which are proportional to property acquisition prices. This is a built-in conflict of interest and was an area rife with abuse in the 1980s. New, trans-national syndication are emerging to purportedly exploit real estate opportunities in other countries.
A few affluent local friends perceive a profitable real estate investment opportunity. They pool their resources to acquire a certain property with appreciation potential, perhaps a piece of farmland near a planned freeway exit. One of these friends may be a real estate developer, and he gets elected to be the general partner in a syndicated limited partnership. For actively managing the syndication, he is paid fees and/or his equity contribution requirements are reduced or eliminated. Everyone knows and trusts each other and works together for their common good. This is the way real estate syndications were supposed to work when they first became used as early as the 1950s.

Beginning my career in Texas in the 1980s, I saw syndication morph into another, more malevolent form. The general partner was a successful developer who would have had no problem receiving 100% LTV financing from a Texas bank or S&L for most anything he wanted to do; as was common in Texas banking of the 1980s. But when commercial real estate values started to decline, these savvy real estate entrepreneurs, who would have normally grabbed good opportunities exclusively for themselves with 100% financing, instead touted their successful real estate experience in reeling in large numbers of limited partners for a syndication. The limited partners were typically doctors, dentists, airline pilots or lawyers -- wealthy, but not financially astute. These new types of public real estate syndicates were chronicled by my former professor, William Brueggeman, in his widely used textbook, Real Estate Finance:

In an operation of this kind the syndicate general partners share few of the risks. They may have originally bought [the property] through another business entity and sold it to the syndicate at a profit. Through another company which they own they may receive substantial remunerations for management services. Above all, as the general partners, all earnings and capital gains not contracted away to the limited partners accrue to their benefit…This has been a matter of increasingly grave concern to state and federal securities sales regulators. [7th edition, 1981]

As commercial real estate markets sank, I witnessed how each syndication seemed to make the general partner richer while making the limited partners poorer. “Syndication” became a dirty word.

In recent months I've seen major real estate purchases by syndicated real estate partnerships at above-market prices. To skirt federal and state securities laws, they conduct “private placements” which allow them to escape SEC scrutiny. The blatant conflicts of interest are plainly disclosed, however, in the "private placement memorandum", that voluminous, catch-all legal document which discloses everything their attorneys tell them to disclose, in the moral equivalent of “fine print”.

A private placement memorandum I saw recently was a good example of an abusive syndication. The general partner purchased a piece of land from itself, on behalf of the syndicate, at a $20 million profit after a one year holding period, in a market with a growing inventory of large land parcels for sale at much lower prices. In addition to the $20 million profit, the general partner and its affiliates earned fees of about $3,300,000 in selling commissions, $500,000 in wholesaling fees, $800,000 in placement fees, $600,000 in reimbursement of offering costs, $350,000 in underwriting fees, and $5,200,000 in reimbursement of offering and organization expense fees. This represents over a $30 million profit on a property that has probably lost value since its purchase as the demand for residential land has waned.

These types of syndication are not necessarily confined to the United States, either, and are increasingly taking on an international flavor. I have recently witnessed Canadian syndicators operating in Arizona, with the limited partners being primarily Canadian. I have also witnessed British and French investors being exploited in Florida.

What should be worrisome is that such syndicates are applying for mortgage financing in an industry where most of the loan underwriters are either too young or too forgetful to remember the abuses of the past. The purchase price agreed to by the syndication is often treated as prima facie evidence of market value by lenders and appraisers, and the loan is consequently underwritten based on the inflated purchase price. Is anything illegal going on? That is for future courts to decide, but the present consequences to commercial mortgage lenders can be catastrophic.

Vernon Martin

ABOUT THE AUTHOR: Vernon Martin, M.S.R.E., CFE
Vernon Martin, CFE, is the principal and founder of American Property Research, a valuation and advisory firm serving commercial mortgage lenders. He is a Certified Fraud Examiner (CFE) and certified general appraiser in several states and has a Master of Science in Real Estate degree from Southern Methodist University and an undergraduate degree in Urban Geography from the University of Chicago. He has previously functioned as the chief commercial appraiser at Home Savings of America, IndyMac Bank and Velocity Commercial Capital. He teaches part-time at California State University and has published in The Appraisal Journal, The Banking Law Journal, Real Estate Review, The RMA Journal, Fraud Magazine and Mortgage Banking.

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While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.
For specific technical or legal advice on the information provided and related topics, please contact the author.

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