Spotting Fraud in Real Estate Investments: Warning Signs of Bad Sponsors

In this episode, we share real-life lessons from bad investments to teach you how to identify and avoid risky real estate sponsors, with practical tips for performing due diligence and protecting your assets.

(Transcribed by TurboScribe.ai. Go Unlimited to remove this message.)

All right, what happened? Welcome back. Go do this. Brian is pumped.

I am. I love it. Bring that energy.

Brian. Come on. Yes.

So, um, yeah, it's been, uh, it's been a week, it's been a week and we're back. No guests today. I feel like we've been, what are you doing trying to get his arm out of my way? My army means my mic.

If you can't, if you're not watching, she's the arm. So I'll give, I'll give some updates guys. So went to Tulsa trends yesterday.

It was at Southern Hills. Uh, anybody that's anybody was there dressed in their suits. I had my, I had my jeans and my shirt on, you know, no jacket as I usually do, but me and Brian didn't go.

So obviously that's not true. I felt like NAOP put on a good, a good performance, a good, a good conference day. Governor Stitt did a good job, I thought, um, talking about what his plans are for the state.

Oklahoma is doing pretty well economically. We've got a budget surplus. I'm surprised he showed up.

It's like a last minute substitution. You get like the transportation secretary. No, he, yeah, he did it.

We have, we also had, uh, man, I'm going to forget his last name, Aaron, who is the Tulsa economic director, area director. And I thought he was super interesting. He moved here from Kentucky, uh, worked, I believe as an intern in the Bush White House.

I'm talking about the plans he has for Tulsa. So overall, good. A couple of points that are positive for us being in this market is Tulsa is outpacing the nation and population growth.

Uh, thought that was great, mainly since that, mainly since the pandemic, I don't have the exact number. It was a graph. You mean percentage growth? Uh, percentage.

Yeah. Yeah. Year over year population growth.

We started outpacing the country in 2019 and then it kind of accelerated during the pandemic. What was interesting is even though our population is outpacing the nation, uh, like new multifamily units coming online has, uh, lagged the nation and the surrounding competitors, uh, competitor, competitor cities in our area. So what are people doing for housing? I mean, well, uh, so what that's doing is it's, it's lowering, it's lowering, uh, industry occupancy and it's raising rents.

So we went, you know, we, we went through, you know, probably a decade or two, a very little rent growth in the apartment sector. Now we are, uh, we may, I may give the, the graph to, uh, to these guys to put up and show up on the YouTube channel, but we're one of the top cities in the nation in apartment, uh, year over year apartment growth, rent growth. It's like a 3.9% and then in CoStar was saying that they expect us to average like 4% for the next three years.

So think about that. I mean, rents are going to be three years from now going to be, you know, 12, 15% higher than they are today. Uh, and so for me, I'm bringing multifamily units online in Bixby, but I, I feel like I want to start a new multifamily complex right now.

Well, a lot of multifamily going up in Owosso, right? Yeah. Yeah. But this, this takes into account all that, you know, it's saying we still have, we still have more room.

Retail is a little bit more subdued. We have a decent retail growth, but the rent growth on retail is going to be like one to one and a half percent over the next three or four years, year over year. So still not bad though.

And retail nationwide is doing pretty well, uh, when, when looking at the last, you know, 10 or 15 years. So overall I thought it was reasonably positive. No one obviously can figure out what's going to go on with, with, uh, interest rates.

They've started to lower them, but I feel like there's inflationary pressure is setting back into the market. Uh, you've got all time highs on the stock market, uh, crypto is kind of taken off. Unemployment is remaining low.

So I'm kind of wondering, you know, how much are rates going to nosedive over the next six months to a year as well? Let's see. Well, when they cut the rates, what, three months ago they, they dipped down and then they went right back up. Right? Yeah.

The 10 year has been kind of rising, uh, which, which makes sense because the market's doing so well. You don't have people flooding money into 10 year treasuries, which would drive down the yield. Uh, so that's, that's it for me from Tulsa trends.

