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Q1 2024 Market Commentary

April 26, 2024

Extend and Pretend: Part Deux

by Timothy J. Videnka, CFA, CFP®

“Trees don’t grow to the sky” – German Proverb

As interest rates have risen over the course of the last 24 months and the likelihood of interest rate cuts in 2024 has decreased considerably, one of the more interest rate sensitive sectors of the economy has been showing signs of stress. Before the Fed began raising interest rates, commercial real estate’s reliance on low-cost financing was a boon for that sector and real estate in general. Naturally, low interest rates tend to make borrowing cheaper for investors and developers. This can stimulate demand for commercial properties as investors seek higher returns compared to other lower-yielding investments. It wasn’t that long ago when money market rates were near zero. Thus, lower financing costs tend to encourage developers to undertake new projects, leading to increased construction activity and expanded supply in the market.

Moreover, low interest rates bolstered property values. When financing costs are low, investors may be more willing to pay up for properties, leading to higher property values. This is a great example of Finance 101 in action. When you have a series of future cash flows from an investment (i.e., rent from real estate, earnings from a common stock, coupon payments from a bond) and you discount those future cash flows at a lower interest rate (discounted rate), this gives you higher present values of the asset that is generating those cash flows. This present value mechanism is agnostic to the asset that is producing the cash flows. In the chart below from Alpine Macro, we can see the historical interaction between exchange traded Real Estate Investment Trusts (REITS) and the 10-year U.S. Treasury from 2000 to 2013, when rates fell, and from 2014 to the present, when rates rose.

As with any specific asset or asset class, there are nuances to the valuation exercise. Within real estate circles, a property’s net operating income divided by its market value is known as the property’s capitalization rate, or cap rate. This is similar to a common stock’s dividend yield or the yield on a bond. Yet, in the real estate realm, the basic tenet of Finance 101 still holds. Ceteris paribus (all else being equal), a lower cap rate denotes higher property values, while a higher cap rate portends lower property values.

But what happens when the cap rate is below the rate at which a property’s loan can be refinanced?

Enter Extend and Pretend.

“Extend and pretend” refers to a strategy employed by lenders to avoid recognizing losses on loans that are unlikely to be fully repaid. This colorful euphemism, by our calculations, was last prevalent during the Great Financial Crisis of 2007-09.

Here are the mechanics of this strategy: Instead of demanding immediate repayment or declaring the loan as non-performing, the lender extends the term of the loan, giving the borrower more time to repay. This extension often comes with revised terms, such as lower interest rates or smaller payments. The lender pretends that the loan is still performing well on their books, even though the borrower may be struggling to make payments or the collateral securing the loan may have depreciated significantly. By doing this, the lender avoids having to mark down the value of the loan as a loss on their balance sheet.

The purpose of “extend and pretend” is to prevent a sudden influx of bad loans from negatively impacting the lender’s financial health. Instead of facing the full extent of losses immediately, the lender hopes that – by giving borrowers more time to recover or by waiting for economic conditions to improve – they may eventually be able to recoup more of the loan amount.

However, while this strategy can help mitigate short-term losses and maintain stability in the financial system during times of distress, it can also prolong the resolution of underlying problems and delay necessary adjustments. In some cases, it may even exacerbate the problem by allowing unsustainable debt burdens to continue growing.

Below are some recent headlines detailing the types of adjustments that take place when the extend and pretend strategy doesn’t work:

As you can see, when adjustments take place, the changes in value of both the building and the loan can be eye-opening, mainly because of the leverage involved.

Conclusion

In closing, the commercial real estate revaluation and subsequent adjustments to loans or sale prices of properties are a reminder of the impact of interest rates on any investment that generates cash flow. As some banks are major holders of commercial real estate loans, the impact on their earnings will need to monitored closely for its translation into the willingness and ability of banks to supply credit to the overall economy. Stay tuned!