It's Happening Again: Inflated Property Values Will Take Down Real Estate Pyramid Scheme

Intercept: THE BIGGER SHORT

Overall,” they write, “actual net operating income falls short of underwritten income by 5% or more in 28% of loans.” This was just the average, however: Some originators — including an unusual company called Ladder Capital as well as the Swiss bank UBS, Goldman Sachs, Citigroup, and Morgan Stanley — were significantly worse, “having more than 35% of their loans exhibiting 5% or greater income overstatement.” The below graph from the paper illustrates just how prevalent this issue is with some of Wall Street’s biggest names:

The paper explains that the authors are “interested in studying intentional income overstatement.” In an interview, Priest said that “we find that the direct inflation of past financials is common practice in the industry” and “our tests demonstrate that this really doesn’t seem to be a pattern that’s driven by coincidence. … It’s hard to argue that these originators are just naive,” making innocent mistakes.

This is a typical fraud. In China, money would change hands with the party desiring a higher vauation compensating the other. Often there would be two prices, one reported to the government for taxes and the other to the bank for a loan.

Flynn’s whistleblower complaint filed with the SEC states that he has identified “about $150 billion in inflated CMBS” issued since 2013 by banks such as Wells Fargo and Deutsche Bank and the “shadow bank” Ladder Capital.

But it’s easiest to understand what seems to be happening in the CMBS market by looking at a single trust.

Take one called “LCCM 2017 LC26,” which Flynn has examined in fine-grain detail. What he’s found appears similar to the residential mortgage trusts of the 2000s, with some newfangled twists.

LCCM 2017 LC26 consists of 57 commercial real estate loans bundled together, with a total unpaid principal balance of $625 million. LCCM stands for Ladder Capital Commercial Mortgage Securities, the trust depositor. 2017 is the year the trust was created. LC stands for Ladder Capital Finance, the trust’s sponsor and mortgage loan seller. 26 means it’s the 26th in a series.

...Flynn then looked at two key financial metrics for each loan: the property’s net operating income, or NOI, and net cash flow, or NCF. In the world of commercial mortgages, a property’s NOI and NCF hold a significance similar to a borrower’s income for residential mortgages. The higher the numbers, the more creditworthy you are, allowing you to borrow more at lower interest rates.

The previous trust’s servicers had reported the NOI and NCF. Then when Ladder Capital packaged them into a new trust, Ladder also reported the NOI and NCF. But the numbers didn’t match.

For instance, one of the loans in LCCM 2017 LC26 was for $14.1 million to refinance the mortgage on an office building in Wilmington, Delaware. The building was 160,500 square feet, all of which was leased by Verizon.

According to the old trust, the building’s NOI for 2016 was $1,285,465. But according to LCCM 2017 LC26, the building’s NOI for 2016 was $1,717,350 — 33.6 percent higher.

According to the old trust, the building’s NCF for 2016 was $1,273,427. But according to LCCM 2017 LC26, the building’s NCF for 2016 was $1,717,350, or 34.9 percent higher.

By Flynn’s calculations, as of April 2019, the 13 anomalous loans had, in aggregate, total inflated NOIs of $2.5 million and NCFs of $3.85 million.

This makes them look much like the loans of the housing bubble. Flynn alleges in his SEC complaint that companies like Ladder Capital have an incentive to exaggerate a business’ income. As Flynn explains in his memo, Ladder “takes profits and fees from originating, arranging, and selling the loans into CMBS trusts, and then selling the securities.”

...Flynn also alleges in the complaint that changes in names and addresses when loans are moved out of old trusts and into new ones are not an accident but suggestive of deliberate obfuscation. “The correlation of name and address changes with inflated numbers,” he says, “is something like 95 percent.”

...This, Flynn contends in his memo, could allow Ladder Capital to make money coming and going. First, Ladder subsidiaries would get the fees for originating and packaging the loans. Next, the seemingly exaggerated NOI and NCF numbers for the 13 problem loans push down the interest rates for the entire trust, including Ladder Capital’s loans to itself.

That’s where Dollar General comes in. Because Ladder Capital is paying the trust a lower interest rate on its mortgages than it would be if the cash flow and income numbers had not been increased, its monthly loan services costs for its properties logically must be lower. And if that lower cost is then translated into a cheaper rent for the tenant — in this case Dollar General, though the logic would apply generally — that means the store’s overall costs would go down significantly, especially compared to other retailers operating in the same areas.