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Tuesday, June 18, 2013

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Home > Bank Resources > Bank Resources Publications > SRC Insights > 2005 > Second Quarter

SRC Insights: Second Quarter 2005

SVP Commentary on...
Top Commercial Real Estate Trends

Throughout the history of banking, asset concentrations have been a primary cause of banking problems. In particular, commercial real estate (CRE) has been vulnerable to cyclical downturns, such as those that preceded the banking problems of the late 1980s and early 1990s. Given this profile, banks are expected to monitor real estate market conditions in their lending area to ensure that bank policies continue to be appropriate for the current market conditions.

In the Third District, from 2001 to 2004, CRE loans grew 55 percent as total CRE loans outstanding increased from $18 billion to $28 billion. CRE as a percentage of tier 1 capital and reserves was equal to 195 percent and 221 percent in 2001 and 2004, respectively. This acceleration is evident both in lending for construