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. An Analysis of the Impact of the Commercial Real Estate Concentration Guidance (Washington, D.C.: April 2013). (For practical purposes, it may be necessary to establish a materiality threshold.). Residential market information is also available from a number of national and regional providers. (See Figure 1.) 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. Most geographic locations in the United States have not experienced serious declines in CRE markets for a number of years. 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. The inventory of other assets for sale -- including office furniture, fixtures, and equipment. Growth in land acquisition, development, and construction (ADC) lending has been especially pronounced. See section titled “Loans in Excess of the Supervisory Loan-to-Value Limits.”. 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? In this case, an upward adjustment in loss rates would seem necessary to address the additional concentration risk. A bank can have significant diversification within its CRE portfolio or have a concentration within a specific CRE category. In areas where management deems risks to be higher, lenders may be instructed to curtail or discontinue lending activities altogether. Various tools may be available to monitor CRE markets, depending on the size of the market. 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. Listed below are some examples of possible indicators that particular markets are at or near a peak. 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. Identify the similarities or differences between the bank’s current portfolio and the historical reference portfolio, and adjust the loss rates appropriately. The monitoring function can be organized in a variety of ways. The Federal Reserve Board's real estate lending standards are found in 12 CFR 208, subpart E. The "Interagency Guidelines for Real Estate Lending Policies" are located in Regulation H, subpart I, 12 CFR 208, appendix C. Commercial Real Estate â¢ 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 âfocuses 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.â 6 The target of the guidance, then, generally would include development and construction loans for which repayment is dependent upon â¦ 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. For example, the appraisal industry is now regulated, and appraisal quality is far superior to what it was in the 1980s. Such an analysis would measure the depth and breadth of the portfolio’s vulnerability to changes in real estate markets and interest rates. In these institutions, the type and level of adjustments to historical loan loss rates are critical elements to developing a useful outcome. While it may be easy to manage a concentration during the good times, managing one once market demand has slowed is much more challenging. Risk management practices should be commensurate with the complexity of the bank and its portfolio. "Adapting to CRE Concentration and Risk Management Guidelines" (April 2007) describes one bank's firsthand experience in incorporating the principles. Portfolio liquidity (ability to sell or securitize exposures on the secondary market).”. An institution’s lending policies should communicate the level of risk acceptable to its board of directors. 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. CRE loan growth recently prompted regulators to issue guidance to address concerns about CRE concentrations and to provide expectations for managing a concentrated portfolio. 238, December 12, 2006, pp. In addition, many banks do not have the resources to search hard copy files and backfill data into their systems. This Guidance is based upon the principles contained in the Agencies' real estate lending standards regulations and guidelines. 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. The failure to control exposure levels when warning signs are evident can result in excessive loan losses. Much has changed in CRE lending since the last downturn. For risk management purposes, a bank may develop stress scenarios customized to its circumstances to make assumptions about how its CRE portfolio would react. Once risk management has compiled the information, it must deliver its market analysis back to the lending staff. 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). The guidance provides supervisory criteria, including numerical indicators, for identifying institutions with potentially significant CRE loan concentrations that may warrant greater supervisory scrutiny. Risk ratings should be accurate and uniformly applied across product lines and geographic areas. The historical loss rates are applied at the same granular level as the reference portfolio. The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system. 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). 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). Management first needs to identify the drivers that will affect segmentation at origination and then capture those data fields on the system. 2 Capital generally is defined as a bankâs long-term source of funding, contributed largely by the bankâs equity stockholders and its own returns in the form of retained earnings. 2. Monitoring speculative single-family housing development can be especially challenging. 74580–74588 (CRE Guidance). 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. 1. While not providing specific information for managing CRE concentrations, it should inform management of the possible level of the bank’s exposure if a CRE downturn were to occur. As banks grow, this process is typically brought in-house. 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. The bank would use the results of
The Federal Reserve Boardâs real estate appraisal standards are found in Regulation H, subpart E, 12 CFR 208.50â51 for state member banks. The usefulness of this type of test relies heavily on the reference portfolio selected to conduct the test. Another technique used by some banks with larger portfolios and more sophisticated internal data is to stress ratings migrations. 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. Independent property inspections—There should be initial site visits and ongoing inspections during the construction phase. The following is the next installment in RMAâs Credit Risk Council 2017 Industry Insights: Perspectives from the Front Line.. Analysis covers testing the common assumptions and combinations of assumptions shown in Table 1. Identify loss rates that occurred as a result of previous market downturns, generally the highest loss rates experienced in the reference portfolio. 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. The results of the scenario might affect the bank’s other credit portfolios and lines of business, in addition to CRE loans. In response to rapid growth in CRE loan concentrations and observed weaknesses in risk management practices at some institutions, the Federal Deposit Insurance Corporation (FDIC), the Board of Governors of the Federal Reserve System (FRB), and the Office of the Comptroller of the Currency (OCC) (collectively, the federal banking agencies) published Joint Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (CRE guidance) in December 2006.1 This article provides additional information and context to some of the topics discussed in the CRE guidance, drawn from the authors’ firsthand observation of the risk management practices of both large and small banks. Reiteration of Interagency Guidance on CRE-Commercial Real Estate Concentrations has had limited impact on Banking Industry. 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. Distribution: FDIC-Supervised Banks (Commercial â¦ 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). 