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Aggressive Underwriting Inflated Building Incomes For Loans Sold Into CMBS, Study Shows

Aggressive underwriting practices on commercial real estate loans before the coronavirus pandemic might now mean that thousand of properties have little hope of staying current with their mortgages. 

A new study finds that in thousands of cases, the underwritten amount of a commercial loan was based on an overstatement of a property's ability to generate income. The magnitude of the overstatement was 5% or more in about a quarter of all the loans studied, according to a study by finance academics John Griffin and Alex Priest of the University of Texas at Austin that reviewed about 40,000 CRE loans totaling $650B made between 2013 and 2019.


"Income overstatement is highly predictive of pre- and COVID-period loan distress, even after controlling for loan characteristics and geographic and time fixed effects," the study noted.

The bundling of loans into packages for resale can create a perverse incentive for lenders to overstate potential income. The process uses key financial ratios to determine a loan's riskiness, most commonly the loan’s debt service coverage and loan-to-value.

"Underwritten operating income is the most important input into both of these ratios," the study said. "To sell the loan at a higher valuation and make a larger spread, originators have a strong incentive to put forward as favorable of underwritten income as possible."

The study corroborates a complaint last year to the Securities and Exchange Commission about inflated financials for CRE loans, the Wall Street Journal reports.

In the complaint, John Flynn, an advocate for CMBS reform, studied CMBS data and alleged that 14 lenders and CMBS servicers inflated property values tied to CMBS loans.

Lenders and securities issuers altered financial data regularly for commercial properties “without justification,” Flynn's complaint stated.

As a result, borrowers qualified for loans they wouldn't have under an honest reckoning, and investors bought securities based on those faulty numbers, ProPublica reports.

Such financial sleight of hand might be grist for a wave of lawsuits as the CMBS market weakens.

"To the extent that there is going to be potential litigation, it would not surprise me if attorneys started looking at [the disclosures in CMBS securitization prospectuses] to try and dig deeper," Korein Tillery law firm partner Steve Berezney told Bisnow.

Not everyone is persuaded that lenders engaged in income overstatement. 

"The CRE Finance Council firmly disagrees with the overall premise of this report," Lisa Pendergast, executive director of that organization, said in a statement.

"As a transparent, well reported market, we believe the claims about the CMBS industry in this document are baseless and misinformed," Pendergast said.

"We are in an unprecedented moment, no one underwrote for a global pandemic ... The pandemic has forced many commercial real estate owners to shutter their businesses, resulting in property owners experiencing dramatic declines in property-level cash flow.”