Three present values and one division turn "extend and pretend" into a decision a credit committee can actually vote on.
An extension beats enforcement when the probability that the business plan succeeds is above the break-even probability: (enforcement value today − extension value if it fails) ÷ (extension value if it succeeds − extension value if it fails). On a €25.0M loan against a €21.0M office, enforcing now is worth 62.9 cents, a successful three-year extension 89.2 and a failed one 53.6, so the extension wins whenever its chance of success is above 26.1 per cent. That number, not the par amount the extension promises, is what a credit committee should vote on.
Worked in full in The Real Estate Workout by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Lenders call the bad version of this trade "extend and pretend": the maturity moves, the loan stays on the books at par and nobody prices the alternative. The good version is the same decision with both branches discounted to today. It takes three present values and one division.
| Input | Value |
|---|---|
| Loan outstanding | 25.00 |
| Market value of the office today | 21.00 |
| Forced-sale discount in enforcement | 15.0% |
| Enforcement and sale costs | 3.0% |
| Time from enforcement to cash | 1.25 years |
| Lender's discount rate | 8.0% |
| Extension term, contract coupon | 3 years, 5.5% |
| Income paid to the lender: plan succeeds / fails | 1.26 / 1.05 |
| Value in year 3: plan succeeds / fails | 24.50 / 18.00 |
| Sale costs on a consensual exit | 2.0% |
The lender's cash during the extension is capped at what the building earns. The contract coupon is 1.375 a year, the income 1.26, and the 0.115 shortfall is added to the balance rather than paid, which is how most restructured loans actually run. For simplicity, both enforcement legs ignore the net income a receiver collects while the sale is prepared; counting it raises the value of enforcing more than the value of extending, so it pushes the break-even probability up, not down.
Break-even probability p* = (E − F) ÷ (S − F)
E is enforcement today, S the extension if the plan works, F the extension if it fails, all present values at the lender's discount rate. In Excel, with the three values in B1:B3: =(B1-B3)/(B2-B3). Each branch is built with =PV(8%,3,-Income) plus the discounted exit.
1. Enforce now. Net proceeds are 21.00 × (1 − 15%) × (1 − 3%) = 17.31, received in 1.25 years. The discount factor is 1.08−1.25 = 0.9083, so E = 15.73, or 62.9 cents on the loan.
2. Extend, and the plan succeeds. Income of 1.26 a year for three years is worth 1.26 × 2.5771 = 3.25 today. The balance grows to 25.36 as the shortfall accrues, but the building sells for 24.50 less 2 per cent, 24.01, and the lender cannot recover more than the sale produces. That 24.01 is worth 19.06 today. S = 3.25 + 19.06 = 22.31, or 89.2 cents. Even the success case does not repay par.
3. Extend, and the plan fails. Income runs at 1.05, worth 2.71. In year 3 the lender enforces anyway, on a building now worth 18.00: net proceeds 14.84, received in year 4.25 and worth 10.70 today. F = 2.71 + 10.70 = 13.41, or 53.6 cents.
4. Break-even. p* = (15.73 − 13.41) ÷ (22.31 − 13.41) = 26.1 per cent.
If the lender believes the leasing plan has a better than one-in-four chance, extending is worth more than enforcing. At an even chance the expected value is 17.86, or 71.4 cents, a gain of 2.13 over enforcing today; at 60 per cent it is 18.75, or 75.0 cents, a gain of 3.02.
The extension is cheap because enforcement is expensive. The forced-sale discount, the costs and fifteen months of waiting take 21.1 cents off a building that is worth 84.0 cents of the loan in an orderly market. The extension's main asset is that it avoids paying that toll today. Its main risk is paying it later, on a lower value.
| Value in year 3 if the plan fails | Failure branch, cents | Break-even probability |
|---|---|---|
| 21.00 (flat) | 60.8 | 7.5% |
| 19.50 | 57.2 | 17.8% |
| 18.00 | 53.6 | 26.1% |
| 16.50 | 50.1 | 32.8% |
| 15.00 | 46.5 | 38.4% |
| Change | Enforce today, cents | Break-even probability |
|---|---|---|
| Forced-sale discount 10.0% | 66.6 | 31.6% |
| Forced-sale discount 15.0% | 62.9 | 26.1% |
| Forced-sale discount 25.0% | 55.5 | 17.0% |
| Discount rate 6.0% | 64.4 | 18.7% |
| Discount rate 10.0% | 61.5 | 33.0% |
| Discount rate 12.0% | 60.1 | 39.6% |
Two readings matter. First, the deeper the forced-sale discount, the easier the extension is to justify: a lender facing a thin buyer pool should extend more readily than one with a liquid market. Second, a lender with an expensive cost of capital needs more conviction, because the extension pushes its cash out by three years. A bank that discounts at 12 per cent needs a 39.6 per cent chance; one at 6 per cent needs 18.7.
The common mistake is to compare enforcement, 15.73 today, with the face amount the extension promises, 25.00, or with its undiscounted success cash, 27.79. Both make every extension look at least 59 per cent better than enforcing. The right comparison is with a probability-weighted, discounted value, and the success branch is capped by the exit value, not by the balance, which is why it reaches only 89.2 cents. The second mistake is to model the failure branch as "enforce at today's value". If the plan fails, the lender enforces later and on a weaker building, which is why moving the failure value from 21.00 to 15.00 multiplies the hurdle by 5.1.
The same enforcement value is the floor for any negotiated exit, which is why it also sets the price of a discounted payoff, and every month it takes is a measurable cost.
Price three things: enforcement today, the extension if it works, the extension if it fails. The break-even probability is the one number that turns "we think the sponsor can lease it up" into a decision. Here it is 26.1 per cent, and it rises fast as the failure value falls. The free workbook for this case runs the extension year by year with the covenants re-tested, so the branches can be built from your own loan rather than from round numbers.
It is extending a defaulted or maturing loan without pricing the alternative, so the loan stays at par on the lender's books. The disciplined version discounts both branches. In the worked case the extension is worth 89.2 cents if the plan works and 53.6 if it fails, against 62.9 for enforcing now, so it is justified only above a 26.1 per cent chance of success.
Because the extension pushes the lender's recovery out by three years or more, while enforcement pays in about 1.25 years. In the illustrative case the break-even probability of success rises from 18.7 per cent at a 6.0 per cent discount rate to 39.6 per cent at 12.0 per cent, with nothing about the building changed.
Not necessarily. If the lender's cash is capped at the building's income, the unpaid interest accrues and the exit value caps the recovery. In the example the balance reaches 25.36 by year 3 but the sale nets only 24.01, so the success case is worth 89.2 cents on the euro once discounted, not 100.
This article is one calculation from The Real Estate Workout. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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