I'm sorry if I butchered it for anybody else that was there. I did my best. Nice.

Very nice. Very nice. So topic for today.

Um, yes. Before we get into the topic for today, we just launched a new investment opportunity. We're acquiring a shopping center up in Grand Rapids, um, Michigan.

That's exciting. And for those of you that are asking, why are you guys acquiring in Grand Rapids, Michigan? Great question. Yeah.

You got the answer for me? I do. Yeah. It's a, it's a great piece of real estate.

Um, a great piece. No answer. Sorry.

Yeah. Yeah. So, uh, really well located, uh, 30,000 cars a day, right in front of it, right across the street from a brand new whole foods.

I think it's a couple of years old. Um, I think the average rent in the center is like 15, $16 a foot. We've got the ability to, um, yeah, yeah, a little, a little low.

I think it's a decent amount low, but again, you know, we can go in and underwrite, you know, what is, what is that? You get 10% rent growth, uh, right off the bat. You know, if you can get some of these tenants, 17, $18 foot, and I feel like that's pretty achievable. Um, I don't think, yeah.

When whole foods puts a brand new store in, I don't think you have to be as worried about right across the street as you would in other locations. Plus, uh, as I understand it, our business partner, Andy Thelin is from Grand Rapids or I don't know if he's from Grand Rapids or he grew up near there. Yeah.

Yeah. Uh, so he's pretty familiar with the area. Pretty familiar with that part of town.

Uh, so it's not like we're just randomly picking a spot in Michigan. We do have some familiarity with it. Yeah.

I think David's managing it for us. Uh, Tomlinson manages Florissant for us, invested in Florissant. But anyway, um, yeah, I think we're about 60% full on that.

We're going to close the first couple of weeks of December. We're in the middle of due diligence right now. So far everything is looking good.

Um, but yeah, that is up on the website to take a look at. And then the topic for today. Okay.

So, um, Brian, why don't you introduce the topic? What was your idea? Yeah. So, uh, you know, I thought that, uh, Joe, I know you've had some problems with this before and, uh, probably have a few examples for us, but I thought, uh, and we actually had an investor come to us with the suggestion is how to spot a bad sponsor. I mean, we've had topic before on how to pick a sponsor and what to look for in a sponsor and in a good sponsor.

But I thought it might be interesting to go from another angle on how to spot a bad sponsor. Well, good. I think I can start it off.

And, you know, when people ask me, Hey Joel, how do you know, uh, what price to pay? How do you know that's a good price? And what did I tell you when you bought those first, you invested those first apartments with me? I said, well, Brian, the reason I think this is a good price is because I paid the wrong price for these same units earlier, uh, you know, two or three years earlier and lost a bunch of money. Learned your lesson. And so, uh, you learn lessons through that failure.

And so I, I'll tell you my experience. I picked a couple of online sponsors to give it a go. And I ended up getting, uh, ripped off by at least two of them.

Online sponsors being through, uh, not necessarily online sponsors. I would say online marketplaces, well known online marketplaces that are notoriously known for soliciting for, for investments like this, but they're not the sponsor, right? Like somebody else is the sponsor. You have to, so I'll use the general term so we don't like get people involved in other companies involved.

But it, you know, if you have ever seen a crowdfunding or heard that term online, there's websites that sponsors can go and pitch their deals and crowdfund their investments. And so, like I said, I'm not going to get into the specific ones, the websites that I mentioned or that I, that I got on, but you know, you think if they, if this is what they do, they, they vet sponsors and they provide opportunities for investors to go and invest with these sponsors. I'm a trusting guy and, and I just thought, okay, they say they're doing their due diligence.

They say they're vetting these guys. And I trusted that. And I, I invested some money with, with a couple of sponsors that I ended up losing my investment on.

And so, uh, I'll start out talking about a couple of those and then we have some specific things that you could spot, uh, that might be red flags. So the first one that I had that I invested in, it checked all the boxes from, you know, just a first look standpoint. They're based out of Manhattan.

Their big pitch was they only buy all cash. The return profile was lower, but they're like, but we don't have any debt. So your risk is so much lower and we have longterm leases with corporations to lease these, these, uh, apartments in, in Manhattan.

And it was their fourth fund. And so I'm thinking, man, these guys have been around a long time. This is the fourth fund.

They've had these other funds that they exited successfully. They had good marketing material, I suppose. Really nice marketing material.

Like, I'm like, oh wow, they spent some money on this stuff. Sent me brochures, sent me, you know, a pin and some other stuff. And I just really felt like that I was going to be in good hands and I, I think, and I'm going with the safe guy, lower return.

It was the pen. It was the pen, wasn't it? The pen and the brochure. Uh, so, uh, what was wrong with that one? Well, first, uh, I found out that they were being investigated because they had lied on their material.

How did they lie? Don't lie. The pen broke first and you knew it was cheap. It was like, oh, the cheap pen.

So they lied in a couple of different ways. They said they were paying all cash. Turns out they didn't pay all cash for all of the properties.

They paid all cash for a couple of the properties and some of them they leveraged up. So this was a fund of multiple properties. Fund of multiple properties.

The fourth fund. Fourth fund. Yes.

How'd you know it was the fourth fund? The biggest problem was I didn't actually take any time to verify their first and second funds and even their third fund. Turns out they did a small third fund. They had never even done a one, a fund one.

Didn't even do a fund two. Just started. That was literally just made up whole cloth to give themselves credibility.

Like it's just a name. Uh, to go with fund four. We just like four.

So we go with fund four. Well uh. Their lucky number.

Yeah. So it turns out, uh, I, I, I think the platform ended up getting sued because they failed to do due diligence. You know, they, they said they did due diligence.

They didn't even verify they had funds. Um, and of course the, the person involved, I don't remember his name off the top of my head, uh, was arrested and sued for fraud and I think he ended up having to go to prison. So in that situation, did you just lose all your money? No.

So, um, turns out, uh, once the SEC got involved and the bankruptcy court like grabbed ahold of all of their assets and they appointed a receiver and so they started selling those assets at a, at a discount and they, I think we were able to get 30 to 35% of our money back. So not a total loss. And this douchebag's in prison.

Uh, yeah. And he served time. So, um, but it was a big learning lesson.

The problem is, is that I invested in several of these crowdfunding deals before, before I found out that first one was a fraud. Uh, so, uh, the second one, and then we'll, we'll go on to some of our red flags. Yeah.

So, uh, let's get a theme. Let's get a big learning lesson. So big, notable, you know, let's just say anybody, somebody vouching for somebody else.

So you just immediately skip all due diligence information, whether that's a website or referral or any, any sorts, right? We still do due diligence information. You cannot skip. I'll tell you this.

So, uh, if somebody says, Hey, I'm vouching for the criterion guys, you should invest with them. Don't take that advice. Call us, come visit us in Tulsa and we'll show you our operation and do your own due diligence.

Right. Yeah. Don't take people's word for it.

So the second one was a hotel conversion. So they had a, it was in Delaware hotel and they, they had an agreement to like turn it into. First of all, what are you even doing? Investing in a Delaware hotel with some random, like, who are you? I was wanting to learn from these guys.

So I thought, well, if I put a little money down, my education is going to go up. You've heard me say that. I'll, I'll, I'll give you a better education for that kind of money next time.

So, uh, the Delaware, Delaware hotel conversion, they like, Hey, this was, it's a, an abandoned hotel, but we have a, this contract with, with Hilton. And so we were going to, as soon as we get the money, we're going to start. Turns out what, what they did, we all assume that the, the website had done due diligence on these guys.

They take, they raised like two and a half million dollars and they, they buy the hotel, uh, and the, the, the deal and they put it on a ground lease for two and a half million dollars. They give somebody two and a half million dollars. They take, they take this property.

Uh, apparently the, the person that they gave the two and a half million dollars was related to the person doing the investment. But once we put our money in that investment a year to go by and we don't hear anything and we're, we're trying to find this guy, Oh, he's, he's had health problems. Oh, he's had a heart attack or he's had a stroke.

And so that kind of buys them some time. Cause you're not like wanting to like show up at the hospital, like Brad, uh, barrage this guy. Well, it turns out they, we, we don't even know to this day exactly what happened.

I think they, they just ran off with the money. I was going to say, there's no hospital, just a big lie. Yeah.

And you know, the challenge is we, we knew we could trace the fraud. We knew, you know what they did, but you really cannot get that money back. It's very, very, very difficult.

You have, you have so many investors and so we had to come together as investors and then we had to hire an attorney. So we had to all put in some money to hire this attorney to try to figure out the corporate structure and where they wired the money to this person and this, this company and who owns that company. And that's really hard to find out.

It's a disaster. Right. And so even if you, you know what they did, you, you, you, you, the chances of getting your money back are very, very low.

And we ended up having to sue the online crowd funder. And that's the only way that we got like 25% of our money back. Just settling with them, uh, in their insurance policy.

Everybody's getting sued. So, uh, the last one, it's not a fraud, but the last one I invested in is a, like a two tenant hotel portfolio. And the only thing I'll say about them is, is, uh, I, I bought it shortly before COVID they, they, as soon as COVID hit, they had to do a cash call.

Right. And, and, and say, Hey, we need more money and your shares are going to be diluted. And so what rubbed me the wrong way is that they didn't have any contingency.

Like the second something went wrong, they did a cash call. I've got a ton of properties, right? With, with precision equity, with criterion, we did zero cash calls to my knowledge, unless I'm forgetting something. We did zero cash calls into COVID.

Now we did pause distributions for a couple of quarters, but these guys, they did a cash call and they've never resumed, uh, distributions got it, got an email today from him said, Hey, you know, we're doing better, but not good enough sending any money. No. And it's been, it's been four years, right? So I imagine that I'll get my initial investment back one day on that deal, but I don't think I'm going to make any money.

Um, I don't think they're dishonest. I just don't think they had a great business plan. And I do think COVID, COVID obviously hit the hospitality sector.

So I'll give them a little bit of a break on that. But so those are some of my experiences. I want to, I want to, we wrote a few other red flags down to help you be able to spot bad sponsors.

So this doesn't happen to you. Yeah. So one of the things we, we looked at was, uh, that we recommend is looking at the, uh, the company structure, the management structure, right? And so how are you going to find out what a company structure is? I mean, you call them on the phone, you see brochures, how are you going to actually find out what their business plan, what their business structure is? Great question.

How would you do it for a criterion? Uh, we, we, yeah, we do it all the time. People, people call and say, Hey, I'm interested in learning more, come, come see us, come, let's set up a zoom, whatever you need to do by structure. I think we really mean by infrastructure, uh, infrastructure is because what we want you guys to not do is if, uh, you got a, a guy or a girl that's just got an idea that they want to buy and they have a company, they've got a great website, but there's no there behind the curtain.

Like who is, uh, do they have a company, do they have employees, do they have an accountant, do they have, do they have, you know, uh, a CPA, uh, do they have an administrator that like make sure that all the stuff's getting done? So that's what we mean by infrastructure. Yeah. So the best way to do that is to go visit them, right? Uh, go and see who they are.

Like I invested with people, I don't know who they were and maybe if I would have tried to show up, I would have gotten a feeling before I gave him $100,000. And so we want you guys to do that before you give us $100,000. But also we had a kind of piggybacking on that point is you shouldn't be like I did giving $100,000 or $50,000 to somebody you don't know, just one off.

You should be saying, Hey, I want to develop a relationship with a sponsor. So even if it's all, it's 50 or a hundred the first time, I'm going to be giving this guy a hundred, a hundred, a hundred if they perform. So it's worth your time to buy a plane ticket, get a buddy, have him go with you and go meet the people that you're going to invest with and spend time with them and make sure that they have, uh, the staying power, the infrastructure, the bandwidth to be able to handle the projects that they're pitching you.

Yeah. A plane ticket night in hotels, a thousand bucks. That's 1% of a hundred thousand dollar investment.

It's well worth going and doing it. And like Joel said, you're most likely doing it to build a relationship. So it's worth hundreds and hundreds of thousands, maybe a million dollars.

And then just shy of having, you know, a staff in an office to, to, does it look like it's ran well? Are, are, are people friendly? Is the office clean? When you call to somebody answer, like, is it, is it just reasonably like a, a, a, a business, you know, I'm not a massive business or is it a person? Yeah, exactly. Uh, nothing completely wrong with just a person, but it's, it's definitely a red flag where I'm like, okay, we're meeting at Starbucks. Like this person has sent me every communication, there's, there's nobody else on the website.

You know, it's, it's one person. There's some inherent problems with that. If it's one person, at least you need to understand that it's just one person.

Yeah. So what do you, what are, what are other ones? Also understand what the sponsor's reporting is going to be to the investors. Yeah.

Good one. So I would, I would ask, Hey, uh, and you can ask us when you invest with us, what is the reporting structure look like? How often do you communicate with your investors? What types of information do you provide? So we, we send out quarterly updates, uh, that kind of tell you how the property is going. We actually send out monthly updates that include most property updates in our monthly newsletter.

Uh, we will provide financials. Either we post them on, on the website or we will provide them when asked for. So there's no hiding anything.

There's always going to be transparency, uh, even when it's, you know, maybe not the best information. Like, uh, we, the other day we had an investor that, that thought the numbers were slightly off and he wanted us to provide them and we've had some tough, uh, uh, tough jobs leasing some of the spaces. I mean, I said, Hey, we're not hitting some of the NOI numbers that we thought because we haven't been able to lease the vacant space and like we thought not, not easy to have that conversation, but it's better to be honest and be able to let the investor know exactly how the deal is going so they can plan.

Um, so that's a big one is just asking, you may get in writing from them, Hey, when do you provide, uh, updates and financials, uh, sample reporting? I mean, we can, we can pull up sample reports that we've sent for years and years and years. They're all sent through the same database is super easy to get sample reporting. They should be able to provide that.

Yeah. So maybe you say, Hey, uh, what's the last, you know, the last deal you did, can I get a year's worth of reporting that you sent out to investors on that deal? Yep. You know, something like that.

Sign an NDA if they need you to. Yeah. Good idea.

Yeah. If they're going to make sign an NDA, I mean, there's just like, that's weird. Well, if it's a, if it's a, uh, a deal that they don't have any involvement in, you're going to see all the financials with, I don't think it's unreasonable to ask you on that deal.

You're going to get a whole year of financials. Yeah. If there, if there's financials in it, I guess, I guess that would be, I was more on the talking about like a qualitative report, you know, Hey, here's the asset.

Here's what happened. Yeah. Yada.

Yada. There's your money. Like it's very simple people.

All right. Last point I have is, uh, the sponsors total assets compared to the deal size. This is a good, this is a good one.

I think this is super important. And, uh, you know, when I first started, I didn't really have any assets. And so me buying a three or $4 million apartment complex that had some risk to it.

Uh, Brian was in on my first deal. So he knows now I hit it out of the park for him on that deal, but it was inherently more risky. Uh, but today, you know, between, you know, uh, criterion $175 million in assets under management precision equity, maybe similar 175,000 or 175 million of assets under management.

So that's a combined 350 million of assets under management. I want to tell you that, you know, we, we have some wherewithal, we have some, we have some knowledge, but, but second, if I, if I bring a $5 million deal to investors, they can be pretty comfortable that if that deal doesn't go perfect, it doesn't cause the overall operation issues. I'm not going to make any bad financial decisions trying to save myself.

Uh, okay. If that deal doesn't go well, because I'm too big, I have too much cashflow for it to impact the overall production of our business. This is mainly a conversation we're having with lenders just because sometimes we're sending people a schedule real estate and they're saying, Oh my gosh, you've, you've personally guaranteed a hundred million dollars worth of debt with a dozen different lenders.

