By Cezary Podkul
Thousands of commercial-mortgage borrowers have been struggling
to meet payments on their loans in the midst of the coronavirus
pandemic. But there might be another reason so many are falling
behind: aggressive lending practices that overstated borrowers'
ability to repay.
A study of $650 billion of commercial mortgages originated from
2013 to 2019 found that even during normal economic times, the
mortgaged properties' net income often falls short of the amount
underwritten by lenders. The underwritten amount should be a
conservative estimate of how much a property earns. Instead, the
actual net income trails underwritten net income by 5% or more in
28% of the loans, according to the study of nearly 40,000 loans by
two finance academics at the University of Texas at Austin.
The study shows risks in the $1.4 trillion market for commercial
mortgage-backed securities, or CMBS, where loans on malls,
apartment buildings, hotels and the like get packaged into bonds
bought by investors, often with guarantees from the government. The
findings suggest that loans sold to investors before the pandemic
frequently featured overstated income and could have more trouble
staying current in case of a downturn.
The findings corroborate a complaint received last year by the
Securities and Exchange Commission stating that commercial mortgage
loans frequently feature inflated financials. They also come at a
sensitive time for the commercial-mortgage-backed securities
industry, which has been seeking a lifeline since the spring, when
the Federal Reserve left out swaths of the market from its $2.3
trillion economic-rescue package.
Congressional legislation introduced last month is seeking to
help the industry survive the pandemic, which has sent commercial
loan delinquencies to near-record highs.
John Griffin, a finance professor and co-author on the study,
says his findings provide evidence that the commercial-mortgage
industry is at least partly to blame. He found that when the
pandemic hit, loans with inflated income were quicker to enter
watch lists for troubled loans maintained by loan servicers. Income
was overstated by more than 5% in more than 40% of loans originated
by UBS, Starwood Property Trust and Goldman Sachs Inc., the study
said. Loans from these originators were among those most likely to
be on a watch list, Mr. Griffin found.
"This is a direct function of the aggressive underwriting," Mr.
Griffin said. He disclosed in his paper that he owns a
fraud-consulting firm, Integra FEC LLC, which could benefit if the
government or investors acted against the bond issuers.
UBS and Goldman Sachs declined to comment. Starwood said it has
"consistently experienced strong performance across its portfolio
of originated loans." The Commercial Real Estate Finance Council,
which represents the industry, called Mr. Griffin's study flawed
and said the industry's record on underwriting was solid.
The organization's chairman, Adam Behlman, said the study should
have used long-term cash flow to judge the underwriting and said
the originators identified in the study had lower-than-average
default rates on their loans. "Defaults are the ultimate barometer
of the quality of the underwriting," Mr. Behlman, a Starwood
executive, said.
The expected income generated by a property is an important
factor in how much the owner can borrow. The bigger a property's
net income, the bigger the value and thus the loan it can support.
Shaving a few hundred thousand of expenses or claiming additional
income can add millions to a loan's size, which can benefit
borrowers by giving them room to cash out equity from properties.
Higher net income also makes loans worth more, enabling more profit
for originators.
Mr. Griffin's study doesn't definitively answer the question of
who might be inflating loan financials. But it does provide
evidence that the industry is aware of the practice. Mr. Griffin
found that loan originators charged higher interest rates for loans
with overstated income, suggesting they viewed them as riskier.
Kroll Bond Rating Agency Inc. and DBRS Morningstar, two rating
firms that grade CMBS bonds, also tended to treat inflated loans
more skeptically in their rating models, the study found.
Kroll declined to comment. DBRS Morningstar said that analyzing
loans' cash flows is a key element of its rating process and that
it consistently applies its criteria when grading deals.
Borrowers, lenders and their representatives have a lot of
leeway in calculating a property's earning power. Unforeseen
circumstances such as a natural disaster can also take a bite out
of expected income after a loan is originated. Sometimes, however,
fraud can play a role, too, according to federal prosecutors.
In 2019, the SEC and the Justice Department each filed fraud
cases against Robert Morgan, who had borrowed about $3 billion to
amass a multifamily property empire that once spanned more than
34,000 units across 14 states. Prosecutors alleged that Mr. Morgan
conspired to create fictitious leases at some of his properties to
make their income look bigger than it was. The SEC alleged that he
ran a Ponzi-scheme-like scam that used investors' money to "repay
an inflated, fraudulently obtained loan" on one of his
properties.
A lawyer for Mr. Morgan said he is "vigorously defending against
the criminal charges." The SEC, which recently disclosed that it
has reached a tentative settlement with Mr. Morgan, declined to
comment.
The SEC has been aware of potential income inflation in CMBS
loans since at least February 2019, when it received a complaint
about the issue. The complaint, earlier reported by ProPublica,
pointed to a pattern of inconsistent figures in different financial
reports providing income for the same property in a previous
year.
Mr. Griffin's study validates inconsistencies in such
overlapping reports. In a subsample of 2,172 loans, Mr. Griffin
found that 70% of loans exhibiting income inflation of 5% or more
in the first year of the CMBS deal also overstated properties'
historical financials.
The SEC declined to comment on the complaint. John Flynn, a CMBS
industry veteran who filed the complaint, said that after poring
over thousands of loans, he feels relieved to see someone else spot
the same pattern.
"It's much more widespread than I even realized," Mr. Flynn
said.
Write to Cezary Podkul at cezary.podkul@wsj.com
(END) Dow Jones Newswires
August 11, 2020 09:36 ET (13:36 GMT)
Copyright (c) 2020 Dow Jones & Company, Inc.
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