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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