Pretend and extend, that informal, off -the-record policy of banks to salvage their borrowers'-not to mention their own-real estate positions, appears to be winding down as regulators clamp down on banks and their now robust balance sheets. The final piece falling into place at precisely the wrong (or right, depending on whether you are a buyer or seller) moment: there is close to $300 billion worth of commercial mortgage maturities expected to peak in 2012 and 2013, with the first wave starting this year. That is according to Foresight Analytics, which along with Delta Associates and Real Capital Analytics, produces a quarterly analysis of the nation's commercial real estate distress.

In a nutshell? June is poised to mark the beginning of the end for not only the recent low-interest rate era but also for policies that have kept many properties afloat, just as the next wave of loans go shopping for refinancing. The many moving parts to this equation have Washington, DC-based Greg Leisch, CEO of Delta Associates, wondering how long the status quo can last. Right now, after a brutal two years, distressed real estate has plateaued between $175 billion and $190 billion, after peaking at $191.5 billion in October 2010. "Any of these factors-interest rates, a scaling back of banks working with borrowers, or prolonged uncertainty about the debt ceiling-could easily tip up back into accelerating distress," he says.

The situation could morph into a period of touch-and-go in even the most stable markets, he adds, pointing to his own city as an example. The group found that the volume of distress in Metro DC rose to $8.2 billion in April 2011 from $3.3 billion in January 2010.

The line of demarcation-that is, the level at which interest rates can rise before more distressed properties will start hitting the market-is widely agreed to be between 100 and 150 basis points. "We believe that in the second half of this year, Treasuries will move into the 3.5% to 4% range," says William Hughes, senior vice president and managing director in the Newport Beach, CA-headquarters of Marcus & Millichap Capital Corp. With the Treasury rate at a 3.19% or so at the beginning of May, that puts the rate increase close to the 100-to-150-bps tipping point.

There is little doubt the rate will go up, Hughes says. "Obviously the Fed and its purchase of just under $600 billion of Treasuries have served to support a low-interest-rate environment," he says. "We do have concerns of taking away what has been, in the past six months, one of the biggest buyers of US Treasury debt."

Exactly when the economy will feel the impact, in the form of rising rates, is debatable, however, says Steve Pumper, executive managing director of Transwestern's Investment Services Group in Dallas. He believes the election year will have an undue influence on rates. "You cannot underestimate what is at stake in Washington and the pressure that will be utilized to keep money fl owing and interest rates lower than they should be," he says.

More likely, Pumper forecasts, there will be a significant uptick in interest rates, but not until 2013. Like Leisch, he doesn't see a problem developing for the industry until rates rise another 100 to 150 bps. "Then the trickle we are seeing now will turn into a moderated, controlled stream," says Pumper.

The debt ceiling is another wild card in terms of both the amount of debt the economy will be forced to shoulder and the inevitable game of chicken the debate over raising the ceiling will provoke in Congress (will they agree to raise the limit? Will Treasury default on its bonds as it has threatened?). A quick resolution that raises the ceiling is not necessarily the answer either, MMCC's Hughes says: "When you create that much debt you tend to have pressure on interest rates."

It also could be a factor in banks' decision-making about their portfolios. Up until now they have been relatively sanguine about extending loans for borrowers. But if the economic situation worsens, lenders may again view the entire category of commercial real estate as toxic. Regulators, according to talk in the market, appear to be already there.

The fact is, despite the sense of dodging a bullet two years ago and the growing confidence in fundamentals, commercial real estate is still grossly overleveraged, C. Geoffrey Mitchell, a Los Angeles-based partner with McKenna Long & Aldridge LLP says, pointing to a chart the firm's managing director, Brian Olasov, developed for clients.

In 1960, commercial mortgages amounted to 7% of total GDP, he notes, a percentage that gradually increased over the years. By 1983 it began spiking dramatically, to reach 15% in 1988. The 1990 recession caused it to drop below 10%, but by 2008 that percentage reached 18% of GDP.

Furthermore, he said, GDP is not rising as it has in previous years. "All of this is to say that by historical norms, there are a lot of underwater properties that could easily tip into distress," says Mitchell. "If the percentage tracked in our chart were to revert to a 40- year mean of 10.1%, we would have to reduce balances by a total of $866 billion."

Also consider this, Mitchell says: banks' profits have been very good for the past year in large part because of low interest rates. "The cost of funds has been very low," he says, "while many business and consumer loans, even if at variable spreads, still have floors that are well above the index plus spread. So times have been good."

But wouldn't this prompt banks to A rise in interest rates will put downward pressure on bank profits along with upward pressure cap rates for commercial real estate, thereby reducing values for that real estate. "This, of course, will make problems worse and make it harder for banks to absorb the losses and harder for property owners to refinance," Mitchell concludes.

But wouldn't this prompt banks to go back to their permissive pretend and extend policies? Not necessarily, he says. They might want to, but bank regulators will not give them the same freedom they did two years ago. "They are putting more pressure on lenders to deal with the worst of their loan problems because banks' capital positions are stronger now than they were a year-and-a-half or two-years ago," he notes. Stabilization of the banking system has come at a cost for some borrowers, agrees Adam Weissburg, a partner at the Los Angeles office of Cox, Castle & Nicholson LLP. Banks are thoughtfully addressing looming maturities rather than continuing to employ "pretend and extend," he says. "To be clear, borrowers may not like the approach. In many instances, regulated banks have sufficient loss reserves and the ability to incur write-off s that they are unwilling to modify, or amend loans without meaningful principal repayment."

This is not to say that borrowers are unable to obtain concessions, Weissburg continues. "But many banks are holding the line and will demand significant paydowns." They are also requesting additional security to shore up depressed loan-to-value ratios, he adds. "Certainly, restructures such as loan extensions, changes in terms of interest or principal reduction without remargining or additional collateral being posted is still occurring, but only where it makes sense for both the bank and the borrowers, and not just the latter."

All of this is speculation, Mitchell points out, based on anecdotal comments from clients and colleagues. "No one knows how much pretend-and- extend really goes on anyway," he believes. "It is not a statistic that the FDIC or the Comptroller of the Currency could produce for you."

Also, not every observer believes banks are ready to cut borrowers loose. Lenders are likely to continue to support borrowers if they have good portfolios and have been good customers, Pumper believes. Given the vagueness of these many moving parts, there are a couple of ways the current situation could play out, Hughes says. Rates could rise, but more properties than expected might find financing from the new sources of capital on the market, from new mezzanine to debt sources. Also, the industry can count on one of its saving graces-the lack of any viable investment alternatives-to continue. Recent events, in fact, are likely to fuel demand for Treasuries as well, Hughes speculates. "With everything going on in the world now-terrorism back on the front pages, the ongoing impact of the natural disasters and nuclear crisis in Japan, the unrest in the Middle East-investors want safety and security. Treasuries still represent that."

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