A growing political and legal scandal is whether real estate developer (and now President) Donald Trump may have illegally altered his financial statements and whether that is a big deal. For those of you who do not believe this is important or possible – or understand how it is done – let me share some insider knowledge.
For a number of years in my early career I was involved with real estate financial statements – first as a paralegal, attacking statements as part of legal challenges; then as a real estate company CFO, preparing statements; and later still, as a securities executive, analyzing prospectus financial statements and their underlying assumptions.
It is helpful to know that many real estate developers are private companies that prepare their own financial statements without a CPA audit. Even if a lender (for example) requires audited financials, the audits may be limited, or may be performed by small, new or less-qualified CPA firms. For the most part, however, the financial statements are generated in-house and are not required to meet audit standards.
These audit rules are set by the national AICPA for the purpose of standardizing financial statements such that the resulting numbers are reliable and verifiable. The conservative guidelines for real estate evaluations typically require the use of “original purchase price” with strict rules as to any change in value so as not to improperly inflate or deflate the asset’s value.
Actual real estate value is not static, however — changing over time and from various causes. Without audit restrictions, the evaluations can change on a whim, depending on need. They can be inflated when the developer wants to be able to reflect a strong financial net worth (in order to obtain a loan for example or for marketing purposes); they can be deflated when the developer has another objective (to decrease the value of a particular property and in turn decrease insurance premiums on that property).
Even with private financial statements, there should be footnotes to explain how an evaluation has been obtained, but the choice of evaluation method also provides many avenues for shifting values. The value might be based on purchase price, or the purchase price plus some increase based on inflation (which can also be adjusted upward or downward at will). Value might be based on the original or the current valuation by a taxing authority. It might be based on what is called a “capitalization” rate – a valuation based on the net income of the property. It might be based on a per-square foot calculation or on “comparables” – the recent sales prices of similar real estate in the area. The number could simply be PFA – “Plucked From the Air.”
If you were to take a piece of real estate and value it by each of these methods using various growth rates, inflation, rents, caps, or otherwise adjusting assumptions, you would find the value of that real estate would wildly fluctuate. The private real estate developer can then pick the value that suits them best at any given time and use that value in their financials and other financial reporting.
That method is unreliable on its face – but made worse if the developer uses different methodologies and thus different values, for different purposes. It is fraudulent to tell an insurance company or your taxing authority that your real estate is worth $20 million dollars, but to report to your lender or potential investors that the same property is worth $200 million dollars.
Depending upon the various ways the real estate developer uses these fraudulent devices, and the various state and federal banking and business regulations that are broken, that particular developer may well find himself in prison. Fraud laws are usually quite punitive because they are enacted to protect other businesses, the stability of our banking system and the public at large. When any one segment is defrauded, the problem eventually affects all of our citizenry in one way or another.
— Jonnie Martin