The new tax rules handed down by the Treasury Department in mid-September are prompting more lenders to employ already-popular “extend and pretend” and “delay and pray” strategies.
These darkly comic catchphrases, of course, are used to describe the practice of extending the maturity on troubled loans rather than working out a deal that would reveal just how little the debt is now worth. Those who follow commercial real estate say the federal government’s new regulations — which were designed to help facilitate the modification process for troubled securitized loans — give loan servicers greater leeway to extend loans.
Attorneys and advisors with experience working on troubled loans say they have seen a big increase in “extend and pretend” transactions this year across various asset classes. They forecast more such deals, thanks to two favorable trends — the new accounting rules and low interest rates.
“Our view is that this condition [of rampant extensions] is going to continue for a while — the alternative is for lenders to decide they have to recognize losses,” said Paul Fried, managing director at advisory firm Traxi.
Real estate experts were wary of predicting how long the extension trend will last, given the complexity of the economic meltdown — and also of these real estate transactions, which have multiple players in the capital stack.
However, experts agree that interest rates are the key factor to watch.
“With what the government is doing in various programs and [the fact that they are] keeping interest rates low … I expect we are going to continue with all these buzzwords: ‘kick can down the road’ or ‘extend and pretend,’” said Lawrence Longua, a director at the REIT Center at NYU’s Schack Institute of Real Estate. “I don’t see that anything other than an increase in interest rates, where it is costing the banks more money to carry these assets, is going to force [banks] into [giving them] attention.”
As The Real Deal reported on its Web site last month, the new rules issued by the Internal Revenue Service give special servicers broader leeway to alter loans in CMBS pools. Previously, servicers could not modify loans until they were in default or at “imminent risk” of defaulting.
Now, the time frame for imminent risk has been lengthened to a year from about three months, according to an analysis by Chicago-based law firm Seyfarth Shaw. But just like in football, each “extend and pretend” play is executed differently. On the whole, though, those familiar with these deals said extensions typically range from 90 days to 12 months.
Both bank loans and CMBS are getting extensions, sources said.
Borrowers typically have to pay a fee, ranging from a quarter of a point to a point, for their extensions. Personal relationships are a big factor in clinching deals, with developers who have earned lenders’ confidence winning extensions where others might not.
“Each transaction is being dealt with on a case-by-case basis,” said Paul Shapses, partner at law firm Herrick Feinstein. “Sometimes the lender will require more equity … others get extensions where management is not in question.”
Lenders don’t want to grant long extensions to troubled loans. The objective is simply to push the problem off until the next quarter or calendar year, in hopes that a stronger economic climate or healthier balance sheet will lessen the pain of a write-down, foreclosure or other headaches that may come.
“A lot of people have rolled problems into 2010,” said Cliff Risman, chair of the hospitality industry team at the law firm of Gardere Wynne Sewell, who said his firm has done at least as many “extend and pretend” transactions this year as workouts.
As worries mount over commercial real estate maturities nationwide next year, New York City faces 209 CMBS loans worth over $7 billion coming due in 2010, according to Trepp. Most of these loans appear current, and it’s unclear how many of the borrowers will seek extensions.
However, bruised bank balance sheets and a freeze on investment capital make refinancing extremely difficult, even for borrowers who are up-to-date on payments.
The commercial real estate outlook was further dampened by the Federal Reserve throwing cold water last month on notions that banks’ commercial real estate portfolios might be improving as lenders slowly work through bad debts. In a statement first reported in the Wall Street Journal, the Fed made an informal comment in a presentation that banks “will be slow to recognize the severity of the loss — just as they were in residential.”
Many observers worry that “extend and pretend,” while helpful to banks and borrowers in the short run, will only exacerbate the industry’s long-term problems.
“That ability to continue to extend is allowing developers to hold on and holders of debt not to have to recognize losses, but at same time it is essentially preventing the resolution of these issues that exist and aren’t going away,” said Scott Singer, executive vice president of real estate finance and consulting firm Singer & Bassuk.
Other potential fallout from “extend and pretend” includes bondholders angry about not getting paid on the date they expected, and borrowers who might try to force a modification with servicers now that the rules have changed — and blame the servicer for the default if they won’t cut a deal.
Given the economic storm of bad debts, weak banks, soaring unemployment and slumping spending by the consumers who drive 70 percent of U.S. economic activity, sources said the lack of fresh capital that underlies the extensions could linger for years.
“There is not a chance we are on track for banks to emerge in a year or two and start any kind of robust lending,” said Traxi’s Fried. “We can throw around phrases like ‘extend and pretend,’ but nobody is really pretending this issue is going to go away: At some point new capital will have to come in.”