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Managing Commercial Real Estate Concentrations Ommercial Real Estate (CRE) Loans Comprise a Major Portion of Many Background Cbanks’ Loan Portfolios

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Managing Commercial Real Estate Concentrations Ommercial Real Estate (CRE) Loans Comprise a Major Portion of Many Background Cbanks’ Loan Portfolios Managing Commercial Real Estate Concentrations ommercial real estate (CRE) loans comprise a major portion of many Background Cbanks’ loan portfolios. Demand for According to History of the Eighties— CRE lending—a traditional core business Lessons for the Future, the high number for many community banks—has been of bank and savings institution failures very strong in recent years, and a growing during the 1980s and early 1990s can be number of banks have CRE concentra- attributed primarily to overinvestment in tions that are high by historical standards CRE loans.2 Weak underwriting stan- and rising. Growth in land acquisition, dards and portfolio management tech- development, and construction (ADC) niques during this time contributed to a lending has been especially pronounced. significant oversupply of CRE properties Many de novo banks in areas with signifi- that weakened the entire CRE market, cant job and population growth (predomi- leaving borrowers unable to repay their nately in East and West Coast states) loans and collateral that provided far less have used ADC loans as the primary asset support than originally thought. Other class to drive growth and meet pre- factors that contributed to the CRE opening projections. The rapid growth in losses included: CRE exposures in recent years presents additional challenges for bank manage- I Lack of market information ment as it monitors and controls risks it I Highly leveraged transactions may not have faced in the past. I Relatively low borrowing costs and the In response to rapid growth in CRE loan easy availability of credit concentrations and observed weaknesses in risk management practices at some I Government policy, including income institutions, the Federal Deposit Insur- tax benefits ance Corporation (FDIC), the Board of I Long gestation periods that allowed Governors of the Federal Reserve System supply-and-demand dynamics to (FRB), and the Office of the Comptroller change before a project’s completion of the Currency (OCC) (collectively, the federal banking agencies) published I Nonrecourse lending and legal struc- Joint Guidance on Concentrations in tures that shielded project sponsors Commercial Real Estate Lending, Sound from risk Risk Management Practices (CRE guid- I Out-of-area lending, including the 1 ance) in December 2006. This article purchase of loan participations from provides additional information and out-of-area lenders context to some of the topics discussed in the CRE guidance, drawn from the I An unregulated real estate appraisal authors’ firsthand observation of the risk industry that often used inflated management practices of both large and assumptions and relied on inexperi- small banks. It covers market monitoring enced appraisers and analysis, credit underwriting and Today, many lenders, directors, and administration, portfolio management, senior officers have not experienced a credit risk rating and review, and stress CRE downturn in their careers. They testing. may never have learned the lessons of 1 Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, Federal Register, Vol. 71, No. 238, December 12, 2006, pp. 74580–74588 (CRE Guidance). Also see FDIC FIL-104-2005 at www.fdic.gov/news/news/financial/2006/fil06104.html. 2 See FDIC’s History of the Eighties—Lessons for the Future, December 1997, at www.fdic.gov/bank/historical/ history/contents.html. 12 Supervisory Insights Winter 2007 the 1980s or may view them as distant CRE loans. The guidance “focuses on history that “can’t happen again.” Indus- those CRE loans for which the cash try and regulatory changes that arose flow from the real estate is the primary from the tumult of the 1980s remain source of repayment rather than loans to intact and are intended to prevent a re- a borrower for which real estate collateral occurrence of the ill-conceived practices is taken as a secondary source of repay- of the past. For example, the appraisal ment or through abundance of caution.”6 industry is now regulated, and appraisal The target of the guidance, then, gener- quality is far superior to what it was in ally would include development and the 1980s. Banks and thrifts must now construction loans for which repayment follow federal appraisal regulations, and is dependent upon the sale of the prop- regulators require banks to establish an erty as well as properties for which repay- effective real estate appraisal and evalua- ment is dependent upon rental income. tion program to ensure independence The CRE guidance also identifies insti- and improve quality.3 4 tutions that are potentially exposed to In addition to the changes regarding significant CRE concentration risk as appraisals, the