Risk rating systems can vary greatly between community and large banks. 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). Adjustments to the historical loss rates may be necessary to account for differences in the current portfolio. The secure Internet channel for FDIC-insured institutions to conduct business and exchange information with the FDIC. 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. Another technique used by some banks with larger portfolios and more sophisticated internal data is to stress ratings migrations. 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. 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. They may have separate legacy systems that do not aggregate data efficiently, if at all. The proposed Guidance sets forth thresholds for assessing whether an institution has a CRE concentration and should employ heightened risk management practices. 2. 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 monitoring function can be organized in a variety of ways. 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. stress tests may be useful for planning purposes and to identify potential vulnerabilities. Banks with limited staffing resources can use external audit staff or consulting firms to conduct the validation. 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. Loan agreements, collateral documentation, and appraisal practices—Robust loan agreements and collateral documentation are expected. 1 Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, Federal Register, Vol. Portfolio liquidity (ability to sell or securitize exposures on the secondary market).”. CRE loan growth recently prompted regulators to issue guidance to address concerns about CRE concentrations and to provide expectations for managing a concentrated portfolio. "Regulatory Guidance on Commercial Real Estate Risk" (April 2007) explains the guidance and the seven key areas. 238, December 12, 2006, pp. A CRE concentration increases the importance of sound lending policies. Regulatory limits for commercial real estate lending levels are at high levels for many community banks. 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. 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. Stressed loss rate testing entails determining loss rates at levels that could be expected during CRE market downturns and forecasting the ultimate effect of these losses on capital. This becomes increasingly important as the bank grows and more people are involved in the risk rating process. The following is the next installment in RMA’s Credit Risk Council 2017 Industry Insights: Perspectives from the Front Line.. Outside of large MSAs, vendor data are often unavailable. 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 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. Real estate investors who really want control over their investments must dig into the industry, know their market and understand the risks and … 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. Strong markets promote additional building, which can result in oversupply followed by weakened market fundamentals. 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. The rapid growth in CRE exposures in recent years presents additional challenges for bank management as it monitors and controls risks it may not have faced in the past. The historical loss rates are applied at the same granular level as the reference portfolio. 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. When compared to the current ratings, the effect of a market downturn could be measured (see Table 2). Plans and budgets are also needed to establish disbursement/draw schedules. Independent property inspections—There should be initial site visits and ongoing inspections during the construction phase. An Analysis of the Impact of the Commercial Real Estate Concentration Guidance (Washington, D.C.: April 2013). 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. Real estate lending represents one of the major components of credit risk at many banks. 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. 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. 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. 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. Essentials of Real Estate Finance provides the tools necessary to analyze income-producing property from the perspective of an institutional investor. Along with project assumptions, loan-specific variables, such as interest rates and LTV ratios inferred from capitalization rates, are commonly analyzed. 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. Commercial real estate (CRE) and multifamily concentrations are an area of scrutiny for regulators in the current exam cycle. 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). Sound risk management strategies are … Figure 1. 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. 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). 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. 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. Many banks fail to collect the data necessary to produce the reports listed above. However, investing in assets that management does not understand can also carry significant risks. Banks may tend to believe that the losses during that time were much more severe than they would ever again encounter. Sponsor or guarantor financial analysis, if applicable. PDF ATTACHED: FIG Partners Industry Analysis 9-7-16 – Impact of CRE Concentration Guidance. Steven G. Johnson Growth in land acquisition, development, and construction (ADC) lending has been especially pronounced. Supervisory Examiner, In this case, an upward adjustment in loss rates would seem necessary to address the additional concentration risk. While the direct costs of these actions are apparent, there are often other costs that bear mention. In these institutions, the type and level of adjustments to historical loan loss rates are critical elements to developing a useful outcome. Distribution: FDIC-Supervised Banks (Commercial … Each year a percentage of credits (obligors in cases of banks with two-dimensional rating systems) improves, remains the same, or declines. This is especially true if the data for the reference portfolio lack granularity. Some analysts suggest that a major sea change has occurred in the form of greater transparency and liquidity that acts as a cushion against the deep losses of the 1980s and 1990s. Following are examples of the types of stress tests commonly used in banks. 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. Residential market information is also available from a number of national and regional providers. 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. 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. In 2006, the FFIEC published the Interagency Guidance “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” (1), which outlined regulators’ expectations for a risk management framework to manage the risk associated with Commercial Real Estate (CRE) concentrations. In particular, small to mid-siz… 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 … Granularity is also necessary to provide an accurate assessment of portfolio risk. 