Waiting for the End of Extend-and-Pretend

The world of commercial real estate seems to be resting on one delay after another.

The Federal Reserve is unsure when rate cuts might happen — if they happen. Price discovery was supposed to start happening a year or two ago when transaction volumes picked up, except they didn’t. And now, loans reaching maturity are being stretched out as borrowers and lenders wait to see if lower rates come and make refinancing easier, taking a weight off everyone’s back.

However, the uncertainty is only increasing. MSCI Real Assets last month noted that $214 billion in loans that should have matured during 2023 apparently were neither refinanced nor sold.

“Given that property owners are not inclined to take a loss on the sale of an asset, nor refinance in a high interest rate environment, we have deemed these loans, ‘likely extensions’, indicating we believe that these loans have been granted some short-term extension to their maturity date,” they wrote. “Taken together, we estimate that as much as $870b of mortgages tied to assets in our database could come due in 2024.”

The Wall Street Journal cited several research sources with similar findings. Autonomous research estimated that 40% of bank CRE loans maturing this year actually being holdovers from 2023 and that banks on average are reserving 8% of their CRE portfolios, which is about five times more than normal. PGIM Real Estate that expected bank CRE maturities was up 35% from previous estimates.

These extensions, no matter what the percentage, allow more time to work out refinancing of some kind so banks don’t have to either write off the value on their books and take back the properties and then try to figure out how to manage them.

All this activity, though, is prefaced on the idea that things will work out. That rates will go down, allowing refinancing that enables everyone to walk away.

However, if there is one thing that history should teach, it’s that pushing problems off to the future generally results in paying compound interest in one form or another, often in widespread problems that can become disasters.

On the finance front, monetary choices made in the 60s and 70s eventually resulted in massive inflation and painful periods of double-digit interest and mortgage rates. The Savings & Loan disaster could have been seen forming, but everyone put off acting. The Global Financial Crisis was called by some who saw the mechanisms and didn’t listen to the earnest advice for everyone to keep trading up on housing.

And, during the recent pandemic, it seemed clear, at least in retrospect, that the world’s supply chain couldn’t get choaked without reducing supply, driving up prices, and setting off a wave of inflation. Think of how long it took the Fed to admit there was a problem and start doing something, at which point if forced them to crank up rates high and quickly.

Property prices are already down. Cap rates are up. Many who speculated on purchases with low interest rates and high leverage thought that would be the future. They were wrong and many, if not most, didn’t hedge.

A growing chorus of voices is calling for commercial real estate to take the medicine before it gets worse. Yes, prices will drop even more. Yes, banks will see loan portfolios take a hit. But what happens if everyone waits? A tsunami of a flood of pain running through everything, where the thought that one set of parties or another might be fine is made through force to look like a child hiding under the blanket to evade monsters. By then, instead of a shot in the arm, the rescue might be a major operation.