Emerging fraud trends: Illegal property flipping with cash-out purchases

A well-known practice in the real estate industry is property flipping. Flipping is a legal and ethical practice when all representations of the property condition and value are true and accurate. However, flipping can also be a fraud-for-profit scheme that may lead to devastating consequences.

What is property flipping?

Property flipping is the process by which an investor purchases a home and then resells it at a higher price a short period of time later. For example, an investor buys a house in need of work for $250,000 in July, renovates the kitchen and bathrooms, and landscapes the yard at a cost of $50,000 and then resells the house two months later (the time it takes to make the renovations) for a price that is reflective of the market value. This is a legitimate business transaction and there are many in the real estate market that make an honest living flipping properties.

When does property flipping become fraudulent?

Property flipping becomes illegal and a fraud for profit scheme when a home is purchased and resold within a short time frame at an artificially inflated value. The flip typically involves a fraudulent appraisal, which may indicate that renovations were made to the home, when, in fact, there were none, or the renovations consisted only of minor cosmetic improvements.

How can a cash-out purchase be used for illegal flipping?

One of the latest developments in illegal flipping is the cash-out purchase. In these instances:

The buyer/borrower approaches the seller of the property and makes an offer considerably higher than the current list price.
The offer will include a stipulation that the additional amount over the asking price will be given to the buyer/borrower at closing.
The stipulation for cash back to the buyer/borrower will often be documented in an addendum to the purchase contract.
An inflated value charged to non-existent home improvements will be used to support the inflated sales price.

For example, the seller lists the property for $150,000. The buyer/borrower offers $199,000. At closing, the seller will receive net proceeds on the $150,000 asking price and the surplus of $49,000 from the loan amount is disbursed to the buyer/borrower at or through closing.

Often, these types of loans end up as first payment or early payment defaults and most likely in foreclosure.

Where is cash-out purchase fraud most common?

There are two real estate market environments where cash-out purchase fraud is most prevalent:

Markets where the housing values have experienced rapid appreciation. Those who perpetrate the fraud are relying on the actual value of the property to rise to the inflated origination value before the lender has foreclosed and detects the inflated value.
Stagnant, even slowing markets, where the property is on the market for an extended period of time. The longer the property is on the market, the more nervous sellers become and are more likely to agree to a cash out purchase arrangement.

What are the 'red flags' of cash-out purchase fraud?

Although challenging to detect, there are a few red flags to look for when reviewing mortgage files:

The home may have been on the market for an extended period of time
The sales contract may have been modified or may include an addendum regarding the payment to the borrower
The appraisal may include red flags symptomatic of inflated value
Many of the same red flags that accompany a traditional flip also apply to cash-out purchase fraud – straw buyer, false source of funds and false occupancy
The preliminary HUD-1 Form may already indicate a portion of the net proceeds going back to the borrower

When any of these red flags surface, it is important to review the file more closely.

Ensure that the borrower truly has the represented funds to contribute at closing; borrowers involved in flipping typically do not
Take advantage of on-line real estate listing tools or contact the listing agent directly to verify the listing history on the property. Instances where the sales price is markedly higher than the list price are cause to ask more questions and to look harder at the appraisal itself.