United States

Close examination of a real estate venture reveals on-going fraud

CASE STUDY  | 

A national real estate investment firm and small regional firm entered into a first-time joint ownership agreement on three multifamily properties within the regional firm’s territory. 

As the equity partner, the national firm received 90 percent of the profits; the regional firm, as managing partner for the properties, received the remainder. The properties were quite profitable: Occupancy was high and tenant delinquencies were low. 

Unexplained variances

Two years into the arrangement, however, things began to change. The national firm’s chief financial officer began seeing a reduction in profits, despite the high occupancy rates and low tenant delinquencies. The properties seemed to be diminishing in profitability with each report and heading toward insolvency. 

When the national firm questioned this dichotomy between revenue and profits, it did not receive a satisfactory explanation of the variances. Rather than accuse its relatively new partner of any inappropriate behavior, the national firm gave them the benefit of the doubt.  

A year later, the national firm launched an organization-wide review of its entire portfolio, including those properties it owned with the regional firm. This initiative raised concerns when it was discovered that the downward trend of profits in the arrangement with the regional firm had continued until there was apparently no cash on hand. 

Follow the money

The national firm engaged the RSM real estate forensic accounting team to evaluate what had happened. The team recommended that the books be examined―starting from the beginning of the joint venture―in order to understand what led to the loss in profits. Notably, the joint partnership agreement gave authority to the regional partner or property manager to disburse funds without independent oversight. Fortunately, the contract between the two companies also allowed for the examination to take place, which is not always the case.

The RSM team examined expenses submitted during this period. Standard procedure includes examination of accounts listed as “other expenses,” and this is where the team found a one-time expense of $160,000 that had no supporting documentation in the general ledger. By way of explanation, the property accountant simply said she was told to record that amount. 

Attention must be paid

Thanks to bank statements and the documents provided, the RSM team found $2.7 million that had been funneled to eight properties owned by the regional firm—something the national firm had overlooked. It appeared that the mortgages needed to be paid on these other properties, and the money was taken from the joint venture to meet the regional firm’s financial obligations. 

Interproperty transfers are common in real estate portfolios; taking a cash surplus from one property to meet a cash shortfall in another within the same portfolio is an efficient use of funds. But in this case, the receiving properties were outside the joint venture portfolio and loaning funds from the joint venture profits to these properties was something that the partnership agreement did not allow.

As in most fraudulent schemes, the initial intent was a short-term “loan” to be repaid, once things turned around. But the turnaround did not come soon enough. The funds were siphoned from the venture in smaller increments and divided among eight properties, which may have accounted for this activity not being noticed initially. In any case, a lack of internal controls allowed the regional firm to use the funds for at least two years.

Armed with the RSM team’s reports, the national firm was able to take the regional firm to court. Ultimately, the court ruled in favor of handing 100 percent of the ownership of all three properties to the national firm. But because the partnership agreement did not allow the national firm to pursue the other properties owned by the regional firm, the redirected $2.7 million was lost. The national firm’s portfolio eventually regained its profitability through a new property manager.

Lessons learned

Hindsight, as they say, is 20/20, and at the end of the day it can be easy to see where mistakes were made. Nevertheless, this situation provided some much-needed reminders for future engagements:

  • Watch the trends. Real estate investments are very sensitive to market trends. Analyzing portfolios against trends both up and down can serve as an early warning of potential problems.
  • Build protection into agreements. Negotiating transaction approval controls, caps on expenditures and examination rights can protect a partner’s interest.
  • Engage the specialists. When confronted with real estate issues that call for forensic accounting, be sure to engage an experienced advisor.

 

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