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Emerging fraud trends: condominium conversion bailouts

During the recent housing boom, to meet the growing homeownership demand and offer an alternative to single-family homes, there was vast growth in apartment complexes converted into condominiums. As we're all too well aware, with a cooling housing market and tighter credit environment, condominium unit sales have lagged and there is an excess of unsold condominiums on the market.

To sell these excess units, there has been an increasing trend of incentives being offered to entice potential buyers. Common incentives include "cash back at closing" or "guaranteed mortgage payments" for a specified period of time. Many condominium units are being marketed to investors looking for "no risk" investments, rather than to buyers looking to occupy the units themselves.

Incentives offered by developers are often legal. Unfortunately, some engage in questionable practices that may involve fraudulent activity, such as condo conversion bailout schemes.

What is the condo conversion bailout scheme?

A condo conversion bailout scheme is one of intentional deception and misrepresentation. It commonly involves multiple perpetrators who create and promote incentive packages that are deliberately concealed from lenders. This scheme also involves inflated property values, and the masking of illegitimate cash disbursements on the settlement statement or failure to disclose them at all.

How does the condo conversion bailout scheme work?

  • The seller, developer, or promoter typically targets buyers with excellent credit who are looking to purchase "no risk" investment properties with little or no money down.
  • As a condition of the sale, the buyer executes a purchase contract detailing the incentive package, which often includes substantial cash back. Other incentives to attract buyers might include:
    • A mandatory "turnkey" management agreement for the income producing properties, granting exclusive authority to the management company (often a subsidiary of the developer) to find tenants. Turnkey management implies that the borrower is not responsible or tasked to do anything to manage the property.
    • An offer to collect rent payments and make the mortgage payments.
    • A promise to guarantee cash flow whether the unit is rented or vacant.
  • Inflating the sales price of the property generates cash to fund the borrower incentives. Funds are provided to the buyer as a lump sum used to make the mortgage or other payments.
  • The inflated sale price is supported by an inflated appraisal report.

These transactions become problematic when the incentives are not disclosed to the lender. This omission, and the inflated appraisal, mislead the lender into funding the loan.

Condo conversion bailout scheme 'red flags'

  • The neighborhood where the property is located had lagging sales followed by a sudden spike in volume and price
  • The mortgage is for a second home and relies on secondary financing
  • Out-of-state borrowers with strong credit scores
  • Payments made by someone other than the borrower
  • Large non-lien disbursements on the HUD-1 Form
  • Excessive real estate fees
  • Large number of condominium conversions in a particular area

Best practices to avoid condo conversion bailouts:

  • Condo project approval
    • Perform a detailed analysis when pre-approving any condominium project.
    • Monitor websites for incentive packages offered for condominium projects.
  • Is the borrower buying a second home?
    • Does the purchase of a second home make sense?
    • What is the distance between the primary residence and the second home the borrower is looking to purchase?
    • How many "second homes" does the borrower have within a short distance of each other?
  • Appraisals
    • In a controlled market, require that comparables be used from outside the complex.
  • HUD-1 Form review
    • Perform a detailed review of the seller portion of the HUD-1 Form.
    • Issue clear closing instructions that prohibit non-lien third party disbursements.
    • Limit real estate commissions to a reasonable percentage.

Important Freddie Mac fraud prevention resources

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