Extend and Pretend a Trillion Dollar CMBS Loan Crisis Doesn't Exist

About $1.5 trillion of US commercial real estate debt comes due for repayment before the end of 2025, according to Bloomberg.

This impending wave of maturing loans is accompanied by nearly 500 million square feet of office and mixed-use properties backed by CMBS loans on the brink of expiration over the next five years.

With 217 million square feet of office leases due to expire in the near term—112 million in 2024 and 105 million in 2025—the CRE market is teetering on the edge of a significant rollover risk. Yet, amidst these concerning figures, the postponement of loans casts a shadow of uncertainty over the market's stability, prompting speculation about the looming threat of a potential downturn and its potential repercussions.

Let's explore the widespread loan modifications hitting the commercial market and their greater implications for the industry and existing tenants. In the meantime, receive exclusive first access to the corporate tenant's survival guide to navigating a post-pandemic office market. 

Extend and Pretend

In the face of impending commercial loan maturities poised to strike, institutions are engaging in a delicate dance of deferral, hoping to sidestep the harsh realities of distressed assets. The "Extend and Pretend" maneuver is little more than wide-scale loan modifications. But in the midst of the market's pressure, professionals have been asking just how realistic the hopeful "extend and pretend" tactic is for long-term stability. Instead, it's been lampooned as the old, “delay and pray.”

At its core, extend and blend is a tactical retreat, allowing lenders to kick the proverbial can down the road, postponing the inevitable reckoning with distressed assets.

Motivated by a desire to preserve appearances and avoid the stigma of foreclosure, lenders cling to the hope that time will offer a solution where none currently exists. But what lies beneath this financial sleight of hand?

As with any bargain, there are consequences. While extend and blend may offer a fleeting reprieve, its long-term implications are fraught with uncertainty. What may appear as a temporary fix could morph into a ticking time bomb, threatening the stability of the entire commercial real estate ecosystem.

Because it's obscuring the truth that the commercial real estate market, especially office, is under water. And because of this, loan deferrals are happening at far more rapid rates than in the past.

With the influx of new loans expected to flood the market in 2024 and beyond, the practice of extending the maturity dates of existing debts while pretending that the borrower's financial situation will improve is likely to become even more commonplace. The extend and pretend approach is becoming a favored tactic for financial institutions. And the numbers speak volumes about the scale of the challenge.

In response to this looming wave of debt, financial institutions may resort to extending the repayment timelines of existing loans, thereby postponing the inevitable reckoning and hoping for improved economic conditions in the future.

This includes the increase in special serviced loans. Over the past two years, (since February 2022) a total of 593 office loans have transitioned to special servicing. Among them, 13.7% underwent modifications, 14.0% were returned to the master servicer for correction, 8.4% were paid off, while the remaining 63.9% remain under the purview of the special servicer.

And this will only get more common especially as only a small fraction of office loans were paid in full this year. 26% of $35.8 billion in CMBS loans that matured last year were paid in full.

Is the precarious support of the extend and pretend strategy turning the CRE market into a house of cards?

CMBS Loans and a Looming Bank Crisis

We may be in for a whole lot of trouble in the next few years. Because obviously, the mass-inability to meet loan obligations not only impacts the borrowers but also poses significant risks to the financial institutions holding these loans.

When loans cannot be repaid, it directly affects the asset values of banks, creating a ripple effect that can destabilize their financial standing. This precarious situation was starkly demonstrated by the closures of Silicon Valley Bank, First Republic Bank, and Signature Bank last year.

Such closures underscore the gravity of the situation, as banks face the prospect of absorbing losses and grappling with impaired asset values. In response to this predicament, banks are compelled to take decisive action. This may involve liquidating loans, a measure taken to recoup whatever value can be salvaged from distressed assets. Additionally, banks may seek alternative strategies to mitigate risk and bolster their financial resilience.

Alternatively, banks may opt to offload the risk associated with non-performing loans, transferring them to other entities better equipped to manage such assets. Transfer or loan sale, is a common strategy employed by financial institutions to mitigate their exposure to defaulted loans. But this opens pandora's box when discussing how tenants come in to play. 

First off, extend and pretend is often not a feasible option for many distressed commercial real estate properties. Lenders are reluctant to extend loans when property values plummet below loan amounts, and without steady income streams, there's little basis for loan extension.

Factors such as collateral quality and tenant stability may sway lenders, but regulatory scrutiny and risk management practices add further caution. While temporary extensions might occur, particularly for issues like higher interest rates, addressing underlying challenges remains crucial for sustainable solutions in CRE distress scenarios. This is further complicated because there will not be cuts in interest rates any time soon. 

There was a hope by commercial landlords and banks that rates would come down, but this is not the reality. National inflation has been sticky and rates were to be cut, it would further fan the flames of inflation.

How Does This Affect Tenants?

And with so many debts and properties changing hands, what happens if you have a lease in one of these buildings? 

The fate of tenants amidst such transactions raises a lot of questions. They can be caught in a complicated crossfire of landlords, lenders, and banks (oh my!).

This dilemma is elucidated by the concept of cross-collateralization. When a property serves as collateral for a loan, tenants holding leases on that property may find themselves affected if the property defaults or changes hands due to a loan transfer.

And that is exactly why tenants have to take such a close look at their landlord’s financials now.

Because roughly 1 in 3 office landlords are on the brink of default. So, even if one of your buildings isn't underwater, they may be tied to other under-performing properties in the landlord's portfolio as collateral. In a portfolio of 20+ or 50+ locations, any one of them can end up on a watchlist tomorrow. Corporate tenants need to be mindful. 

Because, in instances where property owners’ default on loans or banks inherits properties, tenants may encounter disruptions in services or property management. Potential consequences include maintenance issues, delayed responses to tenant requests, and overall deterioration in property conditions.

This highlights the imperative for tenants to conduct thorough due diligence on the financial stability of their landlords. By scrutinizing metrics such as Debt Service Coverage Ratio (DSCR), tenants can assess the capacity of property owners to fulfill their financial commitments and uphold the property to an optimal standard.

How to Survive the Office Apocalypse

It's crucial for tenants to exercise caution and be mindful of the the looming risk of landlord delinquency. The uncertainty in the market and the challenges faced by landlords introduce a level of risk for tenants.

It's essential to strike a balance between seizing the current opportunities and staying vigilant about the potential risks associated with the evolving dynamics of the real estate landscape. Because other than getting caught in the middle of a nasty lawsuit, you may experience a drop in services- that is, if your lease isn't contested to begin with.

But the truth is, that this discussion is only the tip of the iceberg when it comes to navigating this new office market. To fully arm yourself with the knowledge and strategies you need to thrive, we've compiled a comprehensive guide, Surviving the Office Apocalypse. 

Equip yourself with the insights and tactics necessary to navigate this terrain with confidence and efficiency.

Don't miss out on this opportunity to enhance your knowledge and position your business for success. Receive exclusive first access now.