Fraud Prevention: For Commercial Real Estate Valuation

“Incentives are the cornerstone of modern life.”

–Dr. Steven D. Levitt, University of Chicago economics professor and coauthor of Freakonomics

Chapter 3 discussed how the real estate industry often attracts unethical people. The reason is simple: Real estate is where the money is. The word unethical is strong, though, and might lead the reader to overlook situations in which otherwise decent, respectable professionals mislead appraisers because the system rewards such behavior without the threat of consequences. Deception is a real and expected human response to uncontrolled incentives and conflicts of interest.

When working with commission-compensated professionals such as realtors or mortgage brokers, always be aware of the possibility that they will provide inaccurate or biased information. Lending institutions may also have conflicts of interest from their own staff if staff compensation is variable and dependent upon loan production; such conflicts can extend all the way up into senior management.

Dishonesty is like a snowball rolling down a mountainside. Once others are seen doing it, it gets rationalized within the institution and then becomes an acceptable industry practice, perhaps even taught in weekend seminars. Fraud and dishonesty become rationalized with the excuse that everyone else is doing it.

Property owners and developers may also retain “expert” consultants to give appraisers a positive spin on their properties or development projects. While dealing with experts may be intimidating to an appraiser who may not be as specialized, keep in mind that the expert’s objectivity must always be considered.

Steven D. Levitt and Stephen J. Dubner, authors of the book Freakonomics, explain this phenomenon by stating that “experts are human, and humans respond to incentives. How any given expert treats you, therefore, depends on how that expert’s incentives are set up. Sometimes his incentives may work in your favor…. But in a different case, the expert’s incentives may work against you.”¹

For example, a general appraiser values a golf course in a severely overbuilt market and has his appraisal challenged by a well-known golf course management consultant retained by the property owner. The expert states that the comparable sales are all considerably inferior golf courses—non-championship courses with less yardage. Perhaps the appraiser may feel that the valuation must be changed in deference to the expert, not considering that the expert carefully dodged the subject of the poor financial performance of the subject golf course. Always consider the notion that expert opinions, including appraiser’s opinions, are bought and paid for.

Any consultant hired by an owner, developer, or borrower, no matter how impressive the credentials, should be considered to be acting in the capacity of an advocate. Their remarks should be critically examined before being accepted at face value. If the brilliant attorney Johnnie Cochran told you his client was innocent, would you accept that without question?

Remember, also, that USPAP Standards Rule 2-3 requires an appraiser to certify that “the reported analyses, opinions, and conclusions … are [the appraiser’s] personal, impartial, and unbiased professional analyses, opinions, and conclusions.”² This would prohibit an appraiser from relying on a borrower-hired expert’s conclusions.

The financial institutions that have failed during the current global financial crisis have been publicly owned and traded corporations. The system of public ownership has created an incessant need to delight shareholders on a quarterly basis, particularly if management is rewarded according to benchmarks like growth in earnings per share (EPS). This, in turn, has caused many senior managers to turn to accounting gimmicks and loan sales incentive policies that go against sound lending practice. The shareholders and stockholding managers who sell early do quite well, but once the institution is seized by the FDIC, the remaining shareholders are wiped out. In this sense, the largest failed thrift institutions of the last decade seem almost like Ponzi schemes, with Washington Mutual being larger than the Madoff scheme.

Looking at the mortgage industry meltdown of 2007 and 2008, it would be reasonable to ask why so many of the best and brightest financial minds were so wrong again so soon after the savings and loan fiasco of two decades ago.

One explanation is that financial executives were gaming the system in response to unsound executive compensation systems commonly used by public companies. Earnings can often be booked at loan origination, regardless of the soundness of the loan. During the good times, these unsound loans can be sold off to sit in mortgage pools or portfolios as ticking time bombs to be dealt with long after the senior executives have received their bonuses and exercised their stock options. Some executives succumb to such a compelling enrichment scheme.

What do Washington Mutual (WAMU), IndyMac Bank, and Downey Savings have in common? These failed institutions were all regulated by the Office of Thrift Supervision (OTS), which became politicized in favor of deregulation by the incoming Bush administration in 2001 and was merged into the Office of the Comptroller of the Currency (regulator of commercial banks) on July 21, 2011. The accompanying photo shows one of the first symbolic acts of the 2001 administration: at a press conference, a chainsaw was applied to the existing OTS regulations that guarded the safety of the American financial system.

Thrift deregulation in the twenty-first century: chainsaws and the failure of all of the largest thrifts.

As recently reported on CBS’s Sixty Minutes, Herb and Marion Sandler safely and soundly managed World Savings for years before finally succumbing to temptation and receiving millions of dollars in the sale of their doomed institution to Wachovia Bank, which was so badly damaged that the federal government had to force its sale to Wells Fargo.

The two other largest savings and loan institutions in the country, IndyMac and Washington Mutual, were respectively seized by the FDIC in July and September of 2008.

Both institutions were fast growers that were rewarded by Wall Street with high price-earnings multiples and soaring stock prices. Those in the mortgage lending business know, however, that such rapid growth is inconsistent with prudent lending.

Many mortgage-lending institutions rewarded their CEOs and COOs with incentive-based compensation that dwarfed their annual base salaries and encouraged them to do whatever was necessary to increase the stock prices of their institutions. Stock prices moved in tandem with reported earnings.

IndyMac CEO Mike Perry, for instance, had an annual salary of $1 million per year, but his incentive-based compensation (bonuses and stock options) was many times as high. Perry earned over $32 million by selling IndyMac stock from 2003 to 2007, in addition to performance bonuses that were typically 75% to 100% of his base salary.

