Episode 47. New Construction Ponzi Scheme

March 15, 2022

What should you know before your next refi so you don’t trap yourself?

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I know none of us would ever start a Ponzi scheme but what are the red flags? What should you put in every contract to make sure the Seller isn’t doing this? And what should you know before your next refi so you don’t trap yourself as this investor did!


In this week’s podcast episode you’ll learn:
1️⃣ The importance of beefy seller’s representations (and buyer’s attorneys to put ‘em in the contract!)
2️⃣ Red flags to keep an eye out for with contractors
3️⃣ Why cross-collateralization can be risky

Episode Transcript:

Bonnie Galam 0:11
Welcome to the House of Horrors Podcast where each week we dissect problems real estate investors have faced, how they navigated them, and of course, what you can do to avoid ending up in their shoes.

Bonnie Galam 0:24
Hey there, I’m your host, Bonnie Galam. And last week during my conversation with Mike Bonadies, my friend, a property manager, not actually my property manager, but he is a property manager. We were chatting about turnkey properties gone bad. And I kind of casually mentioned this situation involving a real estate Ponzi scheme that I had uncovered. And I thought you know what, at no time like the present, let me jump in front of the mic and record this episode because it is really quite wild. So this is a story of a regular homebuyer who got caught up in what I literally could only describe as a new construction Ponzi scheme. And if you’re thinking, you know, I’m going to bounce out of this episode, because I’m a real estate investor. If you would never buy new construction bear with me, because the lessons of this week’s episode definitely relate to you, even if the only thing new and your properties are LVP floors and paint. And that’s because the way this horror story went so sideways was largely due to construction and financing. And that’s something that we all deal with. Plus, one of those parts of it involving title and financing is actually something that I dealt with myself over the last year. And so we’re going to dissect that, as well. But before we dive into this ongoing horror story, because yes, this is not yet resolved yet. We’re about two years deep into it. But I wanted to share with you guys first some really exciting news that’s going on here and Bonnie land and that is it has been months in the making. But now my signature live legal myth-busting workshop that has been attended live by 1000s of real estate investors is now available for you on demand. I heard from many of you in my DMs that catching things in life can be tricky, or you missed it or you came in late. And so that was especially true for those of you on the West Coast. And so I hear you and I hopefully did something about it. So you can now catch this workshop at a time that works for you. This workshop will bust the three biggest legal misconceptions I see floating around and frankly running rampant in our community that I think are you know, really keeping real estate investors from maximizing their net worth protecting themselves in their portfolio, and actually creating that generational wealth we’re all there to make, and you know my interest, typical Bonnie fashion, I will be telling you what to do instead. And I’ll also be breaking down my entire legal strategy of how to holistically protect and grow your portfolio. But best of all, and drumroll, please. Attendees get limited-time bonuses if they choose to enroll in landlord law school. And they are things like 400 Freaking dollars off a whole bonus mini-course about using virtual assistants to help you scale and leverage your time. And, and this has been super popular with the current students in their masterclass on automating your investing businesses, these business bonuses, these bonuses are not available anywhere else. And so if you would like to learn more from this workshop, about the legal strategy that I teach real estate investors, you can go ahead and sign up for free at Bonnie galam.com forward-slash workshop. Now, let’s dive into this horror story that I think was, you know, not entirely preventable than something where the damages could have been way, way, way, way, way less. When you know, I think about this situation. In retrospect, I see four key problems that arose to create this perfect storm. There was a terrible contract, total mismanagement of funds, cross-collateralization of properties, and a pretty big-time delight. So let’s start with the first problem, this terrible contract, which actually wasn’t so terrible if you were the seller because the seller clearly had hired an attorney at some point to create a contract from him. But it was so lopsided, that it really didn’t protect my client, the buyer at all. And you know what I should, I should caveat, because this is an important caveat that I was actually not an attorney on the transaction. I was hired after the fact to try to settle this in a pre-litigation context after things had already gone off the rails. So I got hired, and as you’ll hear about a year after the contract was signed.

