The Fourth Quarter 2002 issue of SRC Insights included an article titled "Trends in Commercial Real Estate," which discussed the overall quality of commercial real estate (CRE) loans in light of the soft economy. The article indicated that while CRE market conditions for the nation as a whole have been down, CRE loan quality for the Philadelphia region has been relatively stable. Credit risk management practices at Third District banks have been generally satisfactory based on the trend of nonaccrual and delinquent loans, although trends such as these tend to be lagging indicators of true portfolio quality. Nevertheless, the article went on to state that some institutions within the District have started to report increased levels of problem loans. This article serves as a follow-up to "Trends in Commercial Real Estate" and focuses on best practices in managing a CRE loan portfolio.
Taking and managing credit risk is fundamental to the business of banking. Lending funds to borrowers to invest in income-producing propertiessuch as office buildings, shopping centers, apartments, warehouses, and hotelson a sound and collectible basis is a good source of income for the benefit of shareholders. Such lending also serves the legitimate credit needs of the bank's community and, through collateralization, protects depositor funds. However, financing income-producing properties is a specialized type of lending due to its cyclical nature and the tendency of real estate values to fluctuate with economic swings. Commercial real estate business cycles tend to lag general economic cycles, which means that weak market conditions last longer in the CRE industry, particularly because repayment of the loan comes from sale or refinance of the property or income generated from leases.
Losses from CRE lending during the 1980s and early 1990s, which caused several bank failures, are sobering reminders that CRE lending is not for all financial institutions. When poorly managed, banks have incurred an inordinate level of losses from CRE lending compared to other segments of their loan portfolios. In fact, some institutions have concluded that the risks are too great and have opted out of CRE lending altogether.
CRE loans can be profitable as long as the risk management practices that are unique and distinct to this type of lending are in place. Accordingly, to effectively manage this risk, an institution must establish a structure that adequately identifies, measures, monitors, and controls the risks involved in its CRE lending activities. Furthermore, an institution's credit risk appetite must be tailored to the size and complexity of its operations. A fundamentally sound credit risk management program must include, but should not necessarily be limited to, some of the best practices discussed in the information that follows.
Board and Management Oversight
The board of directors should be actively involved in oversight of the risk management process. It should clearly articulate its credit risk tolerance limits and ensure that management implements a risk management process that includes adequate policies, procedures, and limits and sufficient risk measurement and monitoring mechanisms. In addition, accurate and timely management information reports and a sound internal control environment are essential for an effective credit risk management process. Some common credit risk management deficiencies frequently cited by examiners are listed in the table, "Not-So-Best Practices," appearing at the end of this article.
Credit Risk Management Policy and Procedures
The CRE lending policy must represent an institution's best effort to establish guidelines for sound lending practices. The purpose of a bank's CRE lending policy is to establish the authority, rules, and framework to operate and administer the portfolio effectively, ensuring profitability while managing risk. The policy must serve as a framework that sets basic standards and procedures in a clear and concise manner. A sound loan policy promotes the institution's business and lending philosophy as it provides lenders with the necessary reference and clarity to minimize inconsistencies and confusion concerning lending guidelines and objectives.
Each bank's policy will differ, given the institution's strategic goals and objectives and factors such as the experience and ability of the lending personnel, economic conditions, and competition. The complexity and scope of the lending policy and procedures should be appropriate to the size of the institution and the nature of its activities and should be consistent with prudent banking practices and relevant regulatory requirements. At a minimum, the policy should be reviewed and approved annually to ensure that it is not outdated or ineffective. It should remain flexible and in alignment with the organization's strategic objectives. Tenets of a sound policy include adequate diversification standards, underwriting standards, due diligence, loan administration procedures, loan approval processes, and documentation standards.
Diversification Standards. Lending policies should state the permissible types of loans, geographic markets, and loan concentration limits. Concentrations are generally categorized by using the North American Industry Classification System (NAICS) and relating industry exposures to capital level, earnings at risk, or a percentage of outstanding loans. Some institutions track concentrations by geographic area, by terms, or by property type, such as apartment, office building, warehouse/industrial building, hotel/motel, retail, housing project, construction, and land development. Concentration limits must be established to ensure an institution's risk exposure to a particular economic sector in terms of earnings and capital at risk is within its accepted risk tolerance levels.
Underwriting Standards. Credit underwriting standards will vary for different types of income-producing properties and should reflect the inherent risks and characteristics of the project being financed. However, banks should adhere to certain core standards to effectively manage risk. Several practices, processes, and procedures stated in this article are self-explanatory and are prevalent in most lending policies. However, additional guidance is provided in areas that are considered critical to the risk management process.
Underwriting standards that are clearly measurable must be spelled out in the policy. Examples of clearly measurable standards include loan-to-value and debt-to-income ratios, overall credit worthiness of the borrower, financial information requirements, loan maturities by type of property, maximum advance rates, pricing structure, pre-leasing requirements, guarantee requirements, appraisal requirements, general terms and covenants for different types of loans, and charge-off standards.
The appraisal requirements must comply with Uniform Standards of Professional Appraisal Practices (USPAP) and regulatory guidelines, which clearly indicate when an appraisal or evaluation is required and who is approved or qualified to perform the appraisal or evaluation. An independent reviewer, other than the account officer, should attest to the quality of the appraisal report, the validity of the assumptions used, the appropriateness of the comparables and the capitalization rate, and the reasonableness of the lease-up period. The reviewer also should comment on the final value of the collateral and the quality of the report. Using an independent appraisal reviewer is essential to preclude any conflict of interest that may arise by an account officer attempting to meet production goals.
Understanding the competence of management of the borrower or business entity, while not easily "measurable," is also a fundamental component of the underwriting process. The borrower's management team must possess adequate knowledge and experience commensurate with the complexity of the company's business and the project presented for financing. The management team must demonstrate a successful track record of developing and completing similar types of projects on time and within budget.
Due Diligence. It is important for bank management to conduct proper due diligence before acquiring or approving a loan. Such due diligence should continue throughout the life of the loan. Management should regularly obtain and analyze timely and accurate financial and economic data as well as credit report information on borrowers, guarantors, and other related parties. For construction lending, background and financial information on the developer should be evaluated to ascertain the ability and competence of the borrower to manage construction of the project. Reviewing project schedules; cost breakdowns; copies of approvals, surveys, specifications, licenses, contracts, and permits; pro forma statements; and projections are all important elements of the due diligence process. Property informationsuch as current environment reports, insurance, appraisals, and lease agreementsis necessary to help management monitor the value of the underlying collateral.
Loan Administration Procedures. The loan administration function is a critical element in the credit risk management process and should be separate from the lending unit. It is noteworthy that the regulatory rating for asset quality takes into consideration the effectiveness of a bank's credit administration practices and not just its underwriting practices. Banking institutions should have adequate procedures to ensure segregation of duties for loan closing and disbursement processes, payment processing, escrow administration, collateral administration, loan payoffs, collections and foreclosure, and claims processing.
Loan Approval Process. The loan officer is responsible for collecting data, performing due diligence, analyzing the appropriateness of the request, and submitting a clear and detailed presentation to appropriate officers and/or committees for approval. The presentation at a minimum should include discussions about the borrower; a description of the project; a financial analysis, including the project budget; a project feasibility analysis; a review of market conditions; a discussion of repayment sources; a risk summary, stating both strengths and weakness; the presence of security agreements; and the officer's recommendations.
Documentation Standards. Credit documentation requirements for CRE loans will differ depending on the risks, characteristics, and type of project being financed. However, banks must adhere to certain core standards to effectively manage risk. The lending policies should indicate required documentation and record retention periods for loan applications; loan approval and rejection notices; loan agreements and promissory notes; loan reviews; documents creating and perfecting a security interest; appraisal reviews; guaranty and subordination agreements; insurance policies; financial, tax, and credit information; loan reports; and committee and board meeting minutes.
Risk Measurement and Monitoring
The continuous monitoring and reviewing of a credit during its life is just as important as the initial analysis performed during the approval process. Some institutions fail to reinforce the importance of on-going monitoring of a credit after it is booked, which can result in deterioration of the loan portfolio. Some of the important areas that warrant ongoing monitoring include the condition of the economy and local markets, the borrower's business, and the underlying collateral.
Economic and Local Market Conditions. Population, demographics, and employment trends are all good measures that might indicate a potential impact on borrowers' operations and the demand for and supply of CRE. Sale price decreases, rent concessions, absorption declines, and vacancy rate increases are warning signs of potential weakness in real estate markets that might affect the underlying quality of the loan portfolio. Changes in rules and regulations of local municipalities (e.g., zoning requirements) or financial or operational deterioration in major employers or companies in the local markets are other factors to consider when evaluating potential and existing credits.
Borrower's Business Condition. For office buildings, it is very important to obtain current rent rolls and/or updated lease agreements to determine the stability of loan repayment sources. For retail or manufacturing businesses, it is essential to conduct regular visitations to observe the borrower's business activity, staff turnover, and inventory levels and conditions to determine the overall business condition. To obtain current knowledge on a borrower's financial condition, it is imperative to have an adequate tracking system in place to ensure that required financial information is on file. Some institutions also conduct stress tests to evaluate cash flow, debt service capacities, and loan-to-value ratios under various interest rate scenarios.
Collateral Condition. Regular visitations to the underlying CRE sites are necessary to ensure that properties are maintained in proper condition and are being utilized and/or occupied as the borrower indicated. Environmental concerns and hazardous conditions near the collateralized property are other factors that might potentially disrupt the collection of loan payments.
