I. INTRODUCTION
The federal regulatory agencies issued final joint Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (Guidance). This Guidance has been developed to reinforce sound risk management practices for institutions with high and increasing concentrations of commercial real estate loans on their balance sheets. The need for the Guidance arose as a result of observation by the agencies 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 final Guidance is a reminder to institutions that there are substantial risks posed by CRE concentrations and that these risks should be recognized and appropriately addressed. The final Guidance describes sound risk management practices that are important for an institution that has strategically decided to concentrate in CRE lending. These risk management practices build upon existing real estate lending regulations and guidelines. The agencies also have clarified that they are not establishing a limit on the amount of commercial real estate lending that an institution may conduct.
II. SCOPE OF GUIDANCE
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 an abundance of caution. As a result, for purposes of the Guidance, CRE loans include those loans with risk profile sensitive to the condition of the general CRE market (for example, market demand, changes in capitalization rates, vacancy rates, or rents). CRE loans are land development and construction loans (including one-to-four family residential and commercial construction loans) and other land loans. CRE loans also include loans secured by multifamily property, and nonfarm nonresidential property, where the primary source of repayment is derived from rental income associated with the property (that is loans for which 50 percent or more of the source of repayment comes from third party, non affiliated, rental income) or the proceeds of the sale, refinancing, or permanent financing of the property.
Loans to real estate investment trusts (REITs) and unsecured loans to developers also should be considered CRE loans for purposes of the Guidance if their performance is closely linked to performance of the CRE markets. Excluded from the scope of the Guidance are loans secured by nonfarm nonresidential properties where the primary source of repayment is the cash flow from the ongoing operations and activities conducted by the party, or affiliate of the party, who owns the property. The Agencies believe that institutions are in the best position to segment their CRE portfolios and group credit exposures by common risk characteristics or sensitivities to economic, financial, or business developments. Institutions should be able to identify potential concentrations in their CRE portfolios by common risk characteristics, which will differ by property type. The final Guidance notes that factors, such as portfolio diversification, geographic dispersion, levels of underwriting standards, level of pre-sold buildings, and portfolio liquidity, would be considered in evaluating whether an institution has mitigated the risk posed by a concentration. Finally, the Agencies acknowledge in the final guidance that consideration should be given to the lower risk profiles and historically superior performance of certain types of CRE such as well-structured multifamily housing loans, when compared to others, such as speculative office construction.
III. CRE CONCENTRATION ASSESSMENT
The final Guidance provides an institution should perform their own assessment of concentration risk in their CRE loan portfolios. While the final Guidance does not establish a CRE concentration limit, the Agencies have retained high-level indicators to assist examiners in identifying institutions potentially exposed to CRE concentration risk. Owner-occupied loans are not included when the regulators are looking to see if a bank has a “high level indicator of risk.” When the CRE Guidance first came out, the agencies’ Call Reports did not distinguish owner-occupied from non-owner-occupied loans. Changes made to the call report have resulted in a bank now being required to report on the amount of owner-occupied loans it has.
An institution that has experienced rapid growth in CRE lending, has notable exposure to a specific type of CRE, or is approaching or exceeds the following supervisory criteria may be identified for further supervisory analysis of the level and nature of its CRE concentration risk. The supervisory criteria are:
The Agencies state that the foregoing numeric indicators do not constitute limits; rather they will be used as a supervisory monitoring tool. These indicators will assist examiners in identifying institutions with CRE concentrations.
The Agencies recognize that risk characteristics vary by different property types of CRE loans and those institutions are in the best position to identify potential concentrations by stratifying their CRE portfolios into segments with common risk characteristics. The Agencies believe an institution’s board of directors and management should identify and monitor credit concentrations and establish internal concentration limits. The final Guidance clarifies that an institution actively involved in CRE lending should be able to identify concentrations in its CRE portfolio and to monitor concentration risk on an ongoing basis.
IV. RISK MANAGEMENT
The final Guidance builds upon the Agencies’ existing regulations and guidance for real estate lending and loan portfolio management, emphasizing those risk management practices that will enable an institution to pursue CRE lending in a safe and sound manner.
The risk management section in the final Guidance sets forth the key elements of an institution’s risk management framework for managing concentration risk. Further, the final Guidance recognizes the sophistication of an institution’s risk management processes will depend upon the size of the CRE portfolio and the level and nature of its CRE concentration risk. Institutions should address the following key elements in establishing a risk management framework that effectively identifies, monitors, and controls CRE concentration risk:
A. Board and Management Oversight
An institution’s board of directors has ultimate responsibility for the level of risk assumed by the institution. If the institution has significant CRE concentration risk, its strategic plan should address the rationale for its CRE levels in relation to its overall growth objectives, financial targets, and capital plan. In addition, the Agencies’ real estate lending regulations require that each institution adopt and maintain a written policy that establishes appropriate limits and standards for all extensions of credit that are secured by liens on or interests in real estate, including CRE loans. Therefore, the board of directors or a designated committee thereof should:
Periodically review and approve CRE risk exposure limits and appropriate sublimits (for example, by nature of concentration) to conform to any changes in the institution’s strategies and to respond to changes in market conditions.