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. 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. Recursos del seguro de depósito en español, FDIC National Survey of Unbanked and Underbanked Households, Money Smart - A Financial Education Program, Risk Management Manual of Examination Policies, Bank Secrecy Act and Anti-Money Laundering, FFIEC Information Technology Examination Handbook, Consumer Compliance Supervisory Highlights, Organization Directory and Office Contacts, www.fdic.gov/news/news/financial/2006/fil06104.html, www.fdic.gov/regulations/laws/rules/2000-8700.html, www.fdic.gov/regulations/laws/rules/2000-4300.html, www.fdic.gov/news/news/financial/2003/fil0384b.html, www.fdic.gov/news/news/financial/2005/fil9005.html, www.fdic.gov/news/news/financial/1999/fil9994.html, www.fdic.gov/bank/historical/history/contents.html, Freedom of Information Act (FOIA) Service Center, Relatively low borrowing costs and the easy availability of credit, Government policy, including income tax benefits, Long gestation periods that allowed supply-and-demand dynamics to change before a project’s completion, Nonrecourse lending and legal structures that shielded project sponsors from risk, Out-of-area lending, including the purchase of loan participations from out-of-area lenders, An unregulated real estate appraisal industry that often used inflated assumptions and relied on inexperienced appraisers, Total loans reported on the Report of Condition for construction, land development, and other land represent 100 percent or more of the institution’s total capital; or. The FDIC has historical CRE data that could be used to construct loss rates, although the FDIC data lacks much granularity.9. Determining market fundamentals for each product type and geographic market where the bank has funds committed. For BHCs, the appraisal standards can be found in Regulation Y, subpart G, 12 CFR 225.61-67. 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. 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. 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 Fed’s consumer compliance supervisory responsibilities. Monitoring speculative single-family housing development can be especially challenging. However, the analysis of loans granted for speculative lot development projects with slower absorption rates could reveal substantial additional exposure, suggesting that the bank should consider limiting its exposure in certain geographic markets or product types. Analysis covers testing the common assumptions and combinations of assumptions shown in Table 1. 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. A bank’s ability to monitor developments in its CRE market area is a critical element of successful CRE lending. A bank can have significant diversification within its CRE portfolio or have a concentration within a specific CRE category. "Adapting to CRE Concentration and Risk Management Guidelines" (April 2007) describes one bank's firsthand experience in incorporating the principles. the stress year migration to move the appropriate volume of exposures in 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. The regional or national economy shows signs of stress. FIL-104-2005, Joint Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (, 12 CFR 365, Real Estate Lending Standards and Interagency Guidelines for Real Estate Lending Policies (, Interagency Appraisal and Evaluation Guidelines (, FIL-90-2005, Residential Tract Development Lending (, FIL-94-1999, Interagency Guidance on High Loan-to-Value Residential Real Estate Lending (. For risk management purposes, a bank may develop stress scenarios customized to its circumstances to make assumptions about how its CRE portfolio would react. 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'. In areas where management deems risks to be higher, lenders may be instructed to curtail or discontinue lending activities altogether. 3 The federal bank and thrift regulatory agencies have adopted substantially similar appraisal regulations. 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. 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). Generally, the longer a bank has been a CRE lender, the more granular the loss data. Residential Real Estate and Mortgages Not surprisingly, CRE-related loans account for a significant portion … An institution’s lending policies should communicate the level of risk acceptable to its board of directors. The granularity warranted may be product-by-product, location-by-location or some other degree (e.g., price point, speculative versus presold), depending upon the institution’s markets and product types. 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. Commercial real estate (CRE) loans comprise a major portion of many banks’ loan portfolios. Testing each credit in the portfolio, considering the current status of each project against the impact of the sensitivity analysis forecasts. The guidance does not state that the supervisory cri­ teria should be viewed as a hard cap on CRE concen­ tration levels. These drivers could be LTV, rate type (fixed versus floating), debt coverage ratios, or large tenants that could create concentrations when aggregated. each current rating grade to the grades reflected in the stress year ratings matrix. Institutions should track available inventory and their own levels of exposure at a level of granularity sufficient to allow management to determine if the institution should curtail lending for specific products or in locations of concern, even if other products or locations continue to perform well. Calculate the losses that would be expected in a market downturn by applying the adjusted historical loss rates to the current portfolio. Once risk management has compiled the information, it must deliver its market analysis back to the lending staff. Examination Specialist, In light of the possibility of significant losses in CRE portfolios, banks with concentrations in CRE can use stress testing to assess the extent of their exposure to a downturn in CRE markets. Specific, objective rating criteria rather than broad, subjective criteria promote consistency in the rating process. 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. 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. As loan quality deteriorates, banks must expend significant resources, both human and monetary, for collection and, in some cases, foreclosure on the underlying collateral. If CRE lending is the primary earnings driver, the institution should be prepared to diversify into other areas of lending or wait for CRE markets to return. 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. Different CRE types may have different risk characteristics. 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. Direct costs of these actions are apparent, there are often unavailable opportunity cost holding. Agreement with a high percentage of assigned credit ratings can not be within... 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