Bonnie Galam 4:52
And so this was a really lopsided contract. And the reason why it was so lopsided for the seller side was that there were really No representations about the seller’s ability to close or provide a clear title. Now, this is something important to look for in contracts. Because I think when you have like Realtors involved, you think, well, if it was a short sale in some way, they tell me right. And that didn’t happen here. This was something that over time actually became a situation where it became a short sale. But they were under no obligation really to prevent that from happening. And we’ll talk about that more in a second. It also didn’t take into consideration any of the upgrades my clients did to the plans, and materials and how they were to be factored into the price. And so there was a dispute, ultimately, if that was pre-negotiated into the purchase price, or if that was something that was negotiated after the fact. And so things like my client had prepaid for new architectural drawings and had pre-paid for certain materials like cabinets and certain appliances that they had wanted. And it was their understanding that that was a prepayment of the purchase price. And the seller’s position was no those are upgrades, and those are separate. And it didn’t say anywhere, what was the case because it was just this form contract that I don’t think the seller probably even understood other than putting the, you know, the property address in the lot and block numbers in there. And my buyer, I think, just thought, hey, an attorney wrote this up, it must be good. I’m just gonna sign it. And so, they started off on a really bad foot with this contract. And it didn’t become apparent right away as most bad contracts are, usually don’t realize how terrible of a contract is until things start going off the rails. And another piece of this contract that was really bad and bit my client pretty seriously in the butt was that all of the funds that are typically escrowed were immediately issued to the seller. And so when you go into a contract for a property, you usually put like some sort of good faith deposit down. And that’s held in escrow pending closing, depending on you know, purchase price and the type of purchase it is, they are sometimes small. I mean, I’ve seen as low as like 1500 $2,000, less so in this market, because I realized terms or everything right now. But they had put about $100,000 down as a deposit on this property. The purchase price was somewhere in the mid-seven-hundred just to give you some context. And the all of those funds were immediately released to the seller, they weren’t being held by an attorney or by a title company, they were just given to the seller. And I believe that was done under the premise and the assumption by all parties that that money would be used in the construction of the property. And I wish I could just like insert, you know, that little red flag emoji here. Because that is it’s a serious sign of cashflow problems on part of the seller hear that would definitely come into fruition and become more visible in the months to come. And so that leads me to problem number two, which was just total mismanagement of funds by the seller. And so at some point, I don’t really know when the seller started having a cash flow issue. And this was unbeknownst to everyone. And this seller, just to give you a little bit more context was a real estate broker, he owns a real estate brokerage, he was also a developer and had been doing you know, kind of teardowns of these small properties and putting bigger houses on top of them. And he probably had about half a dozen new constructions going at any given time across the state. And at some point what he started doing was using the money from one project to fund and try to finish another and that’s really when the Ponzi schemes started. But it really snowballed when it came to his financing, and we’ll touch on that just a second. But sadly, this guy had access to about like I said about $100,000 of my client’s money upfront because nothing was held in escrow. And as we later found that money wasn’t being used on their own house, it was used to try to deal with the other properties he was working on. And I don’t think it’s always the case that you know, when someone asks for 100% upfront, whether it’s a contractor or developer,

