Look out for the scam: real estate (Article No. 1)

Having covered scams, money laundering, mafia activities and all dark and sundry in Central Europe for more than a decade, what has often occurred to me is the simple fact that while the high-profile cases get the press (or sometimes infamously don’t), the average business rip-off is simply shrugged away as a tax on doing business here.

Which leads me to say the following: first, I don’t agree, and second, business may be business, but you may very well go broke if you do not get yourself educated in order to understand just where the pitfalls truly lie.

Which leads me to real estate.

I could probably write for months on the various real estate rip-off schemes in Central Europe, with these ranging from mafia-esque developer twists to simple property document swindles to construction projects organized without tenders with the profit of local city officials in mind. Rather arbitrarily, let’s take a look at a set-up that has long been in play in the world of commercial real estate, this being the fully-leased, ready-to-sell ploy pawned by real estate developers – not only in Central Europe, but in Western Europe as well.

The background to the play goes like this: commercial real estate developers make plenty of money on the side while developing (a point we’ll cover in further editions), but they make a killing and (whew!) exit the deal typically when they sell to a large open- or close-ended fund that specializes in such buys on a regional basis.

That such funds have been routinely cheated would appear to defy logic, but remember, they are dealing with pros, and the barriers to the truth and downside of later prosecution indeed bring in the profits—for the developers, of course.

Typically, the fund has spent some time scouting for product about to be released to the market. Such a fund is interested primarily (if we are talking about the office segment) in commercial office buildings in the Central Business District (CBD) that can be considered A-class office space in all regards. Often, however, with deadlines on investment and with a chronic lack of product in the region, the haste to invest works against them.

Admittedly, this last statement may confuse the layman. A glance in a number of Central European cities (Warsaw is not a bad example), reveals numerous half-rented office buildings with still more under construction. The catch is that an A-class office building is only half the formula for success. Investment funds seek fully-leased A-class office buildings. Such a rare find means not only a modern, long-term product, but an investment that will pay off debt from day one.

So where is the catch?

The catch lies with tenant agreements. Rental agreements need to be close to the local “headline” value for the sale to go through. The problem is that much of the time they are nowhere close. With so much space available in what has become a very extended economic downturn, competition has pushed such rents down to breaking point for developers—the majority of whom built their business plan five years or even a decade prior to construction.

Yet certain developers are sneaky. They convince tenants to sign two agreements. The first agreement—i.e. the real agreement—guarantees low rent for years to come (and typically amenities such as free parking, a break on common space, etc.). The second, “fictitious agreement” shows a much higher rent level with all of the bells and whistles. This second agreement is for the fund. It convinces fund managers that they will get an optimal return on investment.

Tenants agree to sign such agreements based on kickbacks (an additional discount on the true rental agreement), plus the mutual understanding that they will never be confronted in court. True, they are putting themselves at risk at this point, but in order to be prosecuted, the developer would be forced to incriminate himself before a court.

The developer then takes these “fictitious agreements” with higher rent levels and presents these to the aspiring purchaser. As the agreements appear real (because on paper they are real), accountants stamp the relevant audits and the sale goes through.

The problem appears when the new owners attempt to collect rent. They are then faced with a multi-storied reality of tenants who have legitimate contracts for much lower rent values than they anticipated. This, obviously, means that their investment will take years longer to pay off—and typically such agreements cannot be renegotiated until their due date runs out.

True, at this point the fund could take the entire scam to a prosecutor, but trust me, it never happens. As an investigative journalist I dealt with several such funds, even getting to the point that I was all but begging them to allow me to break these stories in the press. Alas, the downside is simply too painful for even the largest investors to bear. Such a revelation would imply a lack of proper vetting (which would be true), a risk to investor money (which would also be true) and embarrassment to high heaven. As fund managers live and die by their portfolio and their ability to gather more funds for the next project, careers would be put at risk.

Likewise, booting tenants would not be so simple—or even profitable. By booting tenants with real-but-bogus agreements, the new investor would be thereby emptying his building. Thus, he would be in worse shape than when he was first ripped off—i.e. with a building that is no longer fully leased and which would likely be embroiled in embarrassing legal battles. This last fact would further weaken the fund’s chances on garnering cash for further investments.

So what can you say about the developers behind such scams?

Call them evil, dastardly, ingenious, but do not call them the product of communist times or even local. Each and every scam of this type, that I have encountered, was planned and implemented by Western developers with international standing. True, the still-transitional environment of Central and Eastern Europe enables these games, but blaming this type of fraud on the locals would not only be erroneous, but an outright lie.