Extend And Pretend Redux?  We Can Share What We’ve Got Of Yours ‘Cause We Done Shared All Of Mine

Three monkies

When the commercial real estate world and regional banks have problems, they often kick the can down the road rather than addressing the problems to the letter of any given loan agreement.  This process has reared its head several times in the last few years.  The Savings & Loan Crisis of the early 1990s, the Global Financial Crisis, and the COVID-19 pandemic all saw short term relief from banks to help investors and landlords hold on to properties through temporary problems. 

Naturally, since the bulk of the real estate market participants were not around in crises before 1990, most participants are looking at the current situation and expecting something similar.  But there are two differences today that may mean that “extend and pretend” will be a tougher ask this time around. 

First, bank regulations created because of the GFC have resulted in tighter rules for the banks surrounding capital ratios and stress tests.  Second, the fastest interest rate hike cycle in history and rhetoric from the Federal Reserve suggest that increased rates are here to stay for an extended period. 

What the combination of these factors does is shorten the timeframe that banks are able to extend and remove their ability to pretend.  Obviously, market participants on each side are playing the hear no evil, see no evil game for a bit. 

But with time running out on landlords who borrowed money 2020 and 2021 under 3-year, interest only loans with aggressive underwriting, the ability of banks to prop up borrowers is coming to an end. 

The reason why this is different is because there was a bolus of borrowing that took place with that structure during that period because rents were rising, and cap rates were falling.  Most investors believed that trend would continue despite the obvious limitations to returns offered up in that timeframe. 

But as we fast forward to today, the first of those loans are reaching the time for either a balloon payment or a refinancing.  While few landlords have the available capital to make the balloon payment, even fewer are going to like the new terms on the loans associated with buildings purchased during that timeframe.  

Now, banks do not want to own this real estate.  They are in many cases seeing office buildings fail to meet their reserve prices in auctions and they have no idea how to run a multifamily or industrial building appropriately.  It’s just not the business that they’re in. 

We’ve noted in previous issues that there will likely be a decline in asset pricing that comes with this situation, but as it gets closer, the question of who takes this pain hardest and who will benefit from the carnage gets more interesting. 

Landlords and banks will likely bear the brunt of the pain, some heavily invested limited partners will also take losses, but they are also the most likely beneficiaries when conditions improve assuming rational risk taking. 

Source: Bloomberg


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