federal banking agencies, those that have experienced rapid growth along with the Office of Thrift Supervi- in CRE lending, have notable exposures sion (OTS), have established underwrit- to a specific type of CRE, or are ing and risk management requirements.5 approaching or exceed the following A pillar of these requirements is loan-to- supervisory criteria: value (LTV) limits for different CRE prop- I Total loans reported on the Report erty types. Adhering to these regulatory of Condition for construction, land LTV limits should make institutions less development, and other land repre- vulnerable to downturns in CRE markets, sent 100 percent or more of the insti- as borrowers will have more tangible tution’s total capital; or equity in the collateral real estate to cushion against declining values. I Total CRE loans as defined in the Conversely, institutions that ignore these CRE guidance represent 300 percent LTV limits and have substantial volumes or more of the institution’s total capi- of high LTV loans are more susceptible tal, and the outstanding balance of to the adverse affects of CRE downturns. the institution’s CRE loan portfolio has increased by 50 percent or more CRE loan growth recently prompted during the prior 36 months. regulators to issue guidance to address concerns about CRE concentrations and These criteria are not limits and are to provide expectations for managing a viewed neither negatively nor as a safe concentrated portfolio. The CRE guid- haven. A bank can have significant ance recognizes that diversification can diversification within its CRE portfolio be achieved within CRE portfolios and or have a concentration within a specific differentiates risk in different types of CRE category. If a bank’s portfolio goes 3 The federal bank and thrift regulatory agencies have adopted substantially similar appraisal regulations. 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). 4 FIL-74-94, Interagency Appraisal and Evaluation Guidelines, November 11, 1994, www.fdic.gov/news/news/ financial/2003/fil0384b.htm. 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). 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). 6 CRE Guidance, p. 74585. 13 Supervisory Insights Winter 2007 Commercial Real Estate continued from pg. 13 outside of these general guidelines, as obtain market data for CRE other than many do, the bank will not automatically single-family residential properties from be criticized, but heightened risk national providers such as Property & management practices may be needed. Portfolio Research, Real Estate Invest- Different CRE types may have different ment Services, and Torto-Wheaton risk characteristics. Risk management Research. Residential market information practices should be commensurate with is also available from a number of national the complexity of the bank and its port- and regional providers. Outside of large folio. The guidance states, “in evaluating MSAs, vendor data are often unavail- CRE concentrations, the Agencies will able. In these areas, in-house knowledge consider the institution’s own analysis of and communication with local builders, its CRE portfolio, including considera- developers, real estate agents, and civic tion of factors such as: leaders may be the primary tools for gathering information on market activity I Portfolio diversification across prop- and gauging market conditions. erty types. The level of CRE monitoring required I Geographic dispersion of CRE loans. can differ among institutions depending I Underwriting standards. on exposure level or perceived risk in a product type or geographic area. Institu- I Level of pre-sold units or other types tions involved in construction and devel- of take-out commitments on construc- opment lending have a greater need to tion loans. monitor CRE markets, as conditions can I Portfolio liquidity (ability to sell or change dramatically between the time an securitize exposures on the secondary institution makes a loan commitment and market).”7 the time a project is completed. Moni- toring speculative single-family housing These factors could mitigate the risk development can be especially challeng- posed by the concentration. Additionally, ing. Institutions must have a clear under- banks that have experienced recent, standing of the demand for housing significant growth in CRE lending will within geographic areas, submarkets, or receive closer regulatory review than specific projects, as well as price points those that have demonstrated a success- within markets or projects. Institutions ful track record of managing the risks should track available inventory and their of CRE concentrations. own levels of exposure at a level of granu- The remainder of this article provides larity sufficient to allow management to context and additional information for determine if the institution should curtail some of the topics addressed in the CRE lending for specific products or in loca- guidance. tions of concern, even if other products or locations continue to perform well.
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