The end of ‘extend and pretend’? Banks quietly dump commercial real estate loans

America's largest banks are quietly unwinding their commercial real estate (CRE) loans over fears that struggling office owners won’t be able to pay their mortgages.

As The New York Times reported, institutions like Goldman Sachs, Deutsche Bank, and CIBC have collectively sold hundreds of millions of dollars worth of office mortgages since late last year.

Although the sales are a drop in the bucket compared to the $2.5 trillion in total CRE loans held by U.S. banks, experts warn that it could be a sign of things to come.

“What you are seeing right now are one-offs,” said Nathan Stovall, a director of financial research at S&P Global Markets Intelligence. But those one-offs could mushroom into something bigger because “banks are looking to shrink exposures” to CRE, he said.

“The banks know they have too many loans on their books,” said Jay Neveloff, a real estate lawyer at Kramer Levin.

In banking, a common practice with commercial real estate loans is to “extend and pretend.” Put another way, banks simply extend mortgages to give office owners more time to attract new tenants.

But with office vacancies at record highs and mortgage rates above 6%, office owners could find it harder to manage their loans once it’s time to refinance.

Lenders see the writing on the wall and don’t have the appetite to “extend and pretend” anymore.

Until recently, much of the fear in the CRE lending market was concentrated in smaller banks, which are less capitalized and have massive exposure to office loans.

But with a deepening slump in commercial real estate, larger banks are no longer immune.

The risk is bigger than it looks

With $1.6 trillion worth of CRE loans due to mature over the next two years, some of America’s largest banks are on the hook for substantial losses.

Researchers at Florida Atlantic University found that 67 large banks had CRE exposure greater than 300% of their total equity. A “large” bank is any financial institution with more than $10 billion in assets.

By comparison, the industry average for CRE loan exposure was 139% of total equity.

“This is a very serious development for our banking system as commercial real estate loans are repricing in a high interest-rate environment,” said Rebel Cole, a professor of finance at Florida Atlantic’s College of Business.

With commercial properties selling at steep discounts since Covid, “banks are going to be forced by regulators to write down those exposures,” Cole said.

It’s difficult to measure exactly how much value commercial properties have lost in recent years.

According to Fred Cordova, the owner of commercial real estate advisory Corion Enterprises, 30% of U.S. office space is “basically worth nothing.”

Meanwhile, billionaire Starwood Capital CEO Barry Sternlicht estimated the CRE market has about $1.2 trillion of losses “spread somewhere.” The problem is “nobody knows exactly where it is.”

As Creditnews reported, the U.S. had nearly 1 billion square feet of empty office space at the end of last year, which was the highest on record.

At the same time, the construction pipeline for new office buildings recently fell to an 11-year low.