Why ‘Extend and Pretend' May Be Prudent for Both Lenders and Borrowers

Since the U.S. Federal Reserve began raising the Federal Funds rate in March 2022, commercial real estate values have been battered by persistent rate hikes, amounting to more than 500 basis points over a span of just 16 months. CRE values were further eroded as the Consumer Price Index, one measure of inflation, approached 9%, causing operating expenses to rise sharply and net operating income to fall.

For office buildings especially, these conditions were exacerbated by a decline in rents as companies leased less space, due to uncertainty about a potential recession and ongoing work-from-home arrangements for employees.

Against this backdrop, terms like "extend and pretend" and "kick the can down the road" have resurfaced among CRE professionals, as they contemplate maturing loans. These concepts are generally perceived as negative. However, for CRE assets facing refinancing during this period of hardship for borrowers and lenders, buying time may be the most prudent course for both parties.

What Is Extend and Pretend?

"Extend and pretend" is a strategy where lenders extend the terms of a loan instead of foreclosing when the property's value has dropped. This gives borrowers more time, hoping for market improvements, while avoiding immediate financial losses for both parties.

Extend and Pretend Example Scenario

"The textbook example of what would happen in this case is that a bank would institute a foreclosure proceeding and seek to force a sale of the property and collect as much as they can from the sale of that asset," said Scott Singer, a co-leader of Avison Young's debt and equity finance practice in the New York metropolitan area.

"But what happens in many of those situations is that instead of foreclosing on the property, lenders with maturing loans will extend the term, giving the borrower more time to refinance in the hope that values will recover," or that alternative refinancing sources will become available to cover the lost value, Singer added.

The "pretend" part of this concept acknowledges that banks in this situation are not valuing the loan based on the current market value of the property. Extend and pretend enables banks to extend a loan and "keep it out of a maturity default in order to make it appear" that there was no decline in value, Singer said.

Singer noted that "the value of a property at any given time is subjective unless the property is actively being marketed for sale at that exact moment," or a valuation professional has been hired to determine a value for the property or the loan. When conducting workouts or extending loans, sometimes lenders do have valuations conducted.

But if they don't, Singer said, the valuation may be based on the most recent book value of the loan. That value could reflect the original value of the loan, or it might be based on an updated value generated at some point after the loan was originated.

Historical Context and Evolution of "Extend and Pretend"

Origins of "Extend and Pretend" During the Global Financial Crisis (GFC)

The "extend and pretend" strategy became popular during the Global Financial Crisis (GFC) of 2008. Banks faced a surge of non-performing loans as property values plummeted. Instead of foreclosing on these properties, lenders chose to extend the loan terms. This gave borrowers more time to improve their financial situation. Lenders hoped that property values would rebound, allowing loans to be repaid in full.

Application During Different Economic Downturns

During the GFC, extending commercial loans helped banks avoid immediate losses. It also prevented a flood of foreclosures that could further depress property values. This strategy was effective as the Federal Reserve cut interest rates, reducing borrowing costs and helping property values recover.

In contrast, the COVID-19 pandemic presented different challenges. The pandemic led to widespread remote work, reducing demand for office space. Despite the economic uncertainty, many lenders extended loans to give borrowers more time. However, the pandemic's impact on work habits and property values was more profound and lasting. Unlike the GFC, interest rates were already low, limiting the effectiveness of rate cuts.

During both crises, "extend and pretend" provided temporary relief. It bought time for borrowers and lenders to adjust to new market conditions. However, the long-term success of this strategy depended on broader economic recovery and changes in market demand.

Hedging Against Flat or Rising Rates

For a complicated commercial real estate transaction, generally one year would be the shortest extension a borrower would receive, Singer said. "And the transactions that we're involved in - that are really an extension as opposed to refinancing - have ranged as long as three years."

Concerning expectations around interest rates declining, Singer said "there's a lot of hope that rates will go down," based on the current yield curve.

But what investors should prepare for is the possibility that rates will stay the same or even climb higher. Singer said that an increasing number of the recent refinancing or origination negotiations that he's been involved with are focused on "interest reserves and hedge-type protections and how to prevent more problems if rates don't decrease."

Investor and Lender Behavior

In the current economic climate, both investors and lenders exhibit increased risk aversion. Investors are demanding higher yields to compensate for the heightened uncertainty. Lenders are more cautious, focusing on the stability and long-term viability of their investments.

Negotiations Between Borrowers and Lenders

Negotiations between borrowers and lenders have become more complex. Lenders are increasingly requiring additional capital or reserves from borrowers to extend loans. These requirements often include funds for tenant improvements, leasing commissions, and other property-related expenses. Borrowers, in turn, must demonstrate their ability to manage these costs and improve the property's performance.

Loan modifications are now common, with lenders seeking to protect their interests while providing borrowers with the time needed to stabilize their assets. This dynamic creates a delicate balance where both parties must cooperate to navigate the challenging market conditions.

Potential Fallout from "Extend and Pretend"

"Extend and pretend" can be a double-edged sword. If market conditions do not improve, the strategy can lead to several negative outcomes. One major consequence is the accumulation of distressed assets. When lenders repeatedly extend loans without addressing the underlying issues, they risk holding onto properties that continue to decline in value. This can lead to a buildup of non-performing loans, which can strain the financial health of banks and other lending institutions.

Risks of Waiting for Market Recovery

Waiting for the market to recover is inherently risky. The assumption that property values will eventually rebound may not hold true, especially in a volatile or changing economic environment. If property values do not increase as expected, lenders may face significant losses when they finally attempt to sell or foreclose on the properties. This can result in substantial financial hits to banks' balance sheets, potentially leading to a tightening of credit availability as banks become more cautious in their lending practices.

Moreover, the prolonged uncertainty can have a broader impact on the financial system. Banks with a high volume of distressed assets may struggle with liquidity issues, affecting their ability to lend to other sectors. This can slow down economic growth and exacerbate financial instability.

Loan Originations in the Current Climate

The current climate for refinancing is challenging, but active, Singer said. "We've continued to be very active in [loan] originations and we're certainly involved in some situations where an extension is the best outcome for the borrower, the lender or both."

But for the most part, Singer said, "we're focused on originations and we're finding a tremendous amount of liquidity in the market. The reality that we see - dealing with one property at a time - is often very different from the headlines that try to agglomerate the entire commercial real estate market into one sentence."

"What we're finding is that there are many sources out there with both debt and equity who view the challenges in the market now as an opportunity," he continued. Singer said that those opportunities include the potential to gain market share, to extend loans at a higher yield, to do business with more prominent clients and to grow relationships with existing clients.

This article was updated on 12/12/2024