Markets may be monitored by staff or management, but ultimately both must understand what is being monitored and why. The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation are jointly issuing the attached Interagency Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (guidance). Commercial real estate (CRE) and multifamily concentrations are an area of scrutiny for regulators in the current exam cycle. 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. Total CRE loans as defined in the CRE guidance represent 300 percent or more of the institution’s total capital, and the outstanding balance of the institution’s CRE loan portfolio has increased by 50 percent or more during the prior 36 months. A granular rating system that effectively rank orders risk should aid management in identifying the exposures that should be reduced or eliminated if a CRE downturn appears to be on the horizon. Many de novo banks in areas with significant job and population growth (predominately in East and West Coast states) have used ADC loans as the primary asset class to drive growth and meet pre-opening projections. Also see FDIC FIL-104-2005 at www.fdic.gov/news/news/financial/2006/fil06104.html. One of the most prevalent pieces of commercial real estate (CRE) guidance is, "Concentrations in CRE Lending, Sound Risk-Management Practices (PDF)," which was issued on December 6, 2006. Outside of large MSAs, vendor data are often unavailable. Banks should hold capital and reserves commensurate with that risk to protect against the higher chance of loss. The second component is Real Estate Law, which offers an overview of the legal issues confronting the real estate executive. Subprime lending involves extending credit to borrowers who exhibit characteristics that indicate a significantly higher risk of default than traditional bank lending customers. Banks and thrifts must now follow federal appraisal regulations, and regulators require banks to establish an effective real estate appraisal and evaluation program to ensure independence and improve quality.3 4. 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. Following are examples of the types of stress tests commonly used in banks. Analysis covers testing the common assumptions and combinations of assumptions shown in Table 1. Speculators drive prices to unwarranted levels (e.g., home prices increase by 30 percent year-over-year for an extended period, while inventory is expected to grow to unprecedented levels). Unfortunately, the importance of CRE portfolio management and appropriate concentration limits becomes most apparent only when the bank’s market enters a downturn. Examination Specialist, According to History of the Eighties—Lessons for the Future, the high number of bank and savings institution failures during the 1980s and early 1990s can be attributed primarily to overinvestment in CRE loans.2 Weak underwriting standards and portfolio management techniques during this time contributed to a significant oversupply of CRE properties that weakened the entire CRE market, leaving borrowers unable to repay their loans and collateral that provided far less support than originally thought. 1 Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, Federal Register, Vol. August 04, 2020, Transcripts and other historical materials, Quarterly Report on Federal Reserve Balance Sheet Developments, Community & Regional Financial Institutions, Federal Reserve Supervision and Regulation Report, Federal Financial Institutions Examination Council (FFIEC), Securities Underwriting & Dealing Subsidiaries, Regulation CC (Availability of Funds and Collection of Checks), Regulation II (Debit Card Interchange Fees and Routing), Regulation HH (Financial Market Utilities), Federal Reserve's Key Policies for the Provision of Financial Services, Sponsorship for Priority Telecommunication Services, Supervision & Oversight of Financial Market Infrastructures, International Standards for Financial Market Infrastructures, Payments System Policy Advisory Committee, Finance and Economics Discussion Series (FEDS), International Finance Discussion Papers (IFDP), Estimated Dynamic Optimization (EDO) Model, Aggregate Reserves of Depository Institutions and the Monetary Base - H.3, Assets and Liabilities of Commercial Banks in the U.S. - H.8, Assets and Liabilities of U.S. Obtain historical loss rates on CRE loans (the “reference portfolio”) at the most granular level available. When compared to the current ratings, the effect of a market downturn could be measured (see Table 2). One solution does not and should not fit all banks—the risk rating and review process should be commensurate with the bank’s size and complexity. A heat map can serve as a quick reference to identify whether the strategy for a particular market or product type is to grow, maintain, or reduce exposure. The failure to control exposure levels when warning signs are evident can result in excessive loan losses. The usefulness of this type of test relies heavily on the reference portfolio selected to conduct the test. Growth in land acquisition, development, and construction (ADC) lending has been especially pronounced. 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. The number of Banks with CRE Ratios greater than 300% of RBC-Risk-Based Capital is essentially unchanged, the median asset level of these banks is bigger … On December 6, 2006, the Federal Reserve and the other federal banking regulatory agencies issued interagency guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices. Minimum prompt corrective action capital levels, as a result, are not typically appropriate for banks with concentrations.3Likewise, banks with a significant exposure to a particular loan type, market, or industry should incorporate the likelihood of strong correlations among the loans when determining the appropriate allowance for loan … While loan-level sensitivity analysis is a valuable tool for all banks originating CRE loans, this type of analysis could be performed on a portfolio-wide basis. • Total commercial real estate loans should not exceed 300% of capital. 238, December 12, 2006, pp. The specific numerical examples are not intended to represent triggers we believe bankers should use, but merely to illustrate that management may wish to consider a number of concrete numerical indicators in forming a judgment about the risks in a particular market: If CRE lending is a substantial source of revenue, the decision to reduce exposure levels will likely be met with significant resistance from managers and loan officers concerned about short-term earnings performance. Essentials of Real Estate Finance provides the tools necessary to analyze income-producing property from the perspective of an institutional investor. Identify the similarities or differences between the bank’s current portfolio and the historical reference portfolio, and adjust the loss rates appropriately. 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. Determining market fundamentals for each product type and geographic market where the bank has funds committed. Real Estate Financial Modeling, A.CRE 101 - Basic Concepts in Commercial Real Estate, Audio Series, Season 2, Real Estate Case Studies The “Secret” to Learning Real Estate Financial Modeling Just like any skill in life, there are tips and tricks to learning that skill. The level of losses will generally depend on the quality of loan underwriting and the breadth and depth of the CRE market downturn. The FDIC has historical CRE data that could be used to construct loss rates, although the FDIC data lacks much granularity.9. Adhering to these regulatory LTV limits should make institutions less vulnerable to downturns in CRE markets, as borrowers will have more tangible equity in the collateral real estate to cushion against declining values. See also Interagency Guidelines Establishing Standards for Safety and Soundness: 12 CFR 364, appendix A (FDIC); 12 CFR 30, appendix A (OCC); 12 CFR 208, appendix D-1 (FRB); and 12 CFR 570, appendix A (OTS). The secure Internet channel for FDIC-insured institutions to conduct business and exchange information with the FDIC. Regulatory limits for commercial real estate lending levels are at high levels for many community banks. Along with project assumptions, loan-specific variables, such as interest rates and LTV ratios inferred from capitalization rates, are commonly analyzed. 71, No. Reporting systems should be sufficiently detailed to identify situations where the strategy is not being followed. Examination Specialist, As loan quality deteriorates, banks must expend significant resources, both human and monetary, for collection and, in some cases, foreclosure on the underlying collateral. When an institution permits an exception, it should document how the transaction does not conform to the institution’s policy or underwriting standards and why the exception is in the best interest of the bank. Reiteration of Interagency Guidance on CRE-Commercial Real Estate Concentrations has had limited impact on Banking Industry. Loan disbursement practices—They should be based on engineering or inspection reports, requirements for lien waivers from subcontractors, etc. See section titled “Loans in Excess of the Supervisory Loan-to-Value Limits.”. Residential Real Estate and Mortgages 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. This becomes increasingly important as the bank grows and more people are involved in the risk rating process. Independent property inspections—There should be initial site visits and ongoing inspections during the construction phase. 5 See Interagency Guidelines for Real Estate Lending Policies: 12 CFR 365 and appendix A (FDIC); 12 CFR 34, subpart D and appendix A (OCC); 12 CFR 208, subpart E and appendix C (FRB); and 12 CFR 545 and 563 (OTS). the stress year migration to move the appropriate volume of exposures in Banks identified as having CRE concentrations possess an additional level of risk and complexity that should be considered when evaluating the risk rating and review system. Sponsor/developer experience level—Institutions should establish standards to ensure that the sponsor/developer as well as the underlying contractor has a proven track record and sufficient experience in the market and in the property type being developed to complete the proposed project. Other factors that contributed to the CRE losses included: Today, many lenders, directors, and senior officers have not experienced a CRE downturn in their careers. Real estate lending represents one of the major components of credit risk at many banks. (Available data will often be fairly general in nature—losses on hotels, retail buildings, office buildings, etc.—rather than for more specific product types—suburban hotels versus downtown hotels, multitenant office buildings versus owner-occupied office buildings, etc.) Institutions involved in construction and development lending have a greater need to monitor CRE markets, as conditions can change dramatically between the time an institution makes a loan commitment and the time a project is completed. The bank should have a management information system (MIS) that provides sufficient information to measure, monitor, and control CRE concentration risk. Adjusting those limits when market fundamentals change is also a prudent risk management tool. Comm… Good risk management starts with setting reasonable concentration limits for different products and markets. 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. The $51.2 billion-asset New York Community disclosed in a regulatory filing that its regulators lifted a cap that had limited its portfolio of multifamily, non-owner-occupied CRE, and acquisition, development and construction loans to 850% of total risk-based … 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. (See, for example, the discussion of planning for contingencies in “Liquidity Analysis: Decades of Change” in this issue of Supervisory Insights.). At a minimum, the risk rating system should rank order risk in the portfolio and provide enough grades so that the vast majority of loans do not fall into just one grade. Monitoring speculative single-family housing development can be especially challenging. The CRE guidance provides a good framework to assist banks in addressing the concentration risk and also helps establish the federal banking agencies’ expectations during subsequent risk management examinations. This type of system has the added benefit of delineating credit risk, which should aid lenders in mitigating those risks. In addition, many banks do not have the resources to search hard copy files and backfill data into their systems. Online tool that helps depositors determine how the insurance rules and limits apply to a specific group of deposit accounts — what's insured and what portion (if any) exceeds coverage limits at that bank. Such an analysis would measure the depth and breadth of the portfolio’s vulnerability to changes in real estate markets and interest rates. Banks with limited staffing resources can use external audit staff or consulting firms to conduct the validation. In markets where demand is very strong, management may instruct lending staff to pursue additional opportunities and adjust pricing and other terms to attract additional business. Before making a commitment for financing, an institution will analyze sponsor and lender assumptions to determine the degree to which a project can withstand market fluctuations and still repay the loan. Many banks fail to collect the data necessary to produce the reports listed above. For example, the appraisal industry is now regulated, and appraisal quality is far superior to what it was in the 1980s. Many lenders found during the CRE downturn of the 1980s and early 1990s that the “first loss is the best loss,” meaning that it would have been cheaper in the long run to have disposed of distressed CRE assets earlier rather than later. Appraisals 74580–74588 (CRE Guidance). Steven G. Johnson The lending staff must pass along market information to the risk management function. jointly issuing this Guidance to address institutions’ increased concentrations of commercial real estate (CRE) loans. Conversely, institutions that ignore these LTV limits and have substantial volumes of high LTV loans are more susceptible to the adverse affects of CRE downturns. It covers market monitoring and analysis, credit underwriting and administration, portfolio management, credit risk rating and review, and stress testing. Portfolio diversification across property types. 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