The Agencies have observed that commercial real estate (CRE) concentrations have been rising over the past several years and have reached levels that could create safety and soundness concerns in the event of a significant economic downturn. This mechanism ensures that both risk management and the lending staff are in agreement about the marketplace conditions and the lending strategy. Communication must occur between lending and risk management functions. jointly issuing this Guidance to address institutions’ increased concentrations of commercial real estate (CRE) loans. Sound risk management strategies are … History has clearly demonstrated that CRE can experience cyclical changes in which supply and demand get out of balance, resulting in significant losses for financial institutions. The guidance does not state that the supervisory cri­ teria should be viewed as a hard cap on CRE concen­ tration levels. Portfolio Stress Testing and Sensitivity Analysis. 3. These analyses can be conducted on a scheduled basis or when market fundamentals dictate. 71, No. In light of the possibility of significant losses in CRE portfolios, banks with concentrations in CRE can use stress testing to assess the extent of their exposure to a downturn in CRE markets. The review and validation personnel will generally be the best resource for identifying problems in the rating system. The second component is Real Estate Law, which offers an overview of the legal issues confronting the real estate executive. The lending staff must pass along market information to the risk management function. In 2006, the FFIEC published the Interagency Guidance “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” (1), which outlined regulators’ expectations for a risk management framework to manage the risk associated with Commercial Real Estate (CRE) concentrations. Tulsa, OK, Charles M. Foster Listed below are some examples of possible indicators that particular markets are at or near a peak. The guidance “focuses on those CRE loans for which the cash flow from the real estate is the primary source of repayment rather than loans to a borrower for which real estate collateral is taken as a secondary source of repayment or through abundance of caution.”6 The target of the guidance, then, generally would include development and construction loans for which repayment is dependent upon the sale of the property as well as properties for which repayment is dependent upon rental income. CRE updates were released in 2012, along with community bank stress-testing guidance in 2013. Not surprisingly, CRE-related loans account for a significant portion … Analysis covers testing the common assumptions and combinations of assumptions shown in Table 1. In many instances during the 1980s and early 1990s, developers walked away from partially finished properties, and some lenders were forced to complete projects to salvage their investment. This becomes increasingly important as the bank grows and more people are involved in the risk rating process. This is especially true if the data for the reference portfolio lack granularity. Reference Commercial real estate (CRE), such as office towers, shopping centers, and apartment buildings, makes up approximately one-third of the total value of U.S. real estate. While the direct costs of these actions are apparent, there are often other costs that bear mention. The regional or national economy shows signs of stress. After all, how beneficial can market monitoring and analysis be if concentration limits and exposures are not adjusted when that market information indicates a change in market conditions? Managing Commercial Real Estate Concentrations. In these areas, in-house knowledge and communication with local builders, developers, real estate agents, and civic leaders may be the primary tools for gathering information on market activity and gauging market conditions. The composition of a bank's real estate portfolio will vary based on differences in lending experience, market competition, and asset size. As banks grow, this process is typically brought in-house. The stressed loss rates would be developed through an analysis akin to the following: If the bank has not previously experienced significant CRE downturns, using external data may be more appropriate than using internal data. Like an aggregate transactional sensitivity analysis, stressed loss rate testing can provide useful input to a bank’s capital, earnings, and liquidity planning. Credit Underwriting Standards and Administration. The monitoring function can be organized in a variety of ways. Banks with limited staffing resources can use external audit staff or consulting firms to conduct the validation. In addition to the changes regarding appraisals, the federal banking agencies, along with the Office of Thrift Supervision (OTS), have established underwriting and risk management requirements.5 A pillar of these requirements is loan-to-value (LTV) limits for different CRE property types. In areas where management deems risks to be higher, lenders may be instructed to curtail or discontinue lending activities altogether. Stress testing can also inform management of the institution’s specific vulnerabilities to CRE markets and indicate where actions should be taken to mitigate those risks. The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system. With such concerns in mind, federal banking agencies in December issued guidance on risk management expectations for banks with significant concentrations in commercial real estate (CRE) loans. Attachment 1 provides the Federal Register notice of the guidance.2 Attachment provides the interagency guidance. (See Figure 1.) • Total commercial and residential real estate loans secured by real estate with LTVs in excess of FDICIA guidelines should not exceed 100% of capital. 238, December 12, 2006, pp. In addition to being used to determine capital levels, adequacy of the allowance for loan and lease losses, and loan pricing strategy, risk ratings can be used as a parameter for setting concentration limits and sublimits. The guidance states, “in evaluating CRE concentrations, the Agencies will consider the institution’s own analysis of its CRE portfolio, including consideration of factors such as: These factors could mitigate the risk posed by the concentration. Much has changed in CRE lending since the last downturn. The CRE guidance provides several internal and external factors that should be considered when establishing policies, such as market position, historical experience, present and prospective trade area, probable future loan and funding trends, staff capabilities, and technology resources. In December 2015, the joint regulators issued a statement on prudent commercial real estate (CRE) lending that reminded financial institutions of existing regulatory guidance for Commercial Real Estate … Obtain historical loss rates on CRE loans (the “reference portfolio”) at the most granular level available. While measuring risk-based capital, growth and asset quality across these various concentration segments is a great starting point, the guidance recommends: Incorporating this concentration analysis within the allowance for loan and lease loss (ALLL) calculations, Developing sensitivity analysis forecasts, such as increased vacancy rates in the market by product type, slower absorption rates, reduced sales prices, higher capitalization rates, or higher interest rates. Atlanta, GA, Mark D. Sheely Regulatory limits for commercial real estate lending levels are at high levels for many community banks. A common delivery method is to provide lenders with a “heat map” that details management’s view of the demand for product types in each geographic market and directs lenders’ degree of aggressiveness for those products. Another technique used by some banks with larger portfolios and more sophisticated internal data is to stress ratings migrations. 4 FIL-74-94, Interagency Appraisal and Evaluation Guidelines, November 11, 1994, www.fdic.gov/news/news/financial/2003/fil0384b.html. If market conditions deteriorate severely, sponsors or developers may simply abandon a project, especially if they have insufficient capital invested and there is no recourse to the principals. Alternatively, the bank could develop a relationship between economic variables and ratings migrations. Inventory and planned production are excessive relative to market dynamics (e.g., office space in the pipeline exceeds several years’ absorption rate without any significant increase in employment expectations; condominium units in the pipeline exceed the level of several prior years’ sales). Systematically aggregating the results of individual transactional stress tests could involve: For income-producing properties with long-term, fixed-rate loans and long-term tenants, the analysis may reveal little or no additional exposure unless capitalization rates are expected to increase on the specific property type. Testing each credit in the portfolio, considering the current status of each project against the impact of the sensitivity analysis forecasts. The inventory of other assets for sale -- including office furniture, fixtures, and equipment. need further clarification. While it may be easy to manage a concentration during the good times, managing one once market demand has slowed is much more challenging. Transparency is generally evaluated by reading the bank’s rating policy guidelines and conducting transaction testing. is the third leg to any successful rating system. Risk rating systems can vary greatly between community and large banks. Different CRE types may have different risk characteristics. If CRE lending is the primary earnings driver, the institution should be prepared to diversify into other areas of lending or wait for CRE markets to return. The FDIC has historical CRE data that could be used to construct loss rates, although the FDIC data lacks much granularity.9. To reduce potential losses in the future, banks must have strong board and management oversight as well as robust risk management processes for their CRE loan portfolios to recognize and control risk through all phases of the economic cycle. Credit review personnel should provide the board and senior management with periodic feedback regarding the effectiveness of the rating system and any recommended changes for improving transparency and granularity. A well-diversified bank is, in general, better insulated against market downturns. 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