B. Portfolio Management
Institutions with CRE concentrations should manage not only the risk of individual loans but also portfolio risk. Even when individual CRE loans are prudently underwritten, concentrations of loans that are similarly affected by cyclical changes in the CRE market can expose an institution to an unacceptable level of risk if not properly managed. Management regularly should evaluate the degree of correlation between related real estate sectors and establish internal lending guidelines and concentration limits that control the institution’s overall risk exposure.
Management should develop appropriate strategies for managing CRE concentration levels, including a contingency plan to reduce or mitigate concentrations in the event of adverse CRE market conditions. Loan participations, whole loan sales, and securitizations are a few examples of strategies for actively managing concentration levels without curtailing new originations. If the contingency plan includes selling or securitizing CRE loans, management should assess periodically the marketability of the portfolio. This should include an evaluation of the institution’s ability to access the secondary market and a comparison of its underwriting standards with those that exist in the secondary market.
There is more emphasis now on the back end of the loan process – namely, workouts and the disposition of problem assets. Banks holding distressed CRE assets in their portfolios may conclude that it is cheaper in the long run to sell poorly performing CRE loans early rather than hold onto them in the hopes of a market resurgence.
C. Management Information Systems
A strong management information system (MIS) is key to effective portfolio management. The sophistication of MIS will necessarily vary with the size and complexity of the CRE portfolio and level and nature of concentration risk. MIS should provide management with sufficient information to identify, measure, monitor, and manage CRE concentration risk. This includes meaningful information on CRE portfolio characteristics that is relevant to the institution’s lending strategy, underwriting standards, and risk tolerances. An institution should assess periodically the adequacy of MIS in light of growth in CRE loans and changes in the CRE portfolio’s size, risk profile, and complexity.
Institutions are encouraged to stratify the CRE portfolio by property type, geographic market, tenant concentrations, tenant industries, developer concentrations, and risk rating. Other useful stratifications may include loan structure (for example, fixed rate or adjustable), loan purpose (for example, construction, short-term, or permanent), loan-to-value limits, debt service coverage, policy exceptions on newly underwritten credit facilities, and affiliated loans (for example, loans to tenants). An institution should also be able to identify and aggregate exposures to a borrower, including its credit exposure relating to derivatives.
Management reporting should be timely and in a format that clearly indicates changes in the portfolio’s risk profile, including risk-rating migrations. In addition, management reporting should include a well-defined process through which management reviews and evaluates concentration and risk management reports, as well as special ad hoc analyses in response to potential market events that could affect the CRE loan portfolio. Subsequent to issuance of the original Guidance, the FDIC has suggested that MIS reports may include:
o Presold or speculative properties; o Portfolio or borrower aging; o Concentrations in a given market or submarket; and o Aggregate price range of CRE inventory;
o Number and volume of exceptions by nature, justification, and trends; and o Performance of exception loans compared with loans underwritten within guidelines;
D. Market Analysis
Market analysis should provide the institution’s management and board of directors with information to assess whether it’s CRE lending strategy and policies continue to be appropriate in light of changes in CRE market conditions. An institution should perform periodic market analyses for the various property types and geographic markets represented in its portfolio.
Market analysis is particularly important as an institution considers decisions about entering new markets, pursuing new lending activities, or expanding in existing markets. Market information also may be useful for developing sensitivity analysis or stress tests to assess portfolio risk.
Sources of market information may include published research data, real estate appraisers and agents, information maintained by the property taxing authority, local contractors, builders, investors, and community development groups. The sophistication of an institution’s analysis will vary by its market share and exposure, as well as the availability of market data. While an institution operating in nonmetropolitan markets may have access to fewer sources of detailed market data than an institution operating in large, metropolitan markets, an institution should be able to demonstrate that it has an understanding of the economic and business factors influencing its lending markets. The FDIC has identified the following possible indicators that a market is at or near its peak:
E. Credit Underwriting Standards
An institution’s lending policies should reflect the level of risk that is acceptable to its board of directors and should provide clear and measurable underwriting standards that enable the institution’s lending staff to evaluate all relevant credit factors. When an institution has a CRE concentration, the establishment of sound lending policies becomes even more critical. In establishing its policies, an institution should consider both internal and external factors, such as its market position, historical experience, present and prospective trade area, probable future loan and funding trends, staff capabilities, and technology resources. Consistent with the Agencies’ real estate lending guidelines, CRE lending policies should address the following underwriting standards:
An institution’s lending policies should permit exceptions to underwriting standards only on a limited basis. When an institution does permit an exception, it should document how the transaction does not conform to the institution’s policy or underwriting standards, obtain appropriate management approvals, and provide reports to the board of directors or designated committee detailing the number, nature, justifications, and trends for exceptions. Exceptions to both the institution’s internal lending standards and the Agencies’ supervisory LTV limits should be monitored and reported on a regular basis. Further, institutions should analyze trends in exceptions to ensure that risk remains within the institution’s established risk tolerance limits.
Credit analysis should reflect both the borrower’s overall creditworthiness and project-specific considerations as appropriate. In addition, for development and construction loans, the institution should have policies and procedures governing loan disbursements to ensure that the institution’s minimum borrower equity requirements are maintained throughout the development and construction periods. Prudent controls should include an inspection process, documentation on construction progress, tracking pre-sold units, preleasing activity, and exception monitoring and reporting.
Regulators have identified several factors as key to effective underwriting since the issuance of the CRE concentration guidance. These factors include the following:
Banks will need to be able to show policy limits on CRE loans that are appropriate given the bank’s size, resources, and business model. Exceptions to these limits – particularly by a bank that has a CRE concentration – will need to be justified by sound underwriting factors.
More recently, the regulators have expressed concern about banks lending too extensively to out-of-market borrowers. It can be difficult for a bank to have a sufficiently well-developed understanding of the borrowers in unfamiliar markets, and lending out of market may be seen as a red flag about the quality of loans the bank is making
F. Portfolio Stress Testing and Sensitivity Analysis
An institution with CRE concentrations should perform portfolio-level stress tests or sensitivity analysis to quantify the impact of changing economic conditions on asset quality, earnings, and capital. Further, an institution should consider the sensitivity of portfolio segments with common risk characteristics to potential market conditions. The sophistication of stress testing practices and sensitivity analysis should be consistent with the size, complexity, and risk characteristics of its CRE loan portfolio. For example, well-margined and seasoned performing loans on multifamily housing normally would require significantly less robust stress testing than most acquisition, development, and construction loans.
Portfolio stress testing and sensitivity analysis may not necessarily require the use of a sophisticated portfolio model. Depending on the risk characteristics of the CRE portfolio, stress testing may be as simple as analyzing the potential effect of stressed loss rates on the CRE portfolio, capital, and earnings. The analysis should focus on the more vulnerable segments of an institution’s CRE portfolio, taking into consideration the prevailing market environment and the institution’s business strategy.
Regulators are encouraging banks to conduct stress tests not only at loan origination but periodically throughout the life of a loan to assess the impact of changing economic conditions on asset quality, earnings, and capital. They are also looking to see stress testing of variables beyond interest rate, such as vacancy rates, lease rates, and expense scenarios.
The FDIC has suggested that a portfolio analysis might involve the following steps:
G. Credit Risk Review Function
A strong credit risk review function is critical for an institution’s self-assessment of emerging risks. An effective, accurate, and timely risk-rating system provides a foundation for the institution’s credit risk review function to assess credit quality and, ultimately, to identify problem loans. Risk ratings should be risk sensitive, objective, and appropriate for the types of CRE loans underwritten by the institution. Further, risk ratings should be reviewed regularly for appropriateness.
The regulators have identified the following steps that a bank must take in order to deal realistically with asset quality issues:
The question of when to update an appraisal or obtain a new appraisal also has received much attention. Reappraisals or revaluations become increasingly important the more a bank looks to the collateral for repayment. Factors to consider include:
Examiners will be looking for banks to have a policy that explains when a new appraisal is required and when an internal bank adjustment is sufficient. The policy should also address what a bank will do if the new appraisal does not support the project. If a bank’s process for determining when new or updated appraisals are required is not functioning effectively, this may cause examiner-initiated downgrades and required additions to ALLL.
V. ASSESSMENT OF CAPITAL ADEQUACY
In the final Guidance, the discussion on the adequacy of an institution’s capital has been incorporated into the supervisory oversight section to clarify that the assessment of an institution’s capital will be performed in connection with the supervisory assessment of an institution’s risk management.
Since the institution’s capital serves as a buffer against unexpected losses from its CRE concentration, an institution with a CRE concentration and inadequate capital should develop a plan for reducing its concentration or maintaining capital appropriate for the level and nature of the concentration risk. To the extent an institution with a CRE concentration has effective risk management practices or is addressing the need for such practices, the Agencies’ concerns regarding capital adequacy are reduced. However, an institution with a CRE concentration and with no prospects of enhancing its risk management practices should address the need for additional capital. Therefore, the final Guidance reminds institutions that they should hold capital commensurate with the level and nature of the risks to which they are exposed.
While most banks have sufficient capital, bank examiners may expect to see some discussion of allocation of capital to support any concentrations and in particular CRE concentrations. After identifying strong capital levels as one of the key risk management processes to help banks with CRE concentrations manage through changes in market conditions, the FDIC stated:
Capital provides institutions with protection against unexpected losses, particularly in stressed markets. Institutions with significant [construction and development] and CRE exposures may require more capital because of uncertainty about market conditions, causing an elevated risk of unexpected losses. As market conditions warrant, directorates and management should take steps to increase capital levels to support significant CRE concentrations. Capital protection for C&D and CRE concentrations should be strategic priority when contemplating the declaration of cash dividends.
While most banks have capital well in excess of what is required to meet the “well capitalized” standard, banks that are in markets experiencing particularly sharp declines in the CRE market may find that their examiners will be looking for additional capital to cushion anticipated losses.