Folks, last week I made the point that it’s extremely important to confront negative narratives about our industry before they take hold, creep into the interstices between things that are true and then somehow ossified into received wisdom. So, taking on board my own advice, which shockingly I find compelling, I want to sound the alarm about a recent Wall Street Journal story concerning the misstatement of net operating income in our industry (I only wish I could qualify as an influencer here. I read about two teens with millions of followers this weekend; they talk about stuff like..their hair. Is there anyone out there that wants to know about my hair?).
Whoops, got off track there for a moment. In any event, it’s entirely clear to me that we’re watching the early days of a story with us as the villain being woven together from a set of disparate and unrelated stories, sophistic conjectures and sly critiques into something that will be called a “BIG STORY” that will be wrong and damaging to the commercial real estate finance industry.
The Wall Street Journal ran a “news” story about our industry a couple of weeks ago under the title “Commercial Properties’ Ability to Repay Mortgage Overstated, Study Finds.” To an insider, it was blatantly a headline in search of a story. Here’s the short version: Two University of Texas professors, Messrs. John M. Griffin and Alex Priest, culled data (all publicly available) comparing closing date net operating income (NOI) with the performance of commercial mortgages during the first year of the related property’s operation. They “discovered” that pre-closing NOI was often higher than the reported first year NOI. From that they concluded that NOI was overstated and moreover concluded to a significant extent it was intentionally overstated. A disparity discovered by academics between predicted and actual NOI is a yawn. Mix in a soupcon of fraud and now we’ve got a story!
The Journal appeared to have given a lot more deference to the authors than I would have, perhaps concluding that they must surely be thoughtful and diligent because, gosh, they have advanced degrees. At best, this article suffers from the frailty of all academic analyses when professors peer into a complex industry in which they are not full-time participants, looking for something publishable. Academics never truly understand, in these situations the underlying substructure of these complex industries they are looking at because they are essentially dabblers, dilettantes, spending a little bit of their professional life looking into something new and shiny. Nonetheless, they typically convince themselves that they understand it better than the actual inhabitants of that industry.
A version of the old adage that “if you don’t play-a the game, you shouldn’t make-a the rules” comes to mind. Look, if you’re compelled because of a life of publish-or-perish to write about us, at least do it with a great deal of humility.
The Wall Street Journal story reported corroboration for the results of this study from a year old whistle-blower report and a report that the SEC is looking at the quality of disclosure in certain structured finance products. I hate to be picky, but let’s first look at the bio of the principal author, Mr. Griffin, which actually says his focus is “studying the role that anything potentially illegal, illicit or amoral in financial markets” might have on this industry. Talk about a little confirmation bias here? And then, the confirmatory whistleblower was talking his book and owned a financial fraud consultancy and the SEC was focusing its investigation on COVID-19 disclosure, but why let facts get in the way of a good story?
Several thoughtful industry commentators including CREFC have already pointed out the obvious flaws in the good professors’ study – most notably the myopic attention on comparing underwritten NOI with first year performance of the assets, which is a data set far removed from the performance the NOI analysis is designed to illuminate. Also, the study elided the reality that NOI is not a chemistry set experiment and therefore when constructed by different institutions with slightly different data sets will almost certainly produce different values for NOI.
Please take a look at an excellent recent TREPP note by Joe McBride and Manus Clancy reporting on the work they are doing on this issue and the allegations raised in this paper. While the TREPP note indicates that this was a preliminary assessment and they are in the process of doing a deeper dive into the data, TREPP, who is the gold standard for analytics in our industry, certainly put paid to the more egregious conclusions of the study. A little teaser here for the deeper dive that’s under way (which will be delivered to their accounts and may be more broadly published), but looking at six years of data, none of the top 30 originators had a negative average NOI growth achieved after underwriting. Moreover, on an NOI weighted basis, the worst performers were approximately -1% NOI growth. The industry average was well into positive territory. That’s a story worth telling. Joe and Manus are doing God’s work here.
Our Lone Star authors committed one of the classic fallacies of logic by confusing order with causation. Apparently, the authors’ “ta-da” moment was espying that the pandemic had significantly impacted the ability of borrowers to perform! Duh. As one might say (but I certainly wouldn’t because of a dearth of proper early training in Latin), post hoc ergo propter hoc, which roughly means finding causation merely because one event follows the other (which, of course, is the basis for my rally hat at Yankees’ games).
