Falling for a real estate scam is the fear of every novice investor. Many assume that scams only target the elderly and gullible, but the truth is smart, sophisticated investors can fall victim to scams as well.
Recently, radio host DJ Envy has come under fire for his support and promotion of his business partner, Cesar Piña. Envy has hosted Piña on the hit syndicated morning show, The Breakfast Club, created numerous videos online, and hosted educational real estate events around the country. A quick search on Piña’s website lists celebrity clients such as 50 Cent, Don Omar, and Khalil Mack.
However, in late October, Piña was arrested for wire fraud and is accused of running a Ponzi scheme.
“We allege Pina offered a ridiculously high rate of return to investors, then took the millions he got and invested it in himself,” said James E. Dennehy, FBI-Newark Special Agent in Charge, after Pina's arrest.
The allegations are a textbook Ponzi scheme example. A Ponzi scheme is an investment fraud that pays existing investors with funds collected from new investors. Ponzi scheme organizers often promise to invest your money and generate high returns with little or no risk.
Perhaps the most infamous Ponzi scheme came at the hands of Bernie Madoff, who was sentenced to 150 years in prison after embezzling $20 billion from his clients, including Steven Spielberg, Kevin Bacon, Kyra Sedgewick, and Larry King.
To be crystal clear, there is a critical difference between an investment that fails to meet projections and a Ponzi scheme or scam. Oftentimes, investors can make mistakes or fail to project changes to demand and the economic environment. With the rise of interest rates, insurance, and the slowing of rent growth, an increasing number of investments will fail in the near future. This is not the same as operators and fund managers who are stealing money or intentionally running a scam.
The vast majority of people in real estate and other investments are good-natured folks who want to do the right thing. However, a handful of bad apples can ruin the general public’s trust when it comes to investments. Scammers and schemers will always lurk around, but you don’t have to fall prey to their next hustle. Here are some red flags to look for to avoid being scammed.
Scammers love to entice prospects with unbelievable returns. Profit projections that are beyond market norms should be a clear indication that something is amiss. There could be a reasonable explanation, but this is your first sign to ask more questions. As the old saying goes, if the offer is too good to be true, it probably is.
If someone is guaranteeing returns on an equity investment — RUN! Equity investments are not guaranteed. They are calculated risks and smart investors minimize those risks as much as possible, but they would never guarantee returns. Only naive (or predatory) investors would guarantee these returns. This is not to say that an investor can’t make a personal guarantee, but this is usually reserved for loans or debt positions, not equity.
If you don’t understand the basic structure of the investment, there’s a chance that could be deliberate. You want to understand where you fit in the capital stack, who gets paid when, and options to exit your investment. In the case of Piña, it’s still unclear how the investment was supposed to work.
Check referrals, but don’t just ask about previous returns. You want to understand communication styles and transparency. Learn to ask key questions that give better insight into the group’s underlying philosophy and approach. One question I love to ask is, “Tell me about a deal that didn’t go according to plan.” I’m less concerned with the specifics of the deal and more focused on how they talk about the challenges. Do they blame others or take accountability for the things they could control? People who take personal accountability are less likely to be scammers. On the other hand, scammers seem to always blame others.
Take the time to educate yourself about the investment. You should be able to understand if the projected returns are typical or atypical based on the investment type. If returns are atypical, you’ll want to know what allows the operator/manager to deliver outsized returns. You’ll also want to understand the investment period and factors that can impact returns or timing.
Operating agreements and private placement memorandums (PPM) detail key aspects of the investment, along with associated risks. Review these materials and ask questions pertaining to any items you do not understand. Additionally, ask to review financials (rent rolls, profit and loss statements, etc.) to understand financial performance. While there may be some hesitation around sharing everything, you should be able to get enough to paint a decent picture.
Most real estate investors are good people, but there will always be a few you need to avoid. Protecting yourself starts by recognizing potential red flags. Next, you’ll want to take key steps to vet investments and minimize your exposure. Following these steps will reduce the likelihood that you will fall victim to a real estate scam.
About the Author:
John Casmon has helped families invest passively in over $100 million worth of apartments. He is also the host of the #1 rated multifamily podcast, Multifamily Insights. Prior to multifamily, John was a marketing executive overseeing campaigns for Buick, Nike, Coors Light, and Mtn Dew: casmoncapital.com
Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.