There is a worrisome new trend in today's markets. It’s called "Pretend and Extend," and it’s becoming a strong concern throughout the commercial real estate industry.
“Pretend and Extend is a practice by lenders of extending a loan to de facto forbearing a default because they don’t want to deal with the problem,” Chris Grey, a managing partner with the Los Angeles-based real estate advisory firm Third Wave Partners, says. “This usually happens so that the lender can avoid writing down the loan or foreclosing and writing down the asset.”
The New York research firm Real Capital Analytics found that in late July, $93 billion in U.S. office, industrial, retail, and apartment real estate was in default, foreclosure, or bankruptcy, with the specter of troubled hotels and other commercial property types adding $31 billion or more to that total.
The RCA report found that less than one in ten distressed situations have been resolved – an indicator that Pretend and Extend may be taking a stronghold in the real estate world.
Grey says it’s already widespread throughout the industry.
“There are too many cases to really single out a couple of them,” he says. “This practice is not isolated. It is the norm. Most lenders are doing it with most loans if they can get away with it, and regulators are not really trying to get lenders to deal with the problems either. I think the bigger, stronger banks (such as Wells Fargo and JP Morgan) are generally being tougher (on defaulted loans) than the smaller, weaker banks.”
According to the RCA report, loans originated in 2007 were overall the most troublesome for borrowers, though those taken out this year reflect the highest default levels and those originated between 2004 and 2006 are projected to remain problematic as they mature over the coming years. The firm also found that a good deal of the equity in the $1.3 trillion in properties purchased or refinanced between 2006 and 2008 is at risk of losing value entirely.
Grey says Pretend and Extend will help with none of this.
“The current path we're on will not lead to a real economic recovery,” he says. “The economy may enjoy a short-term bounce related to a massive government stimulus and money printing from the Fed, but this will not last. Japan has been doing exactly this for twenty years and their economy has experienced the slowest growth of any major economy in the world during that time.”
Moreover, he believes the tendency to Pretend and Extend destroys industry transparency and prevents the market from correcting itself.
“What needs to happen for the market to improve is that lenders need to deal with their problem assets and either work them out or liquidate them to real market buyers,” he says. “Until this happens, we are stuck in the vicious cycle of denial and stagnation that Japan experienced in the 1990's.”
Far from legislators working to correct the practice, Grey sees institutional encouragement of it.
“Regulators and the government are facilitating and supportive of this practice,” he says. “There is not legislation or even regulatory talk about stopping it as far as I know. The government is partnered with the large banks to prop up asset values, and this is one way to do it.”
He foresees smaller banks being shut down in order for the larger banks to gain market share and assets – and no end in sight for Pretend and Extend: “Basically, there will be selective enforcement of capital adequacy rules and loan markdowns based on whether or not you're a big, politically connected bank or a small, insignificant bank.”