October 27, 2020

Autopsy of a Real Estate Partnership Fraud: No RIP

By Nitasha Giardina, CFE, Director, Advisory Services

Autopsy of a Real Estate Partnership Fraud: No RIP Valuation, Forensic & Litigation Services

Real Estate Partnerships (“REPs”) are generally closely held partnerships of individuals who pool their money to invest in real property. It is common for REPs to include members of a family. Often, one of the family members acts as a general partner (GP), and the remaining members are limited partners (LP). The general partner controls the operations and financial activities of the entity while the limited partners have minimal or no involvement and enjoy the cash distributions, pass through benefits or other attributes if any.

The Potential for Fraud

The financial statements of family-owned REPs often are not as detailed as more sophisticated and larger partnerships and there are minimal or no internal controls around the financial processes. Such an environment creates a higher opportunity for fraud as well as the ability to mask fraud when it occurs. Fraud may be perpetrated internally by the GP or externally by others, and it can occur in one or multiple areas of the REP:

1. Real Estate Investor Fraud

This type of fraud involves a real estate developer soliciting funds from an investor for a percentage interest in the real estate partnership or Limited Liability Company. The developer makes various misrepresentations including but not limited to use of funds, construction plans, sale/rental prices of the property post-construction, and ultimately, the return on investment for the investor. The fraud often unravels when investors start asking for financial information or there are constant changes/delays to the construction plans, or the real estate developer keeps asking for additional funds, which could come in the form of loans or capital contributions.

2. Construction Fraud

This type of frauds occurs during the initial planning or construction phase of a real estate partnership. Fraud schemes include but are not limited to substituting cheaper materials but charging the higher priced materials to the job, inflating the labor and material costs, double invoicing, excessive or unneeded change orders, or the use of the building material from other construction sites, unrelated to the one in which the partners have invested. The fraud often unravels when there is further investigation into escalating construction costs or there is a whistleblower.

3. Shareholder/Member/Partner Fraud

Fraud schemes are perpetrated in various ways, including but not limited to personal expenses being paid through the operations, not showing any cash payments from tenants as revenues, paying more for management fees or other reimbursements beyond what is allowed in the operating, partnership or shareholder agreements, removing equity from the entity by constantly refinancing and using the funds for non-operational purposes. Another area of fraud could involve the controlling party using their influence to coerce employees into carrying out fraud, theft or other activities associated with mismanaging the entity’s assets. The fraud often unravels when one or more investor asks questions about financials and the use of funds, or there is a third party investigation or whistle blower.

4. Employee Fraud

This type of fraud can be perpetrated by anyone ranging from a property superintendent to the property manager (non-owner) itself. They may include paying excessive fees to themselves, create accounting entries for fraudulent payments, hiring specific vendors who provide kickbacks, using funds from one property for another property to cover shortage of funds, underpaying employees but charging market salary, ghost employees, stealing tools and inventory and then requesting additional equipment and inventory, and charging above- market rent and pocketing the difference. These frauds often unravel when the owners/investors either inquire about specific transactions or start managing part or all of the business themselves.

EXAMPLE: Shareholder Fraud

Facts

A second generation REP founded in the 1980s by an individual was now owned by the two sons of the individual. While the older brother was the general partner, the younger brother and some third party investors were the limited partners. The younger brother owned the largest share of limited partnership interest, with the third party investors owning minimal shares.

That REP was one of nine similarly structured REPs jointly owned by the brothers and third parties. Additionally, the older brother owned a management company that managed the nine REPs. The younger brother owned interest in other REPs with partners other than his brother.

Marcum was engaged by the younger brother (“client”).

Trigger

The trigger for the investigation was a constant refinancing of the properties owned by the nine REPs, with the client not seeing any distribution of funds or use of funds in the properties. In addition, loans were repeatedly requested by the older brother from the client to help operate the REPs.

Investigation

Marcum reviewed thousands of pages of financial documents for each of the nine REPs, including but not limited to bank statements, checks, financial statements, tax returns, refinancing documents, and accountant’s work papers. Additionally, we researched vendors, real estate database like ACRIS research for refinancing of properties and communication with various parties. Our review uncovered a massive fraud scheme with multiple tentacles into several parts of the businesses.