Comprehensive Internal Controls
Reporting Process. An adequate reporting process is one of the key elements in a comprehensive internal controls system. Proper controls should be established throughout the life of a loan, from acceptance of the application to the collection of the final loan payment or foreclosure on the collateralized property. Management information systems should be capable of generating accurate and timely loan information by individual loan, by loan type, by market, by classification, by delinquent status, and the like. Each report must be adequately reviewed and approved by the appropriate level of management.
Loan Review. An independent loan review function is another key to early detection of potential credit problems. While each lending officer is the first line of defense to identify potential credit problems, loan reviews often provide more objective and unbiased analyses of the portfolio. Depending on the size and complexity of the institution, the loan review function can be established in-house, outsourced to a vendor, or a combination of internal coverage and outsourcing. Some of the best practices noted in the loan review function include:
Internal Audit. Although internal audit does not normally examine the quality of the loan portfolio, it should test for internal policy and regulatory compliance. Internal audit should also assess the effectiveness of appraisal review, loan review, and loan approval processes.
Capital and Allowance for Loan and Lease
Regardless of how strong a credit risk management process is, incurring credit losses is inevitable. A good complement to sound credit risk management is the maintenance of adequate levels of capital and allowance for loan and lease losses (ALLL). Both levels are considered in many of the loan-related calculations and policy parameters. Setting lending strategies without taking these levels into account could be deemed an unsafe and unsound banking practice.
Regulatory guidelines on capital adequacy for state member banks are outlined in appendices A, B, and E of the Federal Reserve's Regulation H, Membership of State Banking Institutions in the Federal Reserve System. Guidelines for bank holding companies are set forth in appendices A, B, D, and E of the Federal Reserve's Regulation Y, Bank Holding Companies and Change in Bank Control. Banking institutions also should follow the guidance in the Interagency Policy Statement on the Allowance for Loan and Lease Losses issued on December 21, 1993 and in the Final Interagency Policy Statement on Allowance for Loan and Lease Losses (ALLL) Methodologies and Documentation for Banks and Savings Institutions issued on July 2, 2001 to determine the adequacy of ALLL methodology and documentation. These statements are included as attachments to the Federal Reserve's SR Letters 93-70 and 01-17 , respectively.1
External factors such as economic conditions, CRE market conditions, competition, and regulatory changes may affect a bank's CRE credit quality. However, internal factors such as the adequacy of credit risk management processes are the primary determinants of the quality of the CRE loan portfolio. A sound credit risk management program contains four major elements: active board and senior management oversight, adequate policies and procedures, sufficient risk measurement and ongoing monitoring, and comprehensive internal controls and reporting processes. Many of the control elements mentioned in this article may appear to be basic or obvious to a sophisticated and experienced management team. Nevertheless, some institutions have overlooked the fundamental risk management processes and thereby increased the credit risk in their CRE loan portfolios.
If you have any questions on commercial real estate lending best practices, please contact your institution's primary federal banking regulator. If you are supervised by the Federal Reserve Bank of Philadelphia, please contact your institution's central point of contact at the Reserve Bank. Alternatively, you can contact David Fomunyam at (215) 574-4128 or Eddy Hsiao at (215) 574-3772.
Not-So-Best Practices or
Common Credit Risk Management Deficiencies
·Inadequate policies and procedures
·Lack of experienced lenders
·No permanent loan commitment
·Low borrower equity in the project
·Advanced draw requests without adequate inspection
·Inadequate on-going monitoring of or visitation to the construction project
·Failure to ensure all required permits are in place
·Additional advances requested due to frequent changes in budget or plans Policies
·Lack of diversification standards
·Policies not sufficiently detailed to provide adequate guidelines and limitations on each CRE lending product
·Authorization, delegation, review, approval, and reporting processes not clearly identified Appraisals
·No or inadequate appraisal review processes
·Use of unqualified or non-board-approved appraisers
·Questionable appraisal values without adequate reconciliation and/or justification
·Unorganized credit files
·Lack of documentation (e.g., correspondence between lenders and borrowers, current financials, insurance, and tax returns)
·Inadequate onsite visitation and outdated financial and operational analyses on borrower
·Unfamiliarity with or lack of analysis of external factors, such as economic conditions, industry trends, and regulatory changes Information Systems
·Inadequate exception tracking system
·Insufficient loan concentration or stratification monitoring
·Inability to create detailed loan reports Internal Controls
·Inadequate loan review scope and frequency
·Internal audit and/or loan review do not report directly to the board or a designated committee Others
·Extending credit to locations significantly outside the bank's designated markets
·Making unwarranted character loans without proper analysis
·Inadequate procedures to ensure collateral position
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.