Extend and Pretend in Commercial Land

“A rolling loan, they say, gathers no loss.”

Commercial mortgages function differently than residential loans. Investors borrow for shorter periods and structure loans with large balloon payments at the end. They’re designed to be refinanced.

It’s not that market participants have forgotten the lessons of the global financial crisis that followed the 2000s boom, it’s that they remembered them. In the current environment here in 2023, faced with delinquent loan payments, lenders have decided to be patient: Instead of foreclosing on properties whose value is plummeting, they lengthened loan terms and ignore short-term valuations. They called it “extend and pretend.”

Now there are growing fears that this strategy might not work this time. The rapid increase in interest rates over the past year has sucked air out of inflated valuations. As a result, landlords need to come up with more cash to offset the lower building value when they refinance their debt. At the same time, banks and insurers are under scrutiny from regulators and ratings companies over their real estate lending.

Commercial real estate values could fall 30% or more from peak to trough, says KBW. This compares to a similar decline in the early 1990s, following the savings and loan crisis, as well as a 40% decrease after the global financial crisis.

Falling values are only part of the problem. About $1.3 trillion worth of commercial real estate loans will come due by the end of 2025, according to MSCI Real Assets. Most borrowers will need new loans to pay off their old ones, and lenders are being much more careful than they were a few years ago.

Real estate is cyclical. Building a skyscraper typically takes years, and a lot can happen from the time a developer puts capital at risk to when the property starts generating returns.

From March 2020 to July 2022, property values surged 30% in the US, where buildings representing three-fifths of the world’s $33 trillion in real estate assets are located. It felt like we were dealing with a very fit athlete who had a heart attack and six weeks later was running marathons again, said a large Commercial realtor in Florida.

The biggest issue facing commercial real estate today, he says is the strain on banks. Regional and community banks hold about $2.3 trillion in commercial real estate debt, according to Moody’s. Many of these smaller lenders are already facing a crunch thanks to the effect of fast-rising rates. One risk is that banks trying to cut their real estate exposure will have to offload their loans at significant discounts—even if the loans are not in trouble, they were made when rates were low, so a buyer wouldn’t touch them without a discount. This is having an immediate impact on Commercial deal values which are the lowest since Q2 2020 as outlined in our Chart of the Week:

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