Edited by: TJVNews.com

U.S. prosecutors are intensifying efforts to tackle commercial mortgage fraud, a crackdown that is unsettling the $4.7 trillion industry by scrutinizing the financials underpinning major property loans. According to the information provided in a recently published report in The Wall Street Journal, the move comes as regulators and federal prosecutors identify a rise in property loans based on manipulated financials and valuations, a trend that gained momentum from the mid-2010s through 2021. This period saw a significant surge in commercial property prices, creating fertile ground for fraudulent activities as landlords sought to capitalize on inflated valuations.

The current economic landscape, characterized by declining property values due to higher interest rates and an increase in defaults, is exposing numerous fraudulent schemes that went undetected during the market boom, as was reported by The WSJ. This revelation adds to the woes of a commercial real estate market already reeling from its most challenging period since the 2008-09 financial crisis.

Speaking to The WSJ, John Griffin, a finance professor at the University of Texas’ McCombs School of Business, succinctly captured the cyclical nature of fraud: “It’s a general trend throughout history that fraud occurs during boom times and is revealed during bust times.” This pattern is now playing out in the commercial real estate sector, where the previous period of rapid price escalation is giving way to a harsher economic reality.

A key factor enabling real estate fraud is the typically hands-off approach lenders take when assessing a building’s value. As long as financial figures appear consistent with those of comparable properties, lenders tend to accept them at face value. The WSJ report indicated that this trust-based system, however, leaves room for manipulation. Conducting thorough audits is both costly and time-consuming, and lenders, eager to secure deals, often avoid imposing rigorous due diligence that could alienate potential clients.

The recent shift in market conditions has prompted federal prosecutors to ramp up their efforts to uncover and address fraud. As per The WSJ report, they are increasingly collaborating with investigators from the Federal Housing Finance Agency’s Office of Inspector General. This joint effort calls attention to the seriousness with which authorities are approaching the issue.

One high-profile case illustrating the crackdown involves a major commercial property developer accused of inflating the value of several properties to secure larger loans. Prosecutors allege that the developer provided falsified rent rolls and overstated occupancy rates, thereby inflating property valuations, The WSJ report noted.  Such fraudulent activities not only jeopardize the integrity of financial markets but also have far-reaching implications for investors and the broader economy.

The fallout from these fraudulent schemes is considerable. As property values drop and defaults rise, the risk of significant financial losses looms large for lenders and investors alike. The discovery of inflated valuations and doctored financials further erodes confidence in the market, potentially leading to tighter credit conditions and higher borrowing costs for legitimate property owners.

While the exact number of ongoing investigations remains undisclosed, a series of plea deals reached since last fall highlights the scale of the problem. At least five landlords, primarily of apartment buildings in cities such as Cincinnati, Hartford, Conn., and Little Rock, Ark., have admitted to federal fraud charges, according to The WSJ report. These cases involve various fraudulent activities, including falsifying building income statements and faking property sales at inflated prices, all aimed at securing larger loans.

Government-backed mortgage enterprises Fannie Mae and Freddie Mac have responded to these revelations by tightening their lending practices and cracking down on suspicious activities within their rental-apartment lending business. The information contained in The WSJ report said that one notable case involves Meridian Capital Group, a mortgage brokerage that has been effectively blacklisted by both Fannie Mae and Freddie Mac after allegations surfaced that one of its brokers doctored financial statements to secure larger loans. This blacklist has since extended to brokers at other firms suspected of similar misconduct.

In a bid to combat fraud, Freddie Mac has overhauled its underwriting policies. The agency now requires borrowers to submit rent receipts and has instructed lenders to conduct more thorough inspections of apartments to verify occupancy, the report in The WSJ said. Fannie Mae, on the other hand, is meticulously reviewing existing loans to identify those based on dubious financial data, according to sources familiar with the matter.

During a May earnings call, Ivan Kaufman, CEO of commercial mortgage lender Arbor Realty Trust, highlighted the impact of fraud on the industry. Speaking to The WSJ, he noted that fraud, particularly within the brokerage sector, has been an unforeseen challenge contributing to the market’s stress. “I think there was a lot of elevated fraud in the industry through the brokerage industry,” Kaufman remarked.

At the core of this issue is the process by which lenders underwrite commercial mortgages. Borrowers typically submit financial statements known as T-12, which detail a building’s income and expenses over the past year. Lenders rely on these documents to assess the building’s value and determine the loan amount. However, the lack of auditing these statements leaves room for manipulation. The WSJ report explained that most lenders do not verify whether the reported sums actually flowed in and out of the landlord’s accounts, making it easier for unscrupulous individuals to present inflated or entirely fictitious financials.