The controversial practice of “extend and pretend,” in which regulators grant banks and other lenders wide latitude to extend performing loans while avoiding sharp write-downs in value that could otherwise result from marking performing loans to market, is on its way out, according to a new analysis by CB Richard Ellis Econometric Advisors.

But the exit won’t be swift, according to a draft chapter from CBRE’s forthcoming Annual Trends 2011 report. “This process will not end with any fanfare but will fade away as markets recover.” The policy of extending loans whose supporting properties have lost value is a way to nurse an asset back to financial health, the authors report. “Some would argue the patient should be left to pass and the funds tied up in this asset should be used for a new venture to move the economy forward.”

The commercial real estate debt markets’ recovery has been hampered by a lag in the performance of commercial property fundamentals, posing challenges to lenders who want to underwrite deals with complex leasing issues, according to the analysts. Until property fundamentals improve and values become clearer, lenders’ focus is likely to remain on providing debt for the highest quality and best-leased properties in healthy markets.

As a result, a two-tiered commercial real estate debt market has emerged with favorable lending terms for the best properties and growing property fundamental and borrower distress for lagging markets. That pattern is likely to continue in 2011, according to the report.

Ongoing de-leveraging and write-downs of distressed loans, corresponding with a set of lower property incomes and values, will overshadow improvement in commercial lending markets, the Advisors assert.

Lenders play “hard-ball”
More than $200 billion in commercial real estate loans is expected to mature in 2011, the report notes. But a gap exists among refinancing needs, capital availability and property values. While commercial real estate debt outstanding has contracted by some $170 billion or 5% since late 2008, more debt will likely be written down in order to bring debt levels into line with lower values and overall economic activity.

As for the policy of “extend and pretend” that has persisted over the past 18 months, the strategy has played out well given the general rise in asset values, but some lenders are beginning to play “hard-ball” with borrowers as lender balance sheets start to heal and lenders are in better positions to absorb potential losses, according to the analysts.

New loan origination activity remains at near historically low levels, but there are signs that lending markets are gaining momentum, reflecting an increase in the number of core as well as distressed transactions coming to market.

Major banks have been aggressive in shedding their real estate construction and development loans, which have seen a sharp spike in delinquencies during the past year. Delinquencies on the loans topped 16% in the second quarter of 2010, the highest rate on record, according to the report.

Delinquencies offer distress opportunities
Distressed asset investors can expect a moderate flow of opportunities stemming from the expected rise in 2011 of banks’ commercial loan delinquencies and CMBS delinquencies. Banks will continue to struggle with resolving short-term floating rate and construction loan debt. Meanwhile, CMBS servicers will watch the nearly $50 billion of loans scheduled to mature, a large chunk of which are highly-leveraged, five-year interest-only loans issued in 2006.

However, life insurance company loans have shown a strong credit performance, despite the “economic carnage” of the past two years, according to CBRE’s analysts. Life companies’ stronger credit performance has positioned them to compete with a variety of lenders over the next year.

For borrowers who are about to make buys or reset deal capital structures to lock-in low mortgage rates, 2011 may provide a great opportunity. Lenders are expected to gradually take on more risk in the deals they underwrite, and to cast a wider net, according to the authors.

Through most of 2010, lenders have been focused on trophy and other high-quality deals in primary markets. But his year, if the analysis bears out, expect lenders to gradually seek more opportunities in secondary markets as real estate markets improve.