The underlying crisis in commercial real estate is growing below the radar. The new mantra for lenders is extend, amend and pretend. Why extend and pretend? Let’s look at recent history. In 2007, the Commercial Mortgage Backed Securities Market generated over $270 billion in loans. In 2008, the commercial real estate securitization market was less than $30 billion (11% of the previous year). In 2009, activity as of July is just $21.8 billion (Source: Commercial Mortgage Alert). Life insurance companies have also slashed their funding allocations to less that 20% of their 2006/2007 levels.

This lack of liquidity in commercial real estate is further exacerbated by the state of the economy. As job losses continue, demand for office space declines, retailers are under stress as consumers cut back, warehousing and manufacturing space requirements are less and the residential sector for both rental and for-sale housing consolidates.

Loans that just two or three years ago were underwritten at 80% of the then current value are in trouble; today that value is down 25% to 40% and the loan proceeds available against today’s lower value much less at 50% to 60% loan to today’s value. Do lenders wish to foreclose, own and operate properties as loans mature? Not in this market.

Borrowers and lenders are facing a double edged sword. Pressure on rents (top line) and income (bottom line) is coupled with the pressure on the properties to service existing debt and the inability to replace that debt level when it comes due. The solution thus far has been extend, amend and pretend. Extending the loan, and amending its payment terms, takes the pressure of the impending maturity date away, and allows all involved to pretend that all is ok. The loan remains performing.

How do things look better? The loan debt service coverage ratio is defined as Net Operating Income/Debt Service Payments. Market forces and the borrower dictate the numerator of DSCR, while the lender controls the denominator. The lender may extend the loan then: A) reduce the amortization (loan reduction every month) required on the loans or eliminate loan reduction completely by accepting just interest only payments, or B) adjusting the rates from a higher fixed to a now low level floating rate. Once A and/or B are accomplished and the loan is extended, the loan metrics look much improved. DSCR rises or is maintained. The loan remains performing and less subject to regulator scrutiny.

By pushing off to the future loan pay down and maturity, and moving to a floating or low short term rates now, the DSCR rises and the optics for the loan look better today (this is similar to the theatrics ongoing in Washington with the federal budget, but we will save that discussion for another day; kind of an extend and pretend scenario in itself for Congress; push the day of reckoning to the future).

Will this approach work for lenders? Maybe. By postponing loan pay downs (amortization) the lender is hoping that: A) the economy improves, B) top line income rises as demand for all real estate increases and C) liquidity returns to the real estate finance market. If the current–or proposed–government stimulus works (although we have seen few signs other than reduction of systemic risk), demand for all types of goods and services and thus real estate could rise, liquidity may return to the finance market and everything will be rosy.

Or maybe the extend, amend and pretend strategy will bring with it more challenges. What could go wrong? Interest rates could rise as demand for billions in new treasury debt wanes. Interest rates may have to rise on bonds to attract purchasers. Or rising rates could infer that inflation is rising. Inflation is good for real estate owners if they have fixed rate debt. They can repay the debt with inflated dollars easier. But what if the borrowers have moved to floating rate debt (as suggested above), rates rise and pressure increases on the property, borrower and lender as DSCR drops.

Or we could enter a period of stagflation. Prices rise. Rates rise; yet demand is lackluster. Demand for office, retail warehouse/industrial and residential real estate remains weak.

The past year’s financial turmoil has left institutions searching for a solution. The shock to the economy and real estate markets has occurred rapidly. Extend, amend and pretend seems to be an interim solution until stability in the system is realized. Several stronger lenders are admitting their losses, taking the hits and preparing for the future. As noted in the July 20, 2009 Wall Street Journal, the big banks are being aggressive in taking chargeoffs and addressing potential problems, while the smaller banks appear to be less aggressive in recognizing losses. Smaller institutions seem to believe the extend, amend and pretend approach is best. Time will tell.

Commercial mortgage bankers are today working feverishly to deliver solutions to their clients. Liquidity is strong in the multifamily market, with government sponsored entities Fannie, Freddie and HUD as active participants. As a result of this liquidity, multifamily values have not been as severely impacted as other real estate. Hopefully, this reset in the economy means that the real estate market has begun to bottom. One promising sign is that several insurance companies and regional banks are increasing their activity with new originations.

Which way will this all shake out? Strap in and stay tuned. The commercial real estate market is in for continued stress and certainly some changes. But bear in mind that change creates opportunity.

Mark Scott is senior vice president and co-managing director of NorthMarq Capital in Parsippany. He can be reached at [email protected]. The views expressed here are the author’s own.

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