The most combustible assertion made by Messrs. Griffin and Priest is, of course, that the divergence between prediction and performance was the product of intentional fraud. What an astonishing leap to indict the entire industry in an NOI overstatement cabal! Maybe this is the sort of allegation that one needs to get published these days, but it is irresponsible.
All this talk of fraud is news to me, and I’ve been in this business a long time. It is simply not conceivable the folks who write commercial real estate loans for banks and other lenders, professional people all, who are highly committed to preserving the critical integrity of the business that pays their mortgage, somehow joined a giant cabal to overstate NOI in a consistent and coherent way. Nonsense.
Also, it would be stupid and useless. If there is any diddling of data going on in our industry, it’s being diddled in plain sight watched by innumerable deal participants from lenders’ credit departments (the land of Dr. No), to the ratings agencies, to the issuers, the investment grade bond buyer and to the first loss bond buyers. Everyone has (God help me, I’m saying this in a positive way) skin in the game. Our industry is highly data driven and has the benefit of reams of research and extraordinary transparency.
The CMBS Investor Reporting Package or IRP is the gold standard for transparency in all debt markets. The IRP was developed and is maintained and updated regularly by CREFC and its broad cross-section of members including issuers, investor and servicers who work hard to ensure that the IRP is the best data set available in debt capital markets to foster liquidity in a market. It contains hundreds of data fields. NOI is a process based on the manipulation of this data and both the data and the processes are broadly known to industry participants. Whatever is going on in our business, it’s being done in plain sight.
Do our friends from Texas think we’re all naifs, bedazzled by a single data field called NOI? The investors have the data that underlies the calculation through the IRP. They have the IRP. They have or can get the appraisals. They have unbelievable access to market information through appraisals and the information regarding the bonds and the underlying commercial real estate published by a wide range of analytic service providers including TREPP, S&P Global, Moody’s Analytics, CBRE…too many to name. Any competent investor doing its job can take a view on NOI, or indeed any other number, generated by the lender or securitization sponsor of a transaction and can reverse engineer the analytics. While an NOI calculated by a lender and included in a disclosure document by a securitization sponsor is a useful piece of information, it is just that; not the only and indeed not the most determinative data in understanding property values.
The amount of data ignored in this study is breathtaking. Before the pandemic, both watch list and non-performing loans in CMBS were at all-time lows. Loans were performing extraordinarily well, indeed better than would be anticipated by long data sets that were generally available to industry participants. Indeed, the poor special servicers back in January had been recapitulating the life of the Maytag Repairmen; so little to do.
Bottom line, there is no CMBS version of the Trilateral Commission with magic underwear and secret handshakes. There’s just a bunch of people trying to do their best in an uncertain world, working hard to facilitate the smooth functioning of capital markets and the delivery of capital to the economy that needs it.
So what to do? If this narrative of the evil that lurks in the hearts of the typical commercial real estate practitioner is allowed to grow, evolve and take root, if it is allowed to go uncontested in the broader marketplace of ideas, we will lose. Remember that conspiracies are fun. Allegations about people doing bad things are alluring. There will be a natural bias to embrace this narrative throughout the chattering class (an academic study reporting that “all’s well” is simply too boring for words).
Here’s how it’s going to work if we don’t disrupt the growth of this toxic narrative. After this story, someone else will write a story critical of some other aspect of underwriting commercial real estate, asserting some other species of bad behavior. The chattering class will view the current story as corroborative of the new story. Then the assertions in the Lone Star study will be republished with a subsequent story as further corroboration and after a while, as corroboration bangs back and forth in the echo chamber of confirmation bias, it will certainly ossify into orthodoxy. (We are in a time and place where it seems that not only are we entitled to our own opinions but our own facts.)
This story will then become a club that our gloriously elected leaders and their apparatchiki will use to beat us around the head and shoulders over the next several years as the recession plays out and the damage of the pandemic continues to roil markets and American life and we search for villains. Folks, we’ve seen this movie. Let’s not rerun the tape and play it again.
So, up on the barricades everybody. We can’t let this go; can’t let the narrative metastasize and be woven into a broader narrative of Wall Street versus Main Street, good guys and bad guys and nefarious bankers. While our political elites would no more believe that Elvis is still playing gigs in Area 51 than the tooth fairy, trust me, they’re going to believe this story.