Bonnie Galam 9:28
but it’s definitely not a good sign. It’s definitely a red flag that there could be cashflow problems here, you should not have to finance the entirety of a job before it happens that’s a big old red flag. Even if this person is like your brother or something and they had I think a little bit too much trust this guy, because he had done a previous house on the street. And that one had sold and it was finished and so they had no reason to think otherwise in their heads. And meanwhile, there were other properties that were kind of spiraling out of control. And what he had tried to do to prevent that was problem number three, he cross-collateralized. And so actually, after he went under contract with my clients, he started taking out more loans on their property, to try to fund other properties. And so he’s just racking up loans. And the worst part is, is that, you know, if anyone knows about finance, these are not the types of loans that like banks want to give out, we’re talking about second, third, fourth, fifth priority loans here. This is not a purchase money mortgage, where you know, you can go to like any mortgage broker and get them. These are very, very risky loans, because the payday on them becomes less likely, especially in the situation of foreclosure. And so he was getting money from his mom, he was getting money from friends from siblings, and plopping it on this property with enough with liens, they were there, but they weren’t going to fund that property, they were going to, you know, bail out other jobs that he had going on. And it actually got to the point where there was close to $200,000, worth more loans on the property than the property was even worth. And so if the property in its finished position, the condition was gonna be worth around, say, $750, he was holding over $900,000 worth of loans on this property. And he was doing this on other properties. And some of these loans are what’s known as cross-collateralized. And so he was not just using this property as collateral as security for these mortgages, he actually would put a few. And so he had, you know, like I said, probably about half a dozen constructions going on at any given time. And what he would do is he would say, “Hey, Mom, I need $100,000 or $50,000.” And he would secure both this property and another property under that loan. It’s like a portfolio loan, in a sense. And so these properties were now tied together on the title, and so one couldn’t be sold unless the other was sold. And so he just kind of spun this web and spun this web and spun this web, to probably get to the amount of collateral that he needed. But in a sense, he created a not a title, not that like was actually almost impossible to unravel, like the numbers just didn’t work anymore, especially with the fact that he’s still didn’t have the money to finish the house. And so the house wasn’t worth $750,000, it didn’t have kitchens, it didn’t have bathrooms, it didn’t have windows, it didn’t have a driveway like this was not habitable or even close to a habitable house. And so, in its current condition, what was it worth, I don’t know, maybe three something. But my clients didn’t want to have a $300,000 half-finished house, they wanted to have a $750,000 fully finished house. And even if they were willing to purchase it for $350,000, that wouldn’t clear the fact that they had $900,000 worth of mortgages on this property. And so he was in a serious, serious bind. There were a number of conversations that we would have with his attorney and the lender’s attorneys. And the initial loan that was used to purchase this property was from a hard money lender. And the hard money lender eventually sold that loan to, you know, the people that buy loans, the Note buyers out there, go back and listen to the episode with Scott Carson if you want to learn a little bit about note lending and some of the legal stuff that goes into that, but he has sold this property or the hard money lender sold the note to private money, note holder and then there were about three or four different other parties and what we were trying to negotiate and to be frank, this would have been the fastest cleanest way to wrap up this mess was for the seller to do what is known as a deed in lieu of foreclosure basically saying hey, I will give you the property. Do your note holder just don’t foreclose. And so there’s a lot of negotiation that could get into that. But even that first-party lien holder will be almost taking a loss at this point taking the current condition.

Bonnie Galam 14:22
And so he wanted to you know, was willing to take maybe 75 cents on the dollar but in order for the rest of the numbers to work the rest of the noteholders His mom his friends would need to take literally pennies on the dollar out of this and they were not willing to do so which I think was really foolish because if this thing ends up in foreclosure as I said before, this thing is still ongoing. But if this ends up in foreclosure, what could happen is they get nothing at the end of the day. And also like because he was you know not a stranger to them. I thought his deal with him outside the courts. You know this is your son, this is your friend. This is your brother if you want to sue him, you know, on contract theory, then just reserve the right to do that, but release the liens so we can get this proper property sold. And what the private money note Holder was going to do was, he was somewhat of a local guy think he was located in like Maryland or something is he was going to finish it and sell it to my clients. And that way, he would still make some money at the end of the day too. But that wasn’t agreed upon. And we had to get all of the lien holders to agree to it, that all these liens had to be removed in order for my client to be able to purchase it. And you know that this whole situation kind of got me really carefully thinking about my own financing over the last year, because we did, obviously, and I think a lot of people listening may have done, you know, a refinance over the last year or two rates have been low. And so we wanted to lock that in for as long as we could. And one of the ways we were able to get a better rate was by doing what’s known as a portfolio loan. And so we lumped together as collateral, several of our properties in each loan, to be able to get and to be able to negotiate for better rates. And so we did that. And, you know, the lender warned us, Hey, if you want to sell one property, you’re gonna have to refinance, get them all into separate mortgages, and then be able to sell the property, we understood that and frankly, we have no intention of selling this property. So it wasn’t a very risky situation for us. But it, it ties right in. And so this guy was cross-collateralization, cross-collateralizing, with the intent to sell, and we have the cross-collateralization with no intent to sell. So it was a lot riskier. What this guy was doing was he was just piling liens on anything he could. And to be honest, I don’t think that all of this money was going even to these projects. I think that there was, you know, another issue, perhaps personally, that this money was being redirected to because at some point we started talking with the subs are like what’s going on, like, he hasn’t paid us, that’s why the work is not getting done. It’s not that the work is not getting done, because we don’t want to, it’s that he hasn’t paid for materials, and he hasn’t paid for us. So no, we’re not going to show up to the job to do something we haven’t been paid for. So it’s kind of like, where the money goes. And trust me as lawyers, we’re figuring that out. This is not hard stuff too, sort out in, lawyer land following the money is usually a pretty easy thing to do. And because of that, I do think that we’ll be able to pierce the corporate veil here and go after him personally for a number of reasons. But fundamentally, one of the things that really kind of made the damages here go up so exponentially, I’ll say, is the fact that the buyers waited too long, they had too much trust for too long. And I know we talked about this back in the first episode of House of Horrors Two episodes ago, about how much grace period should you give people? How much you know, patience and understanding should you have because I get it escalating to lawyers is not the cheapest option. And it’s definitely not the fastest option. I mean, here we are, you know, going on three years after what was supposed to be the closing date, and this is not yet resolved.

