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The Big Commercial Real Estate Bet

Douglas Lazovick
2 min read

Physically, commercial real estate can be located right next door to a residential property. However, when it comes to working through distress, the two might as well be on different planets.

It seems like you can’t turn on the TV,  surf the internet or open the paper without hearing about the number of residential foreclosures . There’s so many happening, a new word called “robo-signers” has entered our lexicon. But in commercial real estate (CRE), the opposite is true. There’s still plenty of distress, but foreclosures aren’t happening at the same pace. So, why the dichotomy?

Unlike residential, a lot of the distress in the commercial real estate (CRE) market is from loans coming due. In fact, $1.7 trillion in CRE loans are coming due between 2010 and 2014. Many of these loans are under water making it nearly impossible for the borrower to obtain new debt. Without the ability for the borrower to pay off the loan, the lender is faced with the decision to either foreclose on the asset or extend the loan maturity by a year (sometimes more). In many cases, the lender has opted for the latter in hopes that the market rebounds. This strategy the banks are using has often been referred to by critics as “extend and pretend.”

Distress in CRE though extends beyond loan maturities. There is softness in renting / leasing across all product types – making it nearly impossible for some borrowers to service their debt. Again, rather than foreclose, in many instances lenders have not only extended maturities, but have also modified loan terms (often reducing interest rates and /or making the loan interest only). This strategy has often been referred to as “amend and extend.”

Why the leniency? Because CRE  is a business.

With residential, the lender forecloses and ends up selling the home fairly quickly because they have little control over the major factors effecting value – namely supply, demand and financing. With CRE though, values are strongly based upon profits and losses. If the bank forecloses, with CRE vacancies high across the board, it might not make sense to market immediately. Rather, to optimize value, it would makes sense to increase occupancy before bringing to market. In other words, they’re stuck running a business. Given the choice of having to run the property themselves (or selling now at a loss), or seeing if they can work out a solution with the current borrower / operator, once again, the banks often chooses the later.

Furthermore, “amend and extend” and “extend and pretend” allows banks to classify  CRE loan as “performing.” This ultimately frees up capital that the banks would’ve otherwise had to hold as reserves against future losses. In addition, it delays banks from having to write-off the losses loans.

In the last week alone, there were two high profile CRE debt restructures / loan modifications: A $2.7 billion Beacon Capital CBMS loan and  $7 billion in Blackstone debt. In the coming months, I think there will be a few more high profile debt restructures as well a bunch of others that don’t make the front page. These policies being implemented by banks will continue to slowdown foreclosures, and more or less, is a bet that the fortunes of CRE will improve. Recent momentum and CRE outlook studies seem to suggest that this bet may ultimately pay off.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.