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By L. Burke Files
We hear so much about slumlords and how they steal property. Basically, they buy it cheap, collect rent and never make any repairs. Why would someone do this if there weren’t substantial financial rewards? The fact is, they wouldn’t, and there are.
THE TYPICAL SCHEME The typical slumlord acquires property for little (10 percent or less) or no money down. He will typically try to buy a property for $15,000.00 to $20,000.00 per unit, strictly a cash flow decision. The properties he chooses range from a simple four-plex to a large apartment complex that has gone into foreclosure.
No matter the specifics of the property, there are reasons for a “distressed sale.” The distress situation could be because the previous owner just wanted to get out of the apartment business or because an insurance company or another lender foreclosed upon the previous owner of the apartment complex and has put the property up for auction sale to the highest public bidder.
Such situations are rife for a typical slumlord to enter the picture. He does not argue price, only terms. Typically, the terms include a lower-than-market interest rate and a 30-year repayment period. The terms may include a 10-year balloon or a 15-year balloon. This new buyer will not really care about anything beyond the first five years. he wants only to arrange the lowest possible initial payment amount.
With such an arrangement, the slumlord will purchase the property. Initially, he will make the first one to five payments, providing the seller with a false sense of security.
Then the slumlord begins to complain. These complaints can range from deception on behalf of the seller or known or unknown problems that were not previously disclosed. Some readily used problems include undisclosed galvanized pipes, undisclosed environmental liability from asbestos (that is actually one of the newer ones), undisclosed structural damage, and a host of other things that would cause some angst if the previous owner were to initiate foreclosure proceedings and then have to sell a piece of damaged merchandise, something that they thought was in perfectly good shape when they sold it to the slumlord.
It is this point in time that the slumlord begins making either no payments or only partial payments on the note. He uses a variety of legal chicanery; stringing out the foreclosure proceedings, counter-claiming for any number of the host of previous alleged defects or undisclosed environmental liabilities, or claiming that the entire payments were made but the owners of the title company lost them. The slumlord’s actual purpose is to make little or no payment to the seller or the financier for as long as humanly possible.
A practiced and successful slumlord can stretch this fiasco out for up to three years. In one documented case, the new owner was an attorney. (General disclaimer: Neither the writer of the JCFR is implying that all attorneys are crooked jerks. There are, however, a few that might fit this description!)
Mr. Attorney/Property purchaser claimed there was a new asbestos problem and that the ceilings of the entire building were filled with this dangerous material. He then advised the mortgage-holding bank that the price tag to remove the offending material and replace it would amount to $1.1 million. The building was only valued at $3.5 million; thus the investment of $1.1 million would amount to approximately 30 percent. Given the large amount of money involved, the bank just sat on its thumbs for a year and a half. Finally, however, the bank had enough and, unbeknownst to the new owner, initiated a property testing program. This led to the lender discovering the ceiling was filled with mica, not asbestos, and had been all along. The bank immediately initiated foreclosure proceedings.
As the foreclosure date approached, the owner of the property filed for protection under the chapter 11 bankruptcy laws. This slick and calculated move forestalled the bankruptcy for another year. Eventually, the bank did petition to lift the stay on foreclosure and was able to successfully foreclose upon the property.
The financial loss, however, was not yet over. When the property ownership finally reverted to the bank, they found it necessary to invest at least $700,000.00 maintenance dollars because the property had not been maintained for four years.
How much money did the attorney/buyer make on this particular transaction? Well, it is pretty straightforward. The apartment complex had 260 units. He purchased the apartment complex for a purchase price of $3.9 million, putting down $500,000. That left the financed balance at $3,4 million. His payments on the $3.4 million were $15,800 per month. The average rental on the 260 units was $450 each. Over the three-year period of time, the slumlord kept about 85 percent of the units rented (amounting to 221 units). So $450 times 221 units equals $99,450 a month.
In this case at hand, the buyer kept the property for a total of 37 months without paying any mortgage payments. During this time he collected rents amounting to $3,679,650 off of a $500,000.00 (the down payment on the property) investment. Taking this one step further, these figures indicate that the buyer made roughly 19.5 percent on his money every month. Even more amazing is that this number does not include the tax benefits of depreciation nor does it include any type of overhead (such as a manager who was on duty to make sure the rent was collected).
Since the note was a non-recourse note, the property was foreclosed upon, resold and a judgment was obtained against the original purchasing partnership. The general partner was a shell corporation and the attorney/buyer was the only limited partner. As a consequence, no deficiency judgment could ever be collected on this particular property.
Did the bank pursue him? No! Did anyone refer this case to any legal authorities to scrutinize? No!
Typically, this sort of a scam involves a buyer who owns 20-30 properties. The units are purchased from older individuals and the buyer will not argue the price. By agreeing to pay an amount which might appear on the face to be more than the properties are worth, the buyer is able to arrange some terms which enable him to reap large profits from his scam.
So a woman asking $200,000.00 for a beat up 5-plex or 6-plex (that most honest investors would not touch) will get her asking price from the crook in a heart-beat. This is because he can then begin the process of collecting rents and pocketing every cent of the proceeds.
Is the above example an actual fraud? I think so. Are such frauds covered under the legal fraud descriptions in the various states? Quite possibly. What is the likelihood of prosecution for this kind of a scam? Almost zero! Is this type of scheme a wide spread practice? Absolutely!
Let’s take a look at the primary victim here, the financial institutions and/or the sellers of the property. In every instance, since a credit granting relationship exists between seller and buyer, the seller may run a credit report. This will take care of nine out of ten of the problem makers. These are the people who are “professional slumlords” and have not paid bills, usually across several states. The more professional slumlord (sometimes referred to as the institutional slumlord), such as the example above, needs to be treated more carefully.
When a buyer is suspect, an idea is necessary relative to the areas previously operated in the names, business or otherwise, used. Any investigator or information broker can run a quick search and obtain such information. The investigator will check the superior court for that county and for all locations in which the potential buyer has operated properties. The litigation will reveal the entire tale of whether the potential buyer is a victim or a victimizer.
In the above true example, the attorney/buyer walked out of court and told the investigator, “Well, you got this one quicker than most. But let me tell you, usually I can forestall any litigation for an entire year. I have a death in the family, a religious holiday, two medical appointments and, of course, a conflict of schedule. Those five excuses can usually get me through an entire year before I have to even appear in court.”
Here are some of the warning flags:
- The potential buyer does not argue price. This constitutes a BIG warning flag. He does not argue price because he does not care what he is paying for the property on paper. Why would he? He doesn’t intend to make the payment anyway!
- He is most interested in what the monthly payment will be and how much he can lower that monthly payment, especially in the first few years.
- Never trust anyone who wears a better suit than you.
- Always remember the old axiom. “An ounce of prevention is worth a pound of cure.
L. Burke Files is a financial investigator from Phoenix, Arizona. He can be reached at (602) 838-1728.
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