Bonnie Galam 18:22
But also waiting a year, when it’s been months and months, you know, you’re driving past the property, you can see work hasn’t been done. Getting to that point where it’s you know, you’re calling a lawyer, and you’re saying, Hey, I was supposed to close, I haven’t closed. And you know, when I asked them, you know when we’re supposed to close, and they say 13 months ago, I’m like, good. Like things. I’ve been going off the rails for that long. And I mean, these are people who were essentially homeless, they sold their home, they told him, it’s going to be done in 60 days, at some point during this process, which would have been about five months late. And so they’re like, Okay, it’s only gonna be 60 more days. They sold their house in anticipation of that. And then when it wasn’t done, they had to move into a rental, which is where they still are right now. Because they’re, they’re in flux. And to be honest, we all know how the market has gone. And so you know, a property that went under contract in 2019 is very different than what you could get for that same amount of money nowhere in 2022. So, it has been you know, what I think actually wanted a contract in 2018 to close in 2019. And so it has been you know, something where they want to hold their ground and they want this property, and I, to be honest, I can’t blame them. I just it’s a very tricky situation. And I’m, to be honest, I’m not exactly sure how it’s going to resolve for them. But I can tell you that I only hope that it ends with this guy going to jail. But the reality is, is this saga is ongoing and so I don’t know how it’s going to go. I can tell you I did report him to the Attorney General’s office. Because I don’t want him doing this to anyone else. But the litigation is ongoing. And the only good news, as I said before is that I think we’ll be able to pierce the corporate veil and go after him personally due to the type of mismanagement of the funds that happened. And since the seller was also a licensed agent, and actually that was not disclosed, which is required here in New Jersey, it was not disclosed in the contract that he is an agent as well. There are also some computer consumer fraud charges that we can bring against him, which give us triple damages. And so I think there’s money there, I think there’s money to be had. And we can, you know, eventually, get to some sort of a resolution to this horror story. And so how do I think it will shake out, I think what’s eventually going to happen is the first party lien holder is going to foreclose. And it’s going to take years, especially if the seller still holds out and doesn’t do a deed in lieu of foreclosure. And his friends and family members don’t get on board with that. And, you know, hopefully, if my clients are still around, they get the custom home that they bargained for, that they paid a lot of money for, and have nothing to show for it at this time. And so if I could give just, you know, a few pieces of advice, you know, hindsight is always 2020 here, and I just think my clients were had, I think they could have had a better contract that would have protected them and protected like their escrow money. So they wouldn’t be you know, out of pocket, you know, $100,000, which is, you know, no small chunk of change for anybody. And I think there’s, there’s a few things here one is talking with, especially in the instances of like smaller developers, new construction developers, if you can talk to the previous buyers, see if they have referrals, that is huge. I mean, the same way, if you can get that with contractors, that goes a long way to make sure that someone’s not just going to take the money and run. Another thing is, is that just because something is an attorney-drafted contract does not mean it is a good contract, especially if it’s drafted by the other side’s attorney who has absolutely no interest and no duty to protect you the buyer at all. That’s not to say that there may be, you know, a moral consideration here. But if this guy said to his attorney, hey, I need these escrow funds to be released to me to fund the project. I don’t think it’s really his attorney’s job to tell him no if the buyer agrees to that. It’s not the attorney’s job to explain the risks to the buyers. And so if one side has an attorney, I realize it’s you know, an expense, we don’t come for free. But to get an attorney yourself.

