Lenders Wrestle With Extend and Pretend

During the global financial crisis, with a “severe lack of liquidity” in the market, lenders partook of an “extend and pretend” approach to avoid writing down assets on their balance sheets. What worked then is facing bigger problems today, especially in office, according to Trepp.

“The disruption caused by the ‘too big to fail’ institutions was of an unparalleled scale in recent history, resulting in a severe lack of liquidity in the market,” Trepp said. “Lenders found themselves with no resale market for the properties they repossessed, leading to massive charge-offs on these assets.”

But in the midst of chaos, the Federal Reserve sharply cut rates “to stimulate the broader economy and specifically encourage CRE transaction activity.” And it worked well in three ways. As Trepp wrote, “Lenders were motivated to collaborate with borrowers who were willing to fight for their properties, as extending CRE loans into a lower interest rate environment proved beneficial. This strategy offered a lower cost of capital and lower cap rates, consequently driving up property values.”

Additionally, investors could afford to acquire properties in a profitable way and owners could refinance to keep their properties. But the recovery might have only put off the problems for years. The CRE industry quickly became accustomed to low rates as well as high leverage.

The conditions were fine so long as they didn’t change. When the Fed realized it needed to fight inflation, it cranked up interest rates quickly, causing distress, falling valuations, and tighter capita.

“More bluntly speaking, no one wants to refinance from a 4% loan into a 7% loan; investors do not want to pay 7% to finance an acquisition; and even if they did, it’s debatable if the markets would finance the purchase given the general decline in property values and cautious underwriting [which has only gotten tighter] that’s resulted in lower leverage and higher debt yields for recent conduit issuance,” Trepp said.

The result was particularly bad for office, with older buildings facing “functional obsolescence” because modern workers expect more. “Moreover, the sector is burdened by over-leveraged properties, previously considered safe investments but now underwater due to decreased occupancy rates and lack of viable adaptive reuse options at scale.”

The result: office properties that have gone into special servicing face valuation losses of more than 50% and lenders with inadequate reserves “find themselves ill-prepared to absorb losses from this asset class across their portfolios.”

“The journey ahead demands a delicate balance between immediate financial pressures and long-term viability, with a clear-eyed recognition of the transformed landscape of CRE financing,” they concluded.