Fraud Schemes

The brother in control of the operations and finances took advantage of the minimal or lack of involvement by the limited partners and used the REPs as his personal piggy bank account in the following ways:

  1. His management company received thousands of dollars in fees in excess of the 5% stated in the management agreements. The management company also received general partner fees. The GP fees were paid despite the fact that the conditions required under the management agreement for such fees to be paid were never met. The checks were made to and deposited in the bank account of the management company and recorded as management or general partner fees on the books of the REPs.
  2. The older brother also paid thousands of dollars in personal expenses through the REPs, including but not limited to construction and maintenance of personal properties owned by himself. Expenses related to the older brother’s gardener, maid, art, car loan, and household furnishings were being paid out of the REPs. Some of these expenses were recorded as loans to the older brother in the books of the REPs, while other transactions were recorded as expenses of the REPs. However, there were no loan documents, no interest was charged, and there were no payments or agreed upon payment schedules between the older brother and the REPs. In fact, when some of the REPs were sold, the older brother did not return the loans and received a payment from the proceeds of sale.
  3. Our review also found certain checks which were written to legitimate vendors that provided services to the REPs in the past. However, when we took a closer look at these vendors, we observed that some of these checks were endorsed by the older brother or his wife, and these checks were in fact deposited into their bank account(s). In the accounting records of the REPs, these checks were recorded as expenses. While the name on the check would not indicate a fraud, a vertical analysis of the expenses documented a disproportional increase in certain expenses.
  4. In addition to excessive management fees, the older brother also wrote checks to his management company for health insurance for his staff, staff salaries, and other reimbursements. These checks were deposited into the account of the management company of which the older brother was a sole owner. On the accounting records of the REPs, these funds were expensed within selling, general and administrative expenses. While these were legitimate expenses incurred by the management company, the management company is only entitled to management fees and/or other agreed upon expenses from a REP. Furthermore, management company staff were employees of the management company not the REP and, therefore, were not entitled to benefits from the REP.
  5. The older brother also approved several recurring payments to certain employees. These payments were called “reimbursement of expenses” and were recorded under various expenses in the books of the REPs. However, there were no documents maintained and/or provided to support these reimbursements or documents which would indicate that these payments were for the operations of the REPs. One such example was an employee whose annual salary was between $40,000 to $50,000 or $240,000 to $300,000 for a six-year period. The same employee for the same six-year period was paid for reimbursement of expenses that she incurred on behalf of the properties of approximately $500,000 in addition to their annual salary. It was a significant red flag that an employee is getting reimbursed for spending almost twice the amount of their salary on behalf of the property.
  6. In addition to recording his own personal expenses as expenses of the REPs, the older brother also stole the funds that were generated from the refinancing of the properties owned by the REPs. The older brother circumvented the operating agreement of REPs, which allowed for the disbursement of the refinancing funds in the accordance of the GP and LP ownership interest, by paying himself, at times, the entirety of the refinancing funds from a property. Furthermore, the older brother gave incorrect information to the accountant preparing the taxes for REPs stating that the client received distribution from refinancing funds when in fact the client had not received any such distribution. Therefore, the client’s partnership interest tax forms (Form K-1) were incorrect for certain years.
  7. Furthermore, the client made several loans to the REPs to help with operational needs. However, most of the loans from the client were never recorded on the financial statements. Consequently when the properties owned by the REPs were sold, the client was not reimbursed for any of these loans.
  8. Over the period of his ownership, our client bought out several other limited partners. Even though our client executed a transfer of interest, a copy of which was provided to the older brother, such interests were not transferred to the client. When analyzing the tax returns, we observed that, at times, the partnership interests bought out by our client were transferred to the older brother, and it often took several years before our client was allocated back the partnership interests he bought. In such years, the client lost any additional distributions made on the newly purchased limited partners’ interests. Additionally, the client also lost any increase in his basis due to the misallocation of profit to him.

As a result of the above, the client was damaged in excess of $5 million. The other limited partners were also significantly damaged. While the client eventually became aware of some of the fraud schemes described above, the subsequent investigation of the REPs by Marcum uncovered several additional schemes which had previously gone undetected. Finally, some of the smaller properties owned by the REPs were irreparably damaged due to continuous refinancing and drainage of cash from such refinancing by the older brother. Consequently there was also a loss in equity value of the business.

Lessons Learned

Hindsight is 20/20, but it’s imperative to be vigilant about past errors and to put checks and balances in place to protect the future.

It is important to watch for trends not only in revenues but also in expenses and certain balance sheet accounts. If one is a non-controlling party, it’s imperative to request pertinent financial information and review it for patterns.

  1. Whether the entity is self-managed or managed by another individual or entity, it is important to assess where the opportunities to commit fraud exist and to add controls in these areas.
  2. A forensic accountant can help you understand complex financial statements, uncover unusual or inappropriate trends, and suggest controls that can help catch any fraudulent activities prior to excessive damage. Contact your Marcum professional for questions or assistance.

Related Industry

Real Estate