In real estate, there exists a strategy known as extend and pretend. It refers to a practice where loans are extended and losses are deferred, all to maintain the façade of stability and prosperity. However, this once popular and seemingly effective approach is now standing on the precipice of collapse. The cracks in its foundation are becoming increasingly apparent, and the consequences of it loom ominously overhead. Nowhere is this truer than in the New York City multifamily marketplace. Four years ago, the business included 3 caps, cheap debt, generous assumptions, loose underwriting, and little government oversight. Fast forward through HSTPA, COVID, rising rates and overcharge exposure, and we are in a remarkably different business atmosphere.
Let’s discuss why the extend and pretend strategy will not work through the current cycle.
The extend and pretend strategy gained prominence in the aftermath of the 2008 financial crisis and subsequent economic downturn. Faced with the harsh realities of a struggling real estate market, investors and lenders clung to the hope that they could buy time and pretend that everything was fine. By postponing the recognition of losses and engaging in accounting tricks, they sought to weather the storm without inflicting significant damage to their balance sheets. This worked especially well in New York City. If you held onto your assets for a short window of pain from 2009-2011, you did exceedingly well in 2012 and beyond.
The second example of extend and pretend happened in 2020 during the COVID pandemic. Protected by eviction moratoriums and a barbaric legal system, rent stabilized tenants in essence had the government’s blessing to stop paying the rent. Market rate tenants fled to other locations and rents dropped overnight. In 2020 New York lenders extended and pretended on expiring loans or borrowers facing hardship. Loan restructurings were prevalent to get through the unprecedented environment. This mostly worked in 2020, and in 2021 when the federal funds rate dropped to zero, values surged, and lenders were either refinanced out or the property was sold. Crisis averted.
That’s two strikes. Enter the MLB pitch clock and we quickly get to strike three in 2023.
The first factor contributing to the inevitable demise of the extend and pretend strategy is the mounting pressure exerted by policymakers. Stricter regulations and enhanced oversight are being implemented in a misguided approach to preserve affordability. The environment that allowed investors and lenders to flourish is rapidly closing.
In addition to regulatory pressure, shifting market dynamics are also hastening the demise of the extend and pretend strategy. The global COVID-19 pandemic has wreaked havoc on economies, fundamentally altering the ways in which we live, work, and conduct business. Remote work has prompted a reassessment of the necessity for traditional commercial office spaces, while the surge in e-commerce has significantly impacted the demand for retail properties. These seismic shifts have laid bare the vulnerabilities inherent in the extend and pretend strategy as it becomes increasingly difficult to justify inflated property valuations and maintain the illusion of perpetual growth.
Furthermore, investors and lenders, scarred by the experience of the previous crisis, are becoming inherently more risk-averse in the face of uncertainty. The memory of the financial meltdown remains fresh in their minds, and they are now far less willing to turn a blind eye to potential red flags or warning signs. Consequently, the tolerance for extending loans, disregarding underlying problems, and perpetuating the extend and pretend mindset is steadily diminishing. Investors are demanding higher yield and lower risk putting further pressure on a cataclysmic event. Something must happen because there doesn’t appear to be any more moves in the extend and pretend chess match. Here we are in the dead of summer, and it feels like we’re in a stalemate. A game of chicken between borrower and lender. Lenders don’t want the keys and borrowers don’t want to write checks to refinance dead deals.
There is, however, one glimmer of hope. The FDIC has recently published a new interagency policy statement on prudent commercial real estate loan accommodations and workouts. In a nutshell the government is acknowledging hardship and willing to be lenient on his regulatory oversight. They are giving lenders permission to reclassify and modify loans if it’s in the interest of both parties, and the bank can justify a repayment with said borrower. This policy is a continuation of their acknowledgment statement from 2009. This loosening of the reigns is a good thing for the overall health of our industry, however for workouts and extensions to happen you still need two parties to agree on the terms of the transaction. Who better to tell you how hard this is than an investment sales broker!
At no point in history has the market been so nuanced. Lenders and borrowers will surely have to face the music and suffer some losses, but the government has offered a pathway out. The deals that find a way to get extended and pretended will be deal and borrower specific. Some borrowers will be afforded better treatment than others based on their liquidity and relationships. These same borrowers may be able to extend and pretend on some loans but have to take significant losses on others. As we say in the business…every deal is different!
