Extend and Pretend: How Banks are Avoiding Losses on Commercial Real Estate

In the world of commercial real estate, a new trend is emerging that could have significant implications for the market. Goldman Sachs estimates that nearly $1.1 trillion in commercial mortgage loans will need to be refinanced before the end of 2024. However, refinancing these loans is becoming increasingly difficult, leading many borrowers and lenders to engage in a practice known as "pretend and extend."

The Extend and Pretend Strategy

Also known as "kicking the can down the road," the extend and pretend strategy is used by lenders in commercial real estate to defer risks or costs into the future. This approach involves refusing to write down distressed underwater mortgages and giving borrowers extra time to repay their loans. By doing so, banks extend their inevitable losses by pretending everything is fine and ignoring short-term valuations.

The popularity of this strategy is hard to quantify, but it's reported that many lenders turned to this approach to keep themselves afloat during the Great Recession. By waiting out the market and sweeping reality under the rug, instead of demanding loan repayments during the onset of the financial crash, the extend and pretend strategy allowed some lenders to take back properties from borrowers when prices began to recover, thus avoiding a severe financial hit.

Current Environment

Commercial real estate is a highly diverse sector, comprising everything from offices in major cities to data centers and industrial warehouses in rural areas. However, the sector that is facing the strongest headwinds is office real estate. Since the start of the pandemic, occupancy rates have continued to fall, causing valuations to drop as well, given that the value of these properties is tied to the revenue they generate.

Additionally, interest rates have risen sharply since the Federal Reserve began raising rates in March 2022. This has led to a decline in the profitability and valuations of these buildings. When it comes to refinancing, many property owners, as well as lenders, are faced with a difficult decision.

As of December 2023, 6.5% of the balance of office property loan balances were 30 days or more delinquent, up from 5.1% at the end of the last quarter, according to the Mortgage Bankers Association. This indicates a growing trend of financial strain within the commercial real estate sector, which could have far-reaching implications if not addressed.

In conclusion, the "pretend and extend" strategy is a short-term solution that may help some lenders and borrowers navigate the current challenges in commercial real estate. However, it is not a sustainable long-term strategy, and stakeholders in the industry will need to find more viable solutions to address the underlying issues facing the market.