A 2006 IndyMac press release plainly explains the radical difference in future (year 2007) compensation to Perry under various scenarios, with his total compensation limited to $1,250,000 for an EPS growth of less than 5% but a compensation of $8,943,000 for an EPS growth of 17%.³ With a compensation structure like this, it was no wonder why rapid growth was pursued at all costs. Making and selling unsound loans would be the easiest way of meeting such a financial goal.

Kerry Killinger, CEO of Washington Mutual, was also paid a base salary of $1,000,000 in WAMU’s last full year of existence and was incentivized with stock options that brought his total pay package to more than $14 million. The New York Times reported that Killinger received $38.2 million in performance pay ($7.6 million in cash and the remainder in stock) between 2005 and 2008. WAMU’s mortgage-related losses of $8 billion in 2007 and 2008 wiped out all of its earnings in 2005 and 2006.⁴ Both Perry and Killinger are now facing numerous lawsuits from the FDIC, the US Securities and Exchange Commission, and unhappy shareholders.

Franklin Raines, CEO of Fannie Mae, received $52 million in compensation between 1999 and 2004, with $32 million from an incentive plan generating big bonuses for Fannie Mae achieving certain performance yardsticks, such as a 15% annual growth in earnings. Mr. Raines was accused of falsifying the reported earnings to gain his bonuses and was therefore terminated, leading to a $9 billion profit restatement covering the years 2001-2004.

The conflicts of interest in the financial industry have had a very real effect on the integrity of the appraisal profession. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 has not eliminated the need to please stockholders, and some of these conflicts of interest still exist. In performing appraisals for lenders, appraisers need to be alert to possible conflicts of interest that might compromise their appraisals. Objective appraisals have been changed or undone by interference from loan origination personnel and senior executives with compensation linked to loan production. The independent appraiser who has never worked at a financial institution may be confused as to who is in charge and might change the appraisal report at the request of an executive perceived as having a higher rank. Loan salespeople sometimes have “regional vice president” or “senior vice president” titles that serve to confuse independent appraisers. No matter what the perceived rank is, though, the appraiser should “just say no” to loan officer interference that would result in a misleading appraisal report.

If a loan officer calls an appraiser to request a change in violation of USPAP, the appraiser should simply say no. Larger institutions typically have chief appraisers who can advise the appraiser on the proper course of action, but even they can be conflicted at institutions pushing loan sales. Smaller institutions without chief appraisers usually have chief credit officers who can be consulted.

If the chief appraiser or chief credit officer advises you to commit appraisal fraud, however, scratch that institution off your client list. If the institution fails, it is always possible that independent appraisers will be pursued by the FDIC for losses on failed loans.

It is intuitively obvious that a property owner appealing a property tax assessment will want the lowest appraised value possible. Likewise, a property owner establishing a conservation easement, charitable deduction, or trust may want the highest appraised value possible. In these cases, a property owner may expect the appraiser to act as an advocate. An appraiser who succumbs to such pressure may be in violation of state or federal laws in addition to USPAP and professional association codes of ethics.

An appraiser promising to deliver an appraised value as low or as high as possible in order to evade taxes is clearly crossing the line, but sometimes an appraiser is cornered into misrepresenting market value through accepting certain appraisal assignment parameters that would skew the appraised value. Here are certain unacceptable instructions that may cause an appraiser to overvalue a property:

The Pension Protection Act (PPA) of 2006 allowed the Internal Revenue Service to strengthen rules regarding appraisals done for income tax, gift tax, and estate tax purposes, recognizing that appraisals supporting non-cash charitable contributions in particular had previously been inflated in many cases and valuations done for estate or gift taxes had often been understated. Section 1219 of this act spells out new penalties against appraisers for “substantial or gross valuation misstatement.” Appraisals are now required to meet “generally accepted appraisal standards.” USPAP is an example of generally accepted appraisal standards, as is the Uniform Appraisal Standards for Federal Land Acquisitions (also known as the “Yellow Book”) used by federal agencies. For tax returns filed after February 17, 2007, an appraisal report supporting a tax deduction must include language stating that the appraiser understands that a substantial or gross misstatement resulting from an appraisal of the property value that the appraiser knows, or should have known, would be used in connection with a return or a claim for refund may subject the appraiser to a civil penalty under Section 6695A.⁵ Penalties are the greater of $1,000 or 10% of the amount of underpayment attributable to the value misstatement, not to exceed 125% of the appraisal fee earned.

Whenever an appraisal is performed, money is usually at stake. For an appraiser to remain objective, it helps to understand the conflicts of interest at work behind the ordering of the appraisal report, as these conflicts of interest may influence the accuracy of the information that the appraiser is relying upon or even steer the appraiser to a conclusion that does not logically follow from the information presented. The financial industry, in particular, is still troubled with many unresolved conflicts of interest that may steer an appraiser away from the most accurate and objective conclusions possible.

1. Steven D. Levitt and Stephen J. Dubner, Freakonomics: A Rogue Economist Explores the Hidden Side of Everything (New York: Harper Perennial, 2009).

2. Uniform Standards of Professional Appraisal Practice, 2010-2011 ed. (Washington, D.C.: The Appraisal Foundation, 2010), p. U-28.

3. IndyMac Mortgage Services, “IndyMac Signs Long-Term Contract with High-Performing CEO, Michael Perry,” Sept. 22, 2006.

4. Gretchen Morgenson, “After Huge Losses, a Move to Reclaim Executives’ Pay,” The New York Times (February 21, 2009).

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Understanding Conflicts of Interest