Note Brokering &
Investing Academy
Module 9 · Legal & Risk

Flip Flimflam

How the rehab-flip-and-straw-buyer fraud traps note investors, a real case, and ten red flags to check before you buy.

By James C. Levie · 7 min read · Lesson 9.3

An old enemy is waiting to pick your pockets. If you are in the note business long enough, you will be hit, or at least tempted, by the profitable charms of the rehab, the quick resale (the “flip”) and a heavily inflated appraisal with a cooperating straw buyer (the “flimflam”). Here is exactly what the scheme is and how to try to avoid it.

How the flip flimflam works

Speculators buy sub-par, highly distressed foreclosed homes. The innocent sources are often institutions such as HUD, mortgage bankers and banks. Because of the home’s very poor condition and the neighborhood, these homes sell for very small sums. Here is what commonly happens:

  1. A real estate or mortgage speculator buys a property from HUD for $11,000. In its present state it is worth only about $11,000. HUD is not giving away public assets.
  2. The buyer does cosmetic work on the outside, where an appraiser will photograph it: trash removal, taking down window and door board-ups, trim paint. This may cost only $1,000 to $1,500.
  3. The buyer hires a staff appraiser at a well-known appraisal firm who is willing to provide a highly misleading, inflated appraisal. These appraisals use improper comparable sales, make false statements about the extent of the rehab, leave out area crime, board-ups and declining values, and grossly inflate the value. The value given is often the buyer’s desired resale price.
  4. The buyer enlists purchasers who go along with the plan. They sign the credit application, promissory note, mortgage, closing statement and affidavits, and are often coached on down payment, income, employment and occupancy.
  5. The closing statement shows a $7,000 down payment paid on contract and a purchase money first mortgage for the $38,000 balance, at 10%, amortized over 30 years with a 10-year balloon. The seller pays all other closing costs. In fact the buyer put no money down. The credit on the sales contract, carried onto the closing statement, is false.
  6. Armed with a doctored credit package, an appraisal from a widely known firm and a detailed closing package, the seller markets the first mortgage to several note buyers.
  7. The mix of a reputable appraisal, a $7,000 down payment, decent buyer credit and a complete closing package lures an investor into buying the note at a market discount or a loan-to-value ceiling.

Worked example: the $11,000 house sold for $45,000

ItemAmount
HUD purchase price$11,000
Cosmetic work$1,000 to $1,500
Resale price to straw buyer$45,000
Down payment shown (never paid)$7,000
First mortgage: 10%, 30-year amortization, 10-year balloon$38,000
Price investor pays for the note (75% ILTV)$33,750
Area value in very good condition, per local agent$20,000 to $28,000

The investor paid $33,750 for a note on a house never worth $45,000.

What happens when the payments stop

Nine months later the money order payments stop. An inspection reveals that the home is vacant, neighbors say no one has lived there for over a year, and the property is in horrible condition. The extensive renovations in the appraisal were apparently never done. A local real estate agent says that, on its best day and in very good condition, the area supported prices of $20,000 to $28,000. Never $45,000.

The note investor takes a considerable loss. The speculator is long gone, out of state. The buyer can’t be found. The appraisal firm stonewalls when pressed for answers, the staff appraiser no longer works there, and the title company is out of business.

A real case, not a hypothetical

Shocking? Hard to believe? Think again. The author’s firm, along with Chrysler First Financial Corporation and Metropolitan Mortgage & Securities, among others, fell victim to this exact scenario. At last count the total ran to more than 250 bogus transactions.

In a civil suit the author’s firm filed in 1994, it alleged that a national appraisal firm produced hundreds of grossly inflated appraisals through its Tampa, Florida staff appraiser; that a real estate speculator bought distressed properties and quickly resold them to straw buyers (he was convicted of this crime and sent to federal prison); and that a mortgage broker arranged the bogus appraisals and the sale of hundreds of the phony mortgages, knew about the straw buyers and recruited a few himself.

Ten red flags to check before you buy

First and foremost, there is no 100% sure way to stay out of this kind of trouble. But these warning signs should get your attention:

  1. Take steps to verify that an arm’s-length buyer really paid a cash down payment.
  2. Even with an existing appraisal from a major national source, get an independent review of it.
  3. If you can, inspect both the property and the neighborhood in person.
  4. If anything troubles you, ask several local real estate agents for a comparative market analysis (CMA).
  5. Demand copies of all recorded deeds for the two years before the most recent sale. Find out who owned the property and at what prices, and watch for quick flips and rapidly rising prices.
  6. Demand that the appraisal cite any sale of the subject and the comparables in the past 12 months, whatever the appraisal form.
  7. Treat a sales contract that receipts 100% of the cash down payment as a major warning flag.
  8. When permitted, always get an insured closing protection letter from the title agent’s insurance company, and verify the letter with the insurer.
  9. Independently verify the buyer’s employment and contact details. Before buying, question the home buyer: probe, ask, prod. Don’t be afraid of chasing him off. If he runs, let him. You run, too.
  10. List everything that could go wrong, including every way fraud could be committed, forged documents included. Then check out every one of those possibilities.

There are few, if any, real estate miracles. Savvy investors can’t buy distressed properties for $11,000 and resell them a few days later for $45,000 with a few dollars of cosmetic cover-up. Questioning suspicious deals is the only way to lower your odds of falling for this fraud.

If concerned people and companies were willing to share their war stories in a proper, ethical way, the industry could begin to police itself. Silence only licenses more abuse.

Key takeaways

  • Quick flips at big markups are a warning
  • Verify the down payment was really paid
  • Review every appraisal independently
  • Check two years of recorded deeds

Try it yourself

A note’s paperwork shows a $7,000 down payment, but the sales contract says the full down payment was paid outside closing. Which red flag is this, and what should you do?

Show answer

A sales contract receipting 100% of the cash down payment is a major warning flag. Verify that an arm’s-length buyer actually paid it before you buy the note.

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