Extend and Pretend, Round 2

Those of us unlucky enough to be active in the financial markets during the Global Financial Crisis are probably familiar with the term “extend and pretend.” For some, the term may evoke a sense of opportunities missed. Others may feel a sense of relief. Readers who were still in college or younger during the GFC, or those who are newer to the financial markets, may be reading the term for the first time.

From late 2008 through 2011, hundreds of billions of dollars in commercial loans reached their maturity dates. Two big challenges faced the borrowers responsible for repaying these loans. First, due to skyrocketing unemployment and waning demand, property operations income was declining precipitously. The result was material negative growth of net operating income, which drove down the property’s fair market value. That was the driving force behind the second challenge: liquidity. Lenders make new loans either when they have excess deposits or when existing loans are paid off. But with the economy in deep recession, there were no excess deposits. And declining property values meant fewer borrowers were repaying their loans.

In essence, the banks didn’t have any money to make new loans, making the liquidity problem circular: There were no loans available to pay off old loans, because the old loans weren’t being paid off, because there were no new loans available.

Kicking the Can

During the GFC, lenders didn’t want to foreclose on loans and own the underlying real estate. Doing so would require them to accept huge losses on their loan portfolios. It would also require bankers to become real estate operators, collecting rents, paying bills and evicting non-paying tenants. The loan officers wouldn’t actually be doing this work, but neither could anyone else at the bank—they simply weren’t built for these tasks.

Their solution: Extend the borrowers’ original loan terms, typically by a year or two, and pretend the problem doesn’t exist! The concept of “extend and pretend” became a hugely popular “solution” for lenders around the world for several years. Over time, new buyers, including Origin, came into the system with fresh capital to break the vicious liquidity cycle. These buyers’ funds were some of the top-performing in recent memory. As property operations improved, net operating incomes grew, and property values climbed steadily for more than a decade.

In October 2022, we wrote about the tightening of liquidity in U.S. Treasury markets. That tightness trickled down into the rest of the credit markets, including real estate. And it was thrust into the headlines in March 2023 with the collapse of Silicon Valley Bank and the regional banking crisis. For more than a year, stress in the commercial real estate market hasn’t made the front pages other than a brief stint by New York Community Bank, but that doesn’t mean the problem has been solved. Enter extend and pretend, round two.

As of January, $929 billion in commercial and multifamily mortgages are expected to mature in 2024. This is an increase of $270 billion over the amount of maturities expected in 2024 at this time last year. How did those maturities grow by such a huge amount in just a year? Extend and pretend.

‘Otherwise Modified’

Jamie Woodwell, head of commercial real estate research at the Mortgage Bankers Association, notes, “The lack of transactions and other activity last year, coupled with built-in extension options and lender and servicer flexibility, has meant that many loans that were set to mature in 2023 have been extended or otherwise modified and will now mature in 2024, 2026, 2028 or in other coming years.”

Commercial Mortgage Maturities, 2024-28

Source: Mortgage Bankers Association

Today, real estate investors large and small, including Acore Capital and Oaktree Capital Management, have raised multibillion-dollar funds to capitalize on distress in real estate. They’re counting on lenders to foreclose on properties or sell bad loans at a huge discount, accepting loan losses and negatively impacting their earnings. These investors largely have been disappointed so far. Lenders are taking a page out of the GFC playbook and kicking the can in hopes of brighter days when increasing property operating income and lower interest rates re-inflate property values, and the refinance thaw commences.

But lenders can only extend for so long. And as each Federal Reserve meeting passes without a cut in interest rates, the pressure for lenders to act increases. Time will tell if extend and pretend, round two, is a success for lenders or if distressed investments funds will once again post once-in-a-generation returns.