Risk Management 1 Risk Management of Commercial Real Estate Loans at Banks by Lindsay P. Kugel An honors thesis submitted in partial fulfillment of the requirements for the degree of Bachelor of Science Undergraduate College Leonard N. Stern School of Business New York University May 2017 Professor Marti G. Subrahmanyam Professor Stijn Van Nieuwerburgh Faculty Advisor Thesis Advisor Risk Management 2 Table of Contents Risk Management of Commercial Real Estate Loans at Banks ..................................................... 1 Table of Contents .......................................................................................................................... 2 Abstract .......................................................................................................................................... 5 Acknowledgements ....................................................................................................................... 6 Risk Management of Commercial Real Estate Loans at Banks ............................................... 7 Introduction ................................................................................................................................... 7 Why commercial real estate Loans? ........................................................................................... 8 Increasing Renown of the Real Estate Industry .......................................................................... 9 Types of Commercial Real Estate Loans .................................................................................. 10 Construction Loans. .................................................................................................................. 10 Income-Producing Property Loans........................................................................................... 11 Typical Terms ........................................................................................................................... 12 Current Commercial Real Estate Environment ......................................................................... 13 Deterioration of Underwriting Standards.................................................................................. 14 Impending “Wall of Maturities” ............................................................................................... 15 Impact of Risk Retention .......................................................................................................... 16 The Role of Banks in Commercial Real Estate Lending ......................................................... 17 The Importance of Commercial Real Estate Lending for Community Banks .......................... 18 The Looming Effect of Shadow Banking ................................................................................. 23 Commercial Real Estate Loan Risks ......................................................................................... 25 Interest Rate Risk ...................................................................................................................... 27 Commercial Real Estate Price Risk .......................................................................................... 27 Illiquidity Risk .......................................................................................................................... 28 Model Risk ................................................................................................................................ 30 Cash Flow Risk ......................................................................................................................... 30 Concentration Risk.................................................................................................................... 31 Portfolio Risk ............................................................................................................................ 33 Credit Risk ................................................................................................................................ 34 Property-Specific Risks ............................................................................................................ 35 Multifamily. ............................................................................................................................... 36 Industrial. .................................................................................................................................. 37 Office. ........................................................................................................................................ 37 Retail. ........................................................................................................................................ 37 Risk Management 3 Hotel .......................................................................................................................................... 38 Other Risk Factors .................................................................................................................... 38 Risk Management ....................................................................................................................... 40 Volatility ................................................................................................................................... 40 Value-at-Risk (VAR) ................................................................................................................ 41 Other ......................................................................................................................................... 42 Stress Testing ............................................................................................................................... 43 The Current Dodd-Frank Stress Testing Framework................................................................ 44 Commercial Real Estate Loan Stress Testing ........................................................................... 45 Are There Hidden Risks? ........................................................................................................... 47 Problems within Regulatory Environment ............................................................................... 48 Do Stress Tests Cover Unforeseen Risks Faced by commercial real estate Loans? ................ 48 Focus on Larger Banks, What about the Smaller Banks? ......................................................... 49 Lack of Follow-Through ........................................................................................................... 50 Limitations of Stress Tests ........................................................................................................ 51 Metrics that Banks Use to Analyze Loans ................................................................................ 52 Debt Service Coverage Ratio (DSCR) ...................................................................................... 52 Loan to Value (LTV) ................................................................................................................ 53 Debt Yield ................................................................................................................................. 55 Metrics that Banks Utilize in Portfolio-Level Analysis ........................................................... 56 Probability of Default (PD) ....................................................................................................... 56 Exposure At Default (EAD)...................................................................................................... 56 Loss Given Default (LGD) ....................................................................................................... 57 Expected Loss (EL): EL = EAD*PD*LGD .............................................................................. 57 Additional Measures to Implement ........................................................................................... 57 Quantitative Application ............................................................................................................ 58 Framework for Model ............................................................................................................... 58 Loans – Trepp ........................................................................................................................... 59 Data for Regression................................................................................................................... 60 National Council for Real Estate Investment Fiduciaries (NCREIF). .................................. 61 Federal Reserve. .................................................................................................................... 62 Discretized Auto-Regressive Processes .................................................................................... 63 Loan Shocks .............................................................................................................................. 64 Defaults ..................................................................................................................................... 65 Risk Management 4 Loss Given Default. .............................................................................................................. 69 Returns .....................................................................................................................................