Commercial real estate lenders, faced with a $1.9 trillion maturity wall over the next three years, are looking at what is being called a “blend and extend” strategy in which a lender will adjust the interest rate on a loan and ask a sponsor for additional collateral in exchange for a short-term modification.
The blend and extend strategy is intended to give sponsors who have strong properties with near-term debt maturities time to execute a business plan or simply wait for interest rates to moderate. It also keeps lenders from having to take back the keys to properties – something most do not want to do, said John Vavas, a shareholder in the New York office of national law firm Polsinelli.
“It’s a way for the lender and the borrower to keep the loan current for another year or two,” Vavas said. “The lender says, ‘I’m going to blend your rate up, you’re going to put a few extra dollars in as a reserve to cover me for interest shortfalls and we will extend the maturity for two years. The rate won’t be the rate we could get in today’s market, and we’ll charge you a modification fee and then put it all into a blender and extend the loan.’”
Blend and extend is the latest iteration of the “extend and pretend” strategy frequently seen in the wake of the Global Financial Crisis and comes against a backdrop in which commercial real estate debt origination activity has dropped by 52 percent year-over-year, per a late August report from New York-based advisory Newmark. The firm also found that there are 32 percent fewer lenders active in the market than there were during the same period in 2022.
All of this means there needs to be greater innovation and creativity in the capital stack, Vavas said. “There is more equity coming into deals, preferred equity coming into deals in order to get the capital stack to balance out,” he added.
Preferred option
Berkadia’s national JV Equity & Structured Capital team has been seeing a significant use of preferred equity to bridge the gap between sponsor equity and senior mortgages, both for new loans and refinancings, said Cody Kirkpatrick, a Denver-based managing director and founder of the firm’s JV Equity & Structured Capital Group.
“The structural change we are seeing in the debt markets means lower leverage or constrained permanent takeouts on bridge or construction loans,” Kirkpatrick said. “It is a ‘live to fight another day’ mentality.”
In addition to lower leverage and a reduced supply of lenders, lower volume in the transaction market has made it hard for sponsors to move ahead with sales – even with maturities pending.
“When you have a term date for the end of your loans, you only have a couple of options. The sponsor could take the property to market, but it could be a sub-optimal time to sell,” Kirkpatrick said. “There is also a more macro capital markets view that things could be better in a year so if the sponsor can buy more time, things will be better for everyone.”
Kirkpatrick estimated that sponsors are putting in roughly double the amount of equity as they did during earlier parts of the current cycle. “Over time, this will erode IRRs and multiples,” he added.
While pricing has widened in recent weeks for preferred equity, Kirkpatrick noted it is not meant to be a long-term part of a commercial real estate capital stack. “It allows you to shrink your common equity contribution or fill out the capital stack, get the building built or stable and then have some capital event,” he adds.
This push toward preferred equity is likely to continue as sponsors seek to refinance about $728 billion of loans this year and $659 billion and $539 billion of loans in 2024 and 2025, respectively, per data from the Mortgage Bankers Association and Newmark.
Focus on office
CWCapital, a Washington, DC-based asset manager and special servicer, is working through extensions and modifications every day, said Alex Killick, an asset manager. Specifically, the firm is seeing the most distress in the office sector, although there is a bit of multifamily emerging and Killick notes a commensurate pullback in office lending has made it more difficult for sponsors with a maturing office loan in a commercial mortgage-backed securities deal to line up new financing.
“Lending for the office sector has become extremely conservative. What we keep hearing from borrowers is that they went to 15 or 20 lenders and were told, ‘No,’ or only at a very low [loan to value] that would not pay off an existing loan,” Killick said. “As loans mature, they will have a hard time paying off like they normally would.”
CWCapital is tracking a substantial number of extensions, particularly for lenders who are less willing to take back properties.
“Smaller banks, for example, are doing a lot of extensions,” Killick said. “One thing to remember is that office properties generally come with good long-term credit tenant leases. There are very few tenant-rent defaults where companies go out of business and stop paying. If you’ve lost your largest tenants as your loan is maturing, that is a different conversation. But when there is cash flow to work with, that is when loans can get done.”
As an asset manager, CWCapital wants to see new equity, a partial paydown or other enhancements in a deal before granting an extension.
“We want to see some demonstration of commitment, and something being put at risk,” Killick said. “So far, we have been getting that done. We have done some large extensions for Republic Plaza in Denver and 515 Madison Avenue in New York, for example.”
What has helped sponsors so far with extensions, however, has been that reported values have held up. “That has started to crack and we’re starting to see sales get done and those numbers printed and those are significant drops. Whether the base of borrowers will continue to contribute new equity, if they perceive the asset is not worth the debt today, that is the new question. When everything was appraising close where it used to be, it is easy to say, ‘Let’s ride this out.’ But if there are widespread sales and comps that are half of what your debt is, it could be harder to get approval from investors to put in new equity.”
Killick points out: “If you start to see major basis resets there, it could make it harder to grant extensions and it is between now and year-end when that data will start to come through.”
Outlook
Deal flow and transaction volume are down, which is not a surprise to any market participants, Vavas said.
“People have capital and are ready to deploy it. Deals are just hard to pencil out and I’m seeing with my clients – lower-leverage life insurance style companies to higher-yielding debt funds who do more opportunistic investing – deals are just harder to win,” Vavas said.
At the same time, there is a record amount of dry capital ready to be deployed, with Newmark estimating that there is about $261 billion of debt and equity capital on the sidelines.
“There are more people who have capital to put out, people are stretching more than usual, and they’re looking at the traditional underwriting metrics and saying, ‘I can’t get to the proceeds you’re looking for when you look at rising insurance and tax costs and a higher interest rate environment.’ This all means that right now deals just aren’t getting done,” Vavas.
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