What is real estate investment trust (REIT) fraud?

Investment fraud has become the most expensive form of fraud in the US, according to a report by law office Carlson Law. The report states that a staggering $3.82 billion was stolen in 2022 – a significant increase from the previous year’s $1.6 billion. Although the number of investment fraud offenders has decreased in the last five years, the US Sentencing Commission has reported a significant increase in median losses incurred, which is now over $2,880,000. Our 2023 global compliance report also highlighted this trend, with investment fraud emerging as a top concern for firms worldwide.

Investment scams are also rife within real estate – a sector that remains America’s favorite long-term investment despite the increasing risk of fraud. This article considers one particular real estate investment fraud type, known as REIT fraud. 

What are real estate investment trusts?

Real estate investment trusts (REITs) are investment vehicles that allow individuals to invest in real estate without owning the physical properties themselves. These trusts own, operate, or finance income-producing real estate, such as apartment buildings, hotels, shopping centers, or office buildings. REITs are subject to specific regulations and offer certain tax advantages, making them attractive investments for many. 

What is real estate investment trust fraud?

Real estate investment trust fraud occurs when bad actors try to sell REIT investments that turn out to be scams. Unfortunately, this type of scam is not uncommon, and it can be perpetrated by various entities such as fraudulent companies, stockbrokers, and financial advisors. These bad actors often use deceptive tactics to persuade individuals to invest in risky REITs, promising low risks and high returns. While such investments may seem attractive initially, many investors have lost significant value due to uncertain investments in particular REITs.

Common tactics used in REIT fraud

REIT fraud can happen with any type of REIT, but non-traded REITs are more susceptible due to the limited disclosures required for these investments. Investors in non-traded REITs can be victims of fraud in various ways. Common tactics used in REIT fraud schemes include:

• Misrepresentation: Fraudsters may misrepresent the financial health or performance of a REIT, providing false or misleading information to potential investors to attract their money. 
• Ponzi schemes: Some fraudsters set up Ponzi schemes disguised as REITs, promising high returns to early investors using funds from later investors rather than from actual real estate investments.
• Unregistered offerings: Fraudulent REITs may operate without proper registration or may falsely claim to be registered with regulatory authorities. 
• Unauthorized trading: Unscrupulous brokers or investment advisors may engage in authorized trading of REIT shares on behalf of clients, often for their own commissions or fees.
• Account manipulation: Individuals managing REITs may engage in accounting fraud to make their financial statements appear healthier than they actually are. This can involve inflating property values or understating liabilities, creating a false impression of financial stability. 

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REIT fraud red flags

Financial red flag indicators relating to REIT fraud include:

• Unexplained large cash transactions.
• Irregular payment patterns.
• Abnormal trading activity.
• Complex ownership structures.
• Off-book transactions.
• Non-disclosed related-party transitions.
• Misleading disclosures.
• Rapid or unexplained asset growth.
• Unusual tax or accounting practices.

Regulations on preventing REIT fraud

The Securities and Exchange Commission (SEC) regulates REITs in the United States. REITs must adhere to strict disclosures and reporting requirements, including the submission of regular financial reports and disclosures of material information. This information must also be disclosed to the investors, as well as financial statements, property portfolios, and investment strategies. The SEC conducts examinations and investigations to detect and prevent fraud in the REIT industry. Independent audits by certified public accountants are also typically mandatory for REITs. These audits help verify the accuracy of financial statements and detect any irregularities or fraudulent activities. 

While regulatory measures may differ from one jurisdiction to another, investors and industry professionals should be aware of the specific rules and regulations that apply to REITs in their region and stay informed of any updates.

How to mitigate REIT fraud risks

Mitigating REIT fraud risks is crucial for financial institutions to uphold regulatory compliance, protect stakeholders, and safeguard the integrity of financial markets. Some strategies include:

• Enhanced due diligence (EDD): Implement comprehensive due diligence procedures for onboarding REITs as clients. Scrutinize the management team, the REIT’s operational history, and its adherence to regulatory requirements. Continuously monitor the REIT’s activities and financial health, ensuring it maintains compliance with anti-money laundering and combatting the financing of terrorism (AML/CFT) regulations.
• Transparency and reporting: Encourage REITs to provide full transparency by disclosing financial data, property portfolios, and investment strategies in compliance with regulatory guidelines. Promote robust reporting mechanisms to swiftly identify and report any suspicious activities or transactions within REITs.
• Fraud detection solutions: Implement robust fraud detection solutions that have the ability to continuously monitor transactions, identify patterns of fraud, and ultimately enhance the security of investments and regulatory compliance. 
• Audit oversight: Collaborate with reputable auditing firms to conduct independent REIT audits. Insist on auditing compliance with AML and other regulatory requirements to validate financial integrity.
• Investor education: Educate your institution’s clients and stakeholders about the unique risks and red flags associated with REIT investments, bolstering their ability to make informed decisions.

Additionally, in the UK, the 2023 Financial Conduct Authority (FCA) Handbook provides a list of best practices FIs should follow when screening for different types of investment fraud. Firms in the US should take note of these tips, which include: 

• Conducting regular risk assessments while considering the potential loss due to fraud.
• Promptly contacting customers when investment fraud is suspected.
• Modifying transaction monitoring rules to include investment fraud typologies, based on the suggestions of subject matter experts.

Detect REIT fraud with automated solutions

To combat the rising threats of real estate scams, including REIT fraud, compliance teams should consider their transaction fraud risk across three core areas of compliance:

• Process: Firms should assess their enterprise risk and adjust their risk appetite as new fraud types emerge and criminal behavior changes.
• Platform: By establishing the right risk appetite and internal alignment, fraud teams can employ machine learning and behavioral analytics to detect fraud. Unlike a rules-based approach, these automated solutions can forecast future risks and help staff respond to changing risks in near real-time.
• People: Fraud and anti-money laundering teams often work in siloes, making effective detection of financial crimes difficult. Compliance staff must ensure communication channels are in place, particularly when evaluating machine learning-based monitoring solutions.