Earlier in this decade, there was a rush to convert apartment complexes into condominiums. In some markets, the condo conversion frenzy was particularly strong: Florida, for example, saw more than 150,000 apartment units turned into condos between 2004 and 2006.
Unfortunately, not all of those conversions were on the up-and-up – the rise in condo conversions was marred with a residue of fraud.
The fraud scheme goes something like this: apartment owners convert their units to condos, but attempt to sell them at an inflated value. Appraisers and/or brokers with decidedly flexible ethics participate in this scheme by offering a false confirmation on the inflated condo value. For lenders, the fraud becomes obvious if the buyer defaults – the lender is then stuck with loans of an artificially inflated value. In a number of cases, the buyer is also part of the fraud scheme.
To some degree, the emergence of this type of fraud should not have been a complete surprise. Ben Jones, editor of the industry blogs The Housing Bubble and The Foreclosure Report, believes the rise of condo conversion fraud was actually expected to happen.
"I said in early 2005, when the first reports of serious mortgage fraud started to appear out of Ohio and North Carolina, that the housing bubble made fraud indistinguishable from legitimate development, and that would certainly seem to be the case with condo conversions," he remarks. "Florida consultant Jack McCabe said a long time ago that conversions are the last thing to boom and the first to crash. This is because they are a quick way to get in on the tail end of a boom. Fitch Ratings said in 2005 that 30 percent of conversion debt would default. In that environment and masked by a housing bubble, how can anyone really tell what is a fraud and what isn't?"
"Condominiums are one of the primary property types for the subprime market, but also for second home and investment properties for both the prime and subprime markets," observes Dr. Anthony Sanders, professor of finance and real estate at Arizona State University. "The dramatic growth in the condominium market in Florida, Nevada and California in particular has led to rapid origination and underwriting by certain lenders that makes fraud schemes possible.’
Furthermore, many economically depressed urban centers saw condo conversions as a tool to encourage gentrification. However, that strategy also opened the window for possible fraud.
"As time goes on and investment groups try to go in to rehabilitate communities, particularly older neighborhoods where there was no land for condo developments, it creates a perfect storm for making this type of fraud happen," observes Dennis Outlaw, senior consultant for mortgage fraud with Wolters Kluwer Financial Services, Minneapolis.
Keeping track of the level of condo conversion fraud is difficult, since no organization monitors new condo sales – the National Association of Realtors only tracks sales of existing condo units, not the newly converted properties that are susceptible to this chicanery. Industry experts believe the level of fraud is low, but still bothersome.
"Most condo conversions are not fraudulent," says Dr. Mark Fleming, chief economist for First American CoreLogic, Santa Ana, Calif. "People convert apartment buildings into condos all the time. However, there are more of these types of frauds being perpetrated."
But when the fraud becomes prevalent, it quickly generates attention. For example, a Sept. 9 article in the Florida Times-Union reported that "several apartment-turned-condo complexes in the Jacksonville area are swimming in lawsuitsâ�¦at the core are problems with aging buildings that were gussied up with paint and fancy trimmings, but never truly renovated, according to lawsuits. Most were sold as luxury condominiums at discount prices, in deals that homeowners say seemed too good to be true."
Sanders adds there have already been secondary market repercussions based on this fraud.
‘While some of the fraud schemes are quite sophisticated and difficult to detect even with proper origination and underwriting, the sheer speed of loan originations made the detection of fraud more difficult,’ he says. ‘And this has impacted the subprime asset-backed securities (ABS) market where these loans eventually came to be housed – as well as the collateralized debt obligations that were stocked with subprime ABS tranches."
In order to detect this fraud before it takes root, Wolters Kluwers' Outlaw recommends paying close attention to individual projects, since this type of fraud is not common on a wide scale.
"It takes a great deal of contribution from a lot of different parties to make this happen," he says. "It is usually one project at a time before anyone is caught."
Outlaw also proposes having condo homeowner associations file public records on a monthly basis during the conversion process. Continuously updated filings, he adds, would severely diminish the potential for fraud.
"If we look through public files and find a mismatch of information, then we can launch an investigation before we start handing out money," he says.
First American CoreLogic's Fleming advises the use of a high-tech strategy to stave off potential fraudsters. "Use your fraud technology screening tools," he says. "You should be looking for inflated values. Use your collateral risk tools to identify if the quoted values are reasonable."
Fleming also notes certain geographic areas are more prone to condo conversion fraud. "You will find it mostly in the East Coast urban areas and in Florida," he says. "This type of fraud is less popular in the garden-style apartments in California and more popular in high-rises in Washington, D.C., New York City, Chicago, Tampa and Miami."