Bonnie Galam 22:50
Because you can and will be outmaneuvered. And that’s not to say that, you know, lawyers or snakes, or that lawyers are bad people were absolutely not. But if we do anything less than vigorously and exclusively protect the rights of our own clients, then then we’re not doing them the service that they’ve hired us to do. And so just keep that in mind. Just keep that in mind. I see that a lot. Where you know, people just say, like, Oh, I know what I’m doing. And so this looks like a good contract. And, you know, once we’re under the contract, then, you know, I can do inspections, and all that kind of stuff myself. And there, there’s a reason why Real Estate Attorneys exist. So I’ll just put that little plug there. Inside of landlord law school there, there are resources in regards to like how to do due diligence on this type of stuff. But if there’s another attorney on the other side, even if you understand it on your own, I definitely would suggest having an attorney on your end, because even the smallest things like the placement of a comma can make a sentence and a clause means something totally different. And then finally, the last piece of advice that I’d want you to consider is doing early, and I mean, early title commitments file for your title early, I realized that people like to kind of wait later in the process for ordering title. And I think that’s somewhat of a like a little bit of a cost-saving strategy where it’s like, hey, let’s get through inspections and stuff. First, make sure that you know, that this is even a property that we want to buy. I’m not even just talking about new construction here. But file the and you know, get your title insurance, get that title commitment as soon as possible and give it to the seller, in a sense that kind of locks them inputs them on notice like, Hey, this is what’s going on. So don’t go out and take more liens after the fact. But if there are problems with the title, these are not fast things to clean up. I have a situation going on right now with the client where there’s a title issue and we got the title report a week before closing and I told the buyer’s attorney I’m like, Look, you know, we’ll do the best that we can but I think this is a situation we may need months to deal with. And I think it’s something we can probably partially resolve before closing put in escrow and deal with the rest after closing. But it would have been nice to know this, you know, in, you know, a 60-day transaction, we could have known this on day 20. And that would have really given the seller a lot more time to clean it up. In this situation, though, I think that it could have possibly only just put the seller on notice, hey, we know what’s going on. And perhaps even give shed some light on my clients who weren’t, you know, not represented by an attorney not represented by an agent about what the state of this property was. And he had a number of loans on there and continues to tack on loans to this property. And so this Ponzi scheme like I said, I hope it ends up with this guy in jail. But who knows? Next week, though, guys, I am pumped to be joined by my friend Bigger Pockets Rookie, and Single Woman Investing, extraordinary guys. Amelia McGee is joining me and she has only been investing for like 18 months or so. And in that time, she racked up 30 doors. Yep, you heard me right in this market. She racked up 30 doors in less than 18 months, which is absolutely amazing. But in that time, she’s also had her fair share of horror stories. And so if you think real estate investing horror stories are only for us old heads who have been in the game for years. Think again, because Amelia’s first horror story happened within the first week of her closing on her first property. So make sure you subscribe so you don’t miss out on what turns out to be a really fun conversation. Thanks so much for listening to the House of Horrors podcast. Make sure to follow us on Apple Podcasts, Spotify, or wherever you like to listen to podcasts. You can also check out all of our podcast episodes, show notes, links, and more at bonniegalam.com/podcast. You can learn more about legally protecting your portfolio and take my free legal workshop on the three legal myths preventing you from securing and scaling your portfolio and of course what to do instead at bonniegalam.com. And to stay connected and follow along follow me on Instagram at @bonniegalamesq and send me a DM to say hi.

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This is not a law firm. Nothing on this site should be construed as legal advice. Bonnie does not provide you or your company legal advice. We simply provide legal information and education for you to customize and use on your own and have reviewed by your own local attorney. Bonnie is an attorney licensed in NJ and PA, but is not practicing law or establishing an attorney-client relationship with you, ever through Bonnie Galam LLC. Some states may consider this attorney advertising (although it isn't intended to be). Thank you!

This is not a law firm. Nothing on this site should be construed as legal advice. Bonnie does not provide you or your company legal advice. We simply provide legal information and education for you to customize and use on your own and have reviewed by your own local attorney. Bonnie is an attorney licensed in NJ and PA, but is not practicing law or establishing an attorney-client relationship with you, ever through Bonnie Galam LLC. Some states may consider this attorney advertising (although it isn't intended to be). Thank you!

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