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 â¦ If a bank’s portfolio goes outside of these general guidelines, as many do, the bank will not automatically be criticized, but heightened risk management practices may be needed. 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. (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.) Communication must occur between lending and risk management functions. Obtain historical loss rates on CRE loans (the “reference portfolio”) at the most granular level available. stress tests may be useful for planning purposes and to identify potential vulnerabilities. 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. 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. Adjusting those limits when market fundamentals change is also a prudent risk management tool. Commercial real estate (CRE) and multifamily concentrations are an area of scrutiny for regulators in the current exam cycle. In banks with more limited CRE lending experience, the data may be at higher levels, such as all types of ADC loans or even all CRE loans. Many banks fail to collect the data necessary to produce the reports listed above. Reserves for maintenance and improvements. Strong risk management practices and appropriate levels of capital are essential elements of a sound Commercial Real Estate (CRE) lending â¦ Sponsor or guarantor financial analysis, if applicable. The level of losses will generally depend on the quality of loan underwriting and the breadth and depth of the CRE market downturn. Alternatively, the bank could develop a relationship between economic variables and ratings migrations. Transparency is generally evaluated by reading the bank’s rating policy guidelines and conducting transaction testing. 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. 9 See Statistics on Depository Institutions at www2.fdic.gov/sdi/index.asp. 1 Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, Federal Register, Vol. Regulators have removed a key commercial real estate concentration limit for New York Community Bancorp in Westbury, N.Y. 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. The guidance reminds institutions that strong risk management practices and appropriate levels of capital are essential elements of a sound commercial real estate (CRE) lending program, particularly when an institution has a concentration in CRE loans. Calculate the losses that would be expected in a market downturn by applying the adjusted historical loss rates to the current portfolio. 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 â¦ â¢ Total commercial and residential real estate loans secured by real estate with LTVs in excess of FDICIA guidelines should not exceed 100% of capital. 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 Loan agreements should clearly communicate draw schedules, release provisions, and repayment requirements. Atlanta, GA, Mark D. Sheely
Senior Examination Specialist,
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. Review of Monetary Policy Strategy, Tools, and Communications, Banking Applications & Legal Developments, Financial Market Utilities & Infrastructures. Regulatory limits for commercial real estate lending levels are at high levels for many community banks. Residential Real Estate and Mortgages 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 â¦ The regional or national economy shows signs of stress. 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. Although most banks do not perform bankwide scenario stress testing, the process of developing such
Steven G. Johnson
Additional costs accrue during the holding period, including property taxes and the cost of sales, maintenance, and security. Learn if your bank is insured, view locations, track history, and more. Risk rating and review processes should have the following characteristics: Transparency is critical for any risk rating system. 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. Typical loan production and performance reports by type, region, officer, etc. Thus far, the examples cited have not necessarily been related to a particular, perhaps local, event. The second component is Real Estate Law, which offers an overview of the legal issues confronting the real estate executive. The standards primarily focus on the responsibilities of the bank's board of directors for developing and issuing lending policies. 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. Since the onset of the financial crisis in 2008, commercial real estate (CRE) loan delinquencies have more than doubled. need further clarification. For example, the institution may create a CRE risk management function that is responsible for establishing CRE concentration risk limits (approved by the institution’s board) and overseeing compliance with those limits. As loan quality deteriorates, banks must expend significant resources, both human and monetary, for collection and, in some cases, foreclosure on the underlying collateral. 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. 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. Reporting systems should be sufficiently detailed to identify situations where the strategy is not being followed. 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. Appraisals If these data are not available, a bank might choose to apply conservative estimates of migrations to establish a stress year. In many of these instances, costs escalated dramatically as lenders were forced to restart projects and remediate shoddy workmanship, adopt engineering and architectural changes to make the project viable, pay off subcontractor liens, and pursue zoning or other legal issues. Markets may be monitored by staff or management, but ultimately both must understand what is being monitored and why. CRE updates were released in 2012, along with community bank stress-testing guidance in 2013. Managing Commercial Real Estate Concentrations. 4 An Analysis of the Impact of the Commercial Real Estate Concentration Guidance higher than loss rates for owner-occupied loans, were significantly lower than those for construction loans. 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, 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. "Regulatory Guidance on Commercial Real Estate Risk" (April 2007) explains the guidance and the seven key areas. 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. The guidance does not state that the supervisory cri teria should be viewed as a hard cap on CRE concen tration levels. Essentials of Real Estate Finance provides the tools necessary to analyze income-producing property from the perspective of an institutional investor. 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. The CRE guidance recognizes that diversification can be achieved within CRE portfolios and differentiates risk in different types of CRE loans. 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. Subprime lending involves extending credit to borrowers who exhibit characteristics that indicate a significantly higher risk of default than traditional bank lending customers. Commercial real estate (CRE) loans comprise a major portion of many banks’ loan portfolios. 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. The FDIC has historical CRE data that could be used to construct loss rates, although the FDIC data lacks much granularity.9. 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. These analyses can be conducted on a scheduled basis or when market fundamentals dictate. 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. In these institutions, the examples cited have not necessarily been related a. Housing development can be especially challenging be conducted on a scheduled basis when... 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