You know what, what happens? And we just have to explain, okay, well here's, here's each, you know, different site. It's a different entity. It's got an NOI well in excess of the debt service.

We own a big chunk of that. Like these deals in comparison to the whole are, are, are tiny, right? They really are. Our biggest deal is like 14, 14 million bucks, 14 million on, on the biggest deal compared to even, even just criterion 175 it's not, it's not going to take down the whole kit and caboodle.

So I would ask a sponsor if, uh, you can see their schedule of real estate and if that's too intrusive, I would want a list of all the assets they own that doesn't have all the financial information, but at least you can see what their portfolio is. If they're trying to pull off a $20 million apartment investment and they have a two properties, one's an apartment building worth 8 million and one is a retail deal that's 2 million. They have 10 million in assets and they want you to invest in a $20 million apartment deal.

Your money is a little bit more at risk with them than it is with another sponsor that's as a small deal size compared to their portfolio value. So that's a way that you can at least, uh, protect yourself a little bit is understanding what all they own, where it is and how is it in comparison to the size of the opportunity and the risk that they're presenting to you? Yeah. So your, your debt service on, you know, like a million, 2 million, three every single month is like 10,000 bucks, you know? So if you're investing in a deal, the monthly debt service, 10,000 bucks, something comes to rise, you know, can you scrounge together 10,000 bucks? Sure.

When you talk about that times 50, you know, you're borrowing tens of millions of dollars that six month, you know, you're scrounging together $75,000 to keep that debt service payment flow. You're, you're really wanting to be comfortable with what their financing solutions are. Is it non-recourse and they're just about to turn the keys back into the bank, the equities wiped away and you're toast because they can't keep up with it and something happened versus, you know, if it's a 10th or less of the total portfolio size, the rest of the portfolio is going to be able to shed off enough cash just to them as a sponsor, to be able to cover that, that debt service payments where they're not defaulting on the debt, the equity is still intact.

You're buying time to figure it out, to get that income back up, to get your equity back out is the idea. Yeah. I'm going to, I'll just reemphasize it one more time and then we'll, we'll call it a show.

But I mean, just think about it, guys, you got to, you got a person that's got a few little assets and then they buy it off this huge, like I said, $20 million deal. And so now their whole reputation and their livelihoods wrapped up in the success of this deal. Well, let's say that interest rates like they have shoot through the roof.

Now they can't cover their mortgage, right? What are they going to do? Are they just going to, they're just going to turn it back over, wipe out their investor equity and ruin their reputation? Or are they under so much pressure that they got, well, I got a little cashflow from these properties over here and I, I just need, I just need a little bit here to cover a few months so I can get this apartment complex back on track. Yeah. You see, you get them in a position where they're tempted to do something stupid and you don't want to have a sponsor that has put themselves in a position where their livelihoods at stake and they're going to be tempted to do something stupid.

Everybody makes bad decisions when their back's up against the wall. Your job is to make sure their back is not going to be up against the wall because you're investing a good underlying asset with a good capital structure. You know, everything we've, we've structured anyway.

So I'm sure there's a bunch of other ways to find red flags, but those are the ones that we come up with just, you know, trying to think of how we could, could give you guys some advice. Hopefully you'll find it informational, maybe beneficial. And if anybody's thinking about investing with us, give us a call.

We'll help you get to Tulsa. We'll, we'll take you to the office. We'll show you our staff, we'll show you our infrastructure, go over our deal, deal flow and we'll get you comfortable.

So better yet, we'll, we'll, we'll come to you. Yeah. I mean, that's, that's true.

I mean, obviously we're not going to fly the whole company, but initial meeting will come to you if you want. Yeah. Especially if you're in Colorado, Hawaii, Arizona, Las Vegas, Scottsdale for sure.

Yeah. California. If you're in South Dakota, don't, you can come to Tulsa.

That's great. Okay. We'll see you guys next week on how to invest in commercial real estate.

Thanks.

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