The Newest Real Estate Trouble: “Flopping”

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Real estate markets are somewhat inefficient. This shortcoming allows me to make my living, because as an agent, I can add value with a keen sense of pricing. However, the imperfect market also allows room for scams. Meet the newest one: “flopping.”

As detailed by Lew Sichelman, a long-established real estate writer, flopping involves selling an asset at less than market price (to a friendly party, of course) and then reselling it to market.

The property that is bought low and resold high generates a profit, which is split among the parties — generally, the original seller and his non-arm’s-length buyer.

“But wait,” you say, “didn’t that original seller lose a lot of money when he sold his property at a depressed price?”

The answer is: Not if that original transaction went off as a so-called short sale, meaning the property was sold for less than what was owed to the bank, with the bank’s permission. In that case, the bank, not the original seller, eats most of the loss.

Let’s walk through an example. Harry buys a house for $700K at the height of the bubble, putting 10 percent down, and taking out a $630K mortgage. Four years later, that house is worth 20% less, or $560K. The mortgage hasn’t amortized very much, so Harry still owes the bank $610K.

So Harry’s underwater. He could hold and wait for the markets to recover. Or he could sell and pay the bank the balance owed on the mortgage out of his pocket. Or he could convince the bank to approve a “short sale” for less than what’s owed on the mortgage–in which case the bank, to cut its losses, generally forgives the difference between what’s owed and the sale price.

Those are all legitimate choices. The transaction becomes a “flop,” however, when Harry gets greedy.

Say Harry decides to convince the bank that prices have actually declined 30 percent. In that case, it might approve a short sale at $490K. Harry’s friend Barry could buy the house for that, and then months later sell it for the true market price of $560K. Harry and Barry can split the profit of $70K, minus transaction costs; and of course somewhere there is a happy real estate agent who has earned two quick sales commissions.

The protectors against this kind of nonsense used to be real estate appraisers, who even in an inefficient market were seen as the guardians of value. A 10 percent price swing is fine, and hard to prove, but there were at least professionals who knew the submarkets well and could help zero in on that pricing.

Unfortunately, we hamstrung our own watchdogs. After the housing bubble popped, appraisers were scapegoated and reforms were put in place that made sure the least biased parties in the transactions were paid less money.┬áThe Home Valuation Code of Conduct, for instance, was a “reform” meant to insure that appraisers didn’t simply do the bidding of real estate agents, but it instead had the effect of making life tougher for appraisers, who faced the prospect of covering larger market areas and doing more paperwork for lower fees.

Now, of course, we have to pay the price. A study released this spring by CoreLogic, a market research firm, estimates the cost of flopping will exceed $375 million this year, up 20 percent from 2010.

Scarier, to me, is the idea that nearly 2 percent of short sales (1 out of 52) are what CoreLogic would call “suspicious.”

It’s a shame that these scammers are tarring the process of short-selling, which for most parties involved is simply a painful attempt to mark their properties to market, get out from crushing financial burdens, and start afresh.

If you’re buying a short-sale property, read your contract carefully. In an effort to prevent flopping, your lender may block you from reselling for a certain period of time. Usually these clauses aren’t too restrictive (especially given that the CoreLogic study found many flops were resold within a day), but you always want to know what you’re getting into.