The CRE guidance includes a general expectation that an institution with CRE concentrations will conduct portfolio stress testing consistent with the size, complexity, and risk characteristics of its CRE loan portfolio. Testing each credit in the portfolio, considering the current status of each project against the impact of the sensitivity analysis forecasts. Portfolio liquidity (ability to sell or securitize exposures on the secondary market).”. Outside of large MSAs, vendor data are often unavailable. 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 ⦠The board- and management-level handing of CRE concentration was the chief concern of FDIC examiners, making up more than 56% of all the supervisory recommendations regulators made in the two-year period. If sufficient data exist to capture a CRE downturn, the bank could select the year with the highest percentage of downgrades as the stress year. Another technique used by some banks with larger portfolios and more sophisticated internal data is to stress ratings migrations. The Guidance reminds institutions ⦠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, Not surprisingly, CRE-related loans account for a significant portion ⦠Alternatively, the bank could develop a relationship between economic variables and ratings migrations. To assist and encourage banks to recognize and control CRE lending risks, bank regulators have developed a significant body of regulatory guidance for CRE transactions. 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. As loan quality deteriorates, banks must expend significant resources, both human and monetary, for collection and, in some cases, foreclosure on the underlying collateral. 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. Transparency is generally evaluated by reading the bank’s rating policy guidelines and conducting transaction testing. With the risk management tools listed in the CRE guidance and further supported by other regulatory guidance, there is no reason CRE loans cannot continue to be a favored asset class for banks. Loss rates may lag the downturn by a number of months or years. "Adapting to CRE Concentration and Risk Management Guidelines" (April 2007) describes one bank's firsthand experience in incorporating the principles. CRE updates were released in 2012, along with community bank stress-testing guidance in 2013. They may have separate legacy systems that do not aggregate data efficiently, if at all. 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). A well-diversified bank is, in general, better insulated against market downturns. Credit Underwriting Standards and Administration. 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. This Guidance is based upon the principles contained in the Agencies' real estate lending standards regulations and guidelines. The federal banking regulators have issued statements and guidance encouraging banks to continue lending to creditworthy borrowers and explaining how banks can work with troubled borrowers. Consequently, the real benefit of implementing systems to identify and control CRE concentrations lies in limiting the level of risk brought on by those concentrations when markets begin to falter. Listed below are some examples of possible indicators that particular markets are at or near a peak. 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. A bank can have significant diversification within its CRE portfolio or have a concentration within a specific CRE category. When prudent diversification across a variety of asset classes is difficult to achieve, it becomes even more important for management to deploy tools and implement strategies similar to those outlined here to recognize and control the risk taken. Information can be captured on mainframe systems or other systems—including the use of simple spreadsheets—but should be retained in a form that can be readily accessed for analysis purposes. The risks posed by concentrations of credit risk in general, and Commercial Real Estate concentrations in particular, have long been an area of focus for bank regulators. To some extent, the level of CRE lending reflects changes in the demand for credit within certain geographic areas and the movement by many financial institutions to specialize in a lending sector that is perceived to offer enhanced earnings. 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). Regulators and bank management must not become complacent or static in their approach to risk management; they must continually evolve and change as the environment changes and new risks appear. Senior Examination Specialist,
Adjusting those limits when market fundamentals change is also a prudent risk management tool. Strong markets promote additional building, which can result in oversupply followed by weakened market fundamentals. Given that some of the assumptions interact with other assumptions, a range of outcomes may be used to determine if the loan meets the institution’s underwriting criteria and lending standards. Examination Specialist,
The CRE guidance recognizes that diversification can be achieved within CRE portfolios and differentiates risk in different types of CRE loans. While the direct costs of these actions are apparent, there are often other costs that bear mention. 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 ⦠Loan agreements, collateral documentation, and appraisal practices—Robust loan agreements and collateral documentation are expected. The bank would use the results of
The guidance is not intended to limit banks' CRE lending, as the agencies recognize that banks serve a vital role in their communities by supplying credit for business and real estate development. Concentrations of credit exposures add a dimension of risk that compounds the risk inherent in individual loans. Reporting systems should be sufficiently detailed to identify situations where the strategy is not being followed. Commercial Real Estate Issues in 2017. 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. This type of system has the added benefit of delineating credit risk, which should aid lenders in mitigating those risks. Demand for CRE lending—a traditional core business for many community banks—has been very strong in recent years, and a growing number of banks have CRE concentrations that are high by historical standards and rising. Portfolio diversification across property types. 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. Generally, the longer a bank has been a CRE lender, the more granular the loss data. Various tools may be available to monitor CRE markets, depending on the size of the market. Yet, while the CRE credit market has been influenced by excess liquidity for a number of years, recent events in the credit markets for housing and leveraged finance demonstrate that liquidity can evaporate quickly if lenders’ and investors’ perceptions of the level of risk inherent in those loan products change. 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. Sponsor or guarantor financial analysis, if applicable. The remainder of this article provides context and additional information for some of the topics addressed in the CRE guidance. Federal Register proposed guidance entitled âConcentrations in Commercial Real Estate Lending, Sound Risk Management Practicesâ (Guidance).3 Eleven months, one congressional hearing, and over 5,700 comment letters later, the Guidance was issued in final.4 This Article summarizes what transpired during these eleven months, including the is the third leg to any successful rating system. A small, noncomplex bank may need only a one-dimensional rating system with a small number of rating grades, while a large or complex organization may require a rating system with more grades to measure risk levels adequately. The composition of a bank's real estate portfolio will vary based on differences in lending experience, market competition, and asset size. The monitoring function can be organized in a variety of ways. The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system. Lenders often severely underestimate the length of time necessary for the sale of foreclosed assets in a distressed market. Real estate investors who really want control over their investments must dig into the industry, know their market and understand the risks and ⦠In 2006, the FFIEC published the Interagency Guidance âConcentrations in Commercial Real Estate Lending, Sound Risk Management Practicesâ (1), which outlined regulatorsâ expectations for a risk management framework to manage the risk associated with Commercial Real Estate (CRE) concentrations. Sound risk management strategies are ⦠Loan pricing becomes too thin for the underlying risk (e.g., construction loan pricing has fallen almost 150 basis points in recent years owing to competition). 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. the stress year migration to move the appropriate volume of exposures in
An Analysis of the Impact of the Commercial Real Estate Concentration Guidance (Washington, D.C.: April 2013). Independence in the validation process
In particular, small to mid-siz⦠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. Different CRE types may have different risk characteristics. 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 ⦠The Federal Reserve Boardâs real estate appraisal standards are found in Regulation H, subpart E, 12 CFR 208.50â51 for state member banks. Examination Specialist,
The key is to have someone other than the original credit analyst attempt to come to the same conclusion using the tools provided by policy. Identify loss rates that occurred as a result of previous market downturns, generally the highest loss rates experienced in the reference portfolio. Reiteration of Interagency Guidance on CRE-Commercial Real Estate Concentrations has had limited impact on Banking Industry. Bank management should also be willing to forego potential CRE income when the risk exceeds the reward. The institution should also ensure that appropriate management approvals are obtained. These analyses can be conducted on a scheduled basis or when market fundamentals dictate. 2. Columbia, MO, Tracy E. Fitzgerald
When compared to the current ratings, the effect of a market downturn could be measured (see Table 2). 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. Loan agreements should clearly communicate draw schedules, release provisions, and repayment requirements. In December 2015 the regulators is⦠d. Risk management staff should provide its analysis of market data to senior management in a manner they can use to develop a comprehensive lending and risk mitigation strategy. Most institutions that specialize in CRE lending, and especially ADC lending, are accustomed to running analyses to determine loan and project exposure as part of the underwriting process. 8 Appendix A to 12 CFR 365—Interagency Guidelines for Real Estate Lending Policies—states that loans exceeding the supervisory LTV guidelines should be recorded in the institution’s records and reported to the board at least quarterly. 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. Individuals outside the lending process should evaluate and validate the entire process. An Overview of the Interagency Guidance The interagency guidance, " Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (SR7-1)," was issued in 2006. In addition to providing supervisory guidance regarding residential real estate lending, this subsection also contains guidance on subprime lending. In December 2006, the FDIC, in conjunction with the other federal banking agencies, issued joint guidance to financial institutions entitled, Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices,to reinforce sound risk-management practices regarding concentrations in CRE lending. Identify the similarities or differences between the bank’s current portfolio and the historical reference portfolio, and adjust the loss rates appropriately. A bank’s ability to monitor developments in its CRE market area is a critical element of successful CRE lending. Typical loan production and performance reports by type, region, officer, etc. 4 FIL-74-94, Interagency Appraisal and Evaluation Guidelines, November 11, 1994, www.fdic.gov/news/news/financial/2003/fil0384b.html. Atlanta, GA, Mark D. Sheely
PDF ATTACHED: FIG Partners Industry Analysis 9-7-16 â Impact of CRE Concentration Guidance. Managing Commercial Real Estate Concentrations. 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. Real Estate Financial Modeling, A.CRE 101 - Basic Concepts in Commercial Real Estate, Audio Series, Season 2, Real Estate Case Studies The âSecretâ to Learning Real Estate Financial Modeling Just like any skill in life, there are tips and tricks to learning that skill. Granularity is also necessary to provide an accurate assessment of portfolio risk. The bank should have a management information system (MIS) that provides sufficient information to measure, monitor, and control CRE concentration risk. Real estate lending represents one of the major components of credit risk at many banks. Risk management practices should be commensurate with the complexity of the bank and its portfolio. Underwriting weakens to unreasonable levels or to levels banks previously would not have approved (e.g., deposits for qualifying presold condominium units are reduced by half to entice enough preconstruction buyers to demonstrate demand for a project). 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. The concentration consists of 4 courses (12 credits). A CRE concentration increases the importance of sound lending policies. Many banks fail to collect the data necessary to produce the reports listed above. Appraisals They may never have learned the lessons of the 1980s or may view them as distant history that “can’t happen again.” Industry and regulatory changes that arose from the tumult of the 1980s remain intact and are intended to prevent a re-occurrence of the ill-conceived practices of the past. Each year a percentage of credits (obligors in cases of banks with two-dimensional rating systems) improves, remains the same, or declines. Thus far, the examples cited have not necessarily been related to a particular, perhaps local, event. 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. ⢠Total commercial real estate loans should not exceed 300% of capital. 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. The guidance does not state that the supervisory cri teria should be viewed as a hard cap on CRE concen tration levels. The usefulness of this type of test relies heavily on the reference portfolio selected to conduct the test. Robust risk management systems can also track the number of exceptions by type and amount to help point out areas of policy that may need permanent amendment or that need to be reinforced by the institution’s board of directors. The CRE guidance also identifies institutions that are potentially exposed to significant CRE concentration risk as those that have experienced rapid growth in CRE lending, have notable exposures to a specific type of CRE, or are approaching or exceed the following supervisory criteria: These criteria are not limits and are viewed neither negatively nor as a safe haven. Account officers, loan review personnel, and regulatory examination staff should be able to review rating guidelines and reach the same conclusion on the rating grade assigned to individual credits. Many institutions will want to expand the level of information captured to specifically include underwriting characteristics, such as LTVs, debt service coverage levels, speculative versus presold units, etc., to allow for more enhanced reporting and analysis. Obtain historical loss rates on CRE loans (the “reference portfolio”) at the most granular level available. In many larger metropolitan statistical areas (MSAs), institutions can obtain market data for CRE other than single-family residential properties from national providers such as Property & Portfolio Research, Real Estate Investment Services, and Torto-Wheaton Research. 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. For example, the ADC loss history on the reference portfolio is for a geographically diverse group of loans, but the current portfolio is largely concentrated in one location. Posted on 9/6/2017. 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). In areas where management deems risks to be higher, lenders may be instructed to curtail or discontinue lending activities altogether. Branches and Agencies of Foreign Banks, Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks, Senior Loan Officer Opinion Survey on Bank Lending Practices, Structure and Share Data for the U.S. Offices of Foreign Banks, New Security Issues, State and Local Governments, Senior Credit Officer Opinion Survey on Dealer Financing Terms, Statistics Reported by Banks and Other Financial Firms in the United States, Structure and Share Data for U.S. Offices of Foreign Banks, Financial Accounts of the United States - Z.1, Household Debt Service and Financial Obligations Ratios, Survey of Household Economics and Decisionmaking, Industrial Production and Capacity Utilization - G.17, Factors Affecting Reserve Balances - H.4.1, Federal Reserve Community Development Resources, Concentrations in CRE Lending, Sound Risk-Management Practices (PDF), An Analysis of the Impact of the Commercial Real Estate Concentration Guidance (PDF), Interagency Statement on Meeting the Needs of Creditworthy Borrowers, Section 2231.0, "Real Estate Appraisals and Evaluations", Section 3270.0, "Section 4(c)(8) of the BHC Act (Real Estate and Personal Property Appraising)", Section 3070.0, "Section 4(c)(8) of the BHC Act (Mortgage Banking)", Section 2128.08, "Subprime Lending (Risk Management and Internal Controls)", Section 2080.1, "Commercial and Industrial Loans", Section 2100, "Real Estate Construction Loans", Section 2103.1, "Concentrations in Commercial Real Estate Lending, Sound RiskâManagement Practices", Section 2040.1, "Loan Portfolio Management" (Mortgage Banking Subsection), Section 2043.1, "Nontraditional MortgagesâAssociated Risks", Section A.2040.3, "Loan Portfolio Management: Comprehensive Mortgage Banking Examination Procedures", Section 2135.1, "Subprime Mortgage Lending", Section 2200.1, "Other Real Estate Owned", Section 4140.1, "Real Estate Appraisals and Evaluations". See 12 CFR 323 (FDIC); 12 CFR Part 34, subpart C (OCC); 12 CFR 208.18 and 12 CFR 225, subpart G (FRB); and, 12 CFR 564 (OTS). Like an aggregate transactional sensitivity analysis, stressed loss rate testing can provide useful input to a bank’s capital, earnings, and liquidity planning. As banks grow, this process is typically brought in-house. Although most banks do not perform bankwide scenario stress testing, the process of developing such
3. No matter the form of the market analysis, management must convey its strategy to lending staff in a timely manner and maintain sufficient oversight of lending activity to ensure that the loans being originated are consistent with management’s strategy. This includes meaningful information on CRE portfolio characteristics relevant to the institution’s lending strategy, underwriting standards, and risk tolerances. The regulatory agencies have gone on record stating that 'concentrations are bank killers' - and that most of the banks that failed during the great recession were 'CRE Concentrated'. Residential Real Estate and Mortgages Concentrations, as previously noted, mean higher inherent risk. For example, a community bank might assume layoffs at a major employer and measure the anticipated results on new housing demand and other CRE property performance. The level of CRE monitoring required can differ among institutions depending on exposure level or perceived risk in a product type or geographic area. In general, the loss rates from the reference portfolio will be a good starting point. In these institutions, the type and level of adjustments to historical loan loss rates are critical elements to developing a useful outcome. The Federal Reserve Board's Division of Consumer and Community Affairs issues Consumer Affairs (CA) letters addressing policy and procedural matters of continuing relevance to the Fedâs consumer compliance supervisory responsibilities. The FDIC has historical CRE data that could be used to construct loss rates, although the FDIC data lacks much granularity.9. Insulated against market downturns, generally the highest loss rates, although the FDIC would ever encounter... Broad, subjective criteria promote consistency in the CRE guidance recognizes that diversification can be conducted on a basis. 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