Dusting Off an Old Playbook – April 8, 2024
Standard & Poor’s reported an increase in extending maturities on commercial mortgages. This type of loan modification may have kept mortgage delinquency rates from rising higher than they did the year prior.
“Our view is that extending maturities for loans with stable cash flows has helped keep trust expenses down and has prevented higher losses typically associated with property liquidations at distressed prices,” S&P credit analyst Larry Kay observed.
Those of you who know Larry Kay know that he has been a mainstay of securitized commercial mortgage analysis at Kroll Bond Rating Agency for a number of years now. The preceding intel came from an article that was published in early 2011, as the industry gradually emerged from the 2008 global financial crisis, but which is now startlingly relevant again.
Fast forward to 2024, and lenders are once again addressing a high volume of commercial real estate loan maturities by modifying the terms. CRED iQ said late last month that the number of modifications in 2023 more than doubled compared to 2022.
“Of the $162 billion in securitized commercial mortgages which matured in 2023, 542 loans were modified with cumulative balances just over $20 billion, which is a 150% increase from the amount of modifications that occurred in 2022,” the data, analytics and valuation firm reported.
According to CRED iQ’s 2024 CRE Maturity Outlook, 2024 will see $210 billion in securitized loan maturities. “CRED iQ predicts that the modification trend will continue to surge as more special servicers decide to ‘pretend and extend’ versus foreclose on these commercial properties,” wrote company founder Michael Haas.
That’s a page from the post-GFC playback. If memory serves, the phrase was inverted back in the day; then, the common refrain was “extend and pretend.” The sentiment, though, is exactly the same—extending a loan’s maturity to avoid recognizing a loss on that loan—although the circumstances today are quite different.
In the early 2010s, Trepp’s Vivek Denkanikotte wrote in March, “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. Lenders found themselves with no resale market for the properties they repossessed, leading to massive charge-offs on these assets.
“In response, the Federal Reserve aggressively cut rates to stimulate the broader economy and specifically encourage CRE transaction activity. 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.”
In contrast, the current environment has seen the Fed “aggressively” hike rates, wrote Denkanikotte. And while loan origination didn’t fall off a cliff between 2022 and 2023, as it did during the GFC, “the majority of the fixed-rate loans originated before 2022 carry interest rates in the 3–5% range, whereas current refinance rates for these loans hover between 6.5–10%, illustrating a substantial increase in the cost of capital. Higher borrowing costs, coupled with higher capitalization rates, precipitate a decline in property values, exacerbate loan-to-value ratios, and tighten debt service coverage ratio/debt yield constraints.
“Additionally, the looming maturity of a significant volume of loans through 2027 across all lender sources creates a sense of urgency. The availability of sophisticated capital on the sidelines, eagerly awaiting distressed sales opportunities, adds an additional layer of complexity to the extend and pretend strategy.”
Looking at the currently challenged office sector, CRED iQ reported that only 26% of the $35.8 billion of office CMBS loans that matured in 2023 actually paid off in full, as borrowers struggled to get refinancing or sell their properties. CRED iQ analyzed 593 office loans that transferred to the special servicer since February 2022. Out of these loans, approximately 13.7% were modified, 14.0% returned to the master servicer as corrected, 8.4% paid off and the remaining 63.9% are still in special servicing.
For the office sector in particular, Denkanikotte wrote, “the situation is particularly precarious, given the structural shifts in work habits and property valuation criteria. Lenders and borrowers alike must navigate these turbulent waters with a keen understanding of the broader economic impacts, innovative financing solutions, and a strategic approach to asset management and loan extensions.”