Two new phrases have entered the commercial real estate industry lexicon in recent months: "Pretend and extend" and "A rolling loan gathers no loss." Both witticisms describe an ongoing phenomenon in commercial real estate
finance: as the level of distress mounts, lenders have been loath to seize properties from troubled borrowers. Instead, in many cases banks are generously granting extensions or other modifications even in situations where it appears unlikely that borrowers will be able to pay back the loans.
From January through April of this year, the 20 largest banks in the country reported that modifications of existing loans outnumbered new commitments by approximately two to one. What's at work is that lenders are attempting to avoid recognizing write downs and losses on their commercial real estate loan books. Loans originated at the height of the market were done at near 100 percent loan-to-value ratios and underwritten with generous assumptions on increasing occupancies and rents. But in the past two years commercial real estate values have dropped considerably and fundamentals have weakened. Rents and occupancies are now dropping quickly, not rising. On top of everything, a major source of financing, the commercial mortgage-backed securities (CMBS) market, remains locked down.
Many banks hope that if they stave off foreclosure for a year or two, even if a distressed sale becomes inevitable, they will be able to recover more of their investment than they would if they sold right now. So lenders are playing a waiting game. Foreclosing on assets today means they would have to manage properties in a treacherous economic climate. The alternative would be to sell. But the investment sales scene is not encouraging. Distressed assets are trading at steep discounts to peak market prices.
If banks were to take back these assets now and try to sell them, they would fetch prices as much as 35 percent off pricing peaks. In May, the most recent month for which data are available, only $418 million in retail properties changed hands, representing a 12 percent decline in sales activity compared to April and a decline of 89 percent compared to May of 2007, the peak period for the investment sales market.
When a borrower does go into default and the bank takes over the property, the servicers are increasingly turning to receivers to take over the management of such properties and eventually attempt to sell them (a sale outside foreclosure also allows the lender to provide seller financing, rather than looking for an all-cash buyer) Meanwhile, banks and other traditional lenders want time to develop a long-term strategy for their real estate portfolios, as well as being reluctant to sell at the bottom of the market.
Lenders are not treating all borrowers equally, however. They are making distinctions based on the quality of borrowers and assets. In cases where properties boast healthy cash flows and owners with proven track records, lenders see little reason to foreclose. Why go through the tumult of a foreclosure and changing over day-to-day property management if the current management team is doing a good job? In these cases, the delinquencies are more the result of the poor financial climate than they are of mismanagement.
Market observers hope the current logjam will start to un-wind by the first quarter of 2010. If their predictions are on target, it will be another three to five years before all the bad commercial loans out there get resolved. But if lenders continue to postpone dealing with troubled assets, the resolution of this crisis might take as long as 10 years.
The good news is that in many cases, lenders are not simply extending the loans, they are trying to rework the terms in such a way that they don’t have to come back to the negotiating table six months or a year down the road. They are factoring in falling cash flows and the possibility of higher vacancies and lower rents. The bad news is that in a number of instances, banks may not be lowering those assumptions enough. Meanwhile, with banks unwilling to take
troubled assets to market, opportunistic investors continue to stay away from acquisitions and the process of price discovery in commercial real estate continues to be arduous.
finance: as the level of distress mounts, lenders have been loath to seize properties from troubled borrowers. Instead, in many cases banks are generously granting extensions or other modifications even in situations where it appears unlikely that borrowers will be able to pay back the loans.
From January through April of this year, the 20 largest banks in the country reported that modifications of existing loans outnumbered new commitments by approximately two to one. What's at work is that lenders are attempting to avoid recognizing write downs and losses on their commercial real estate loan books. Loans originated at the height of the market were done at near 100 percent loan-to-value ratios and underwritten with generous assumptions on increasing occupancies and rents. But in the past two years commercial real estate values have dropped considerably and fundamentals have weakened. Rents and occupancies are now dropping quickly, not rising. On top of everything, a major source of financing, the commercial mortgage-backed securities (CMBS) market, remains locked down.
Many banks hope that if they stave off foreclosure for a year or two, even if a distressed sale becomes inevitable, they will be able to recover more of their investment than they would if they sold right now. So lenders are playing a waiting game. Foreclosing on assets today means they would have to manage properties in a treacherous economic climate. The alternative would be to sell. But the investment sales scene is not encouraging. Distressed assets are trading at steep discounts to peak market prices.
If banks were to take back these assets now and try to sell them, they would fetch prices as much as 35 percent off pricing peaks. In May, the most recent month for which data are available, only $418 million in retail properties changed hands, representing a 12 percent decline in sales activity compared to April and a decline of 89 percent compared to May of 2007, the peak period for the investment sales market.
When a borrower does go into default and the bank takes over the property, the servicers are increasingly turning to receivers to take over the management of such properties and eventually attempt to sell them (a sale outside foreclosure also allows the lender to provide seller financing, rather than looking for an all-cash buyer) Meanwhile, banks and other traditional lenders want time to develop a long-term strategy for their real estate portfolios, as well as being reluctant to sell at the bottom of the market.
Lenders are not treating all borrowers equally, however. They are making distinctions based on the quality of borrowers and assets. In cases where properties boast healthy cash flows and owners with proven track records, lenders see little reason to foreclose. Why go through the tumult of a foreclosure and changing over day-to-day property management if the current management team is doing a good job? In these cases, the delinquencies are more the result of the poor financial climate than they are of mismanagement.
Market observers hope the current logjam will start to un-wind by the first quarter of 2010. If their predictions are on target, it will be another three to five years before all the bad commercial loans out there get resolved. But if lenders continue to postpone dealing with troubled assets, the resolution of this crisis might take as long as 10 years.
The good news is that in many cases, lenders are not simply extending the loans, they are trying to rework the terms in such a way that they don’t have to come back to the negotiating table six months or a year down the road. They are factoring in falling cash flows and the possibility of higher vacancies and lower rents. The bad news is that in a number of instances, banks may not be lowering those assumptions enough. Meanwhile, with banks unwilling to take
troubled assets to market, opportunistic investors continue to stay away from acquisitions and the process of price discovery in commercial real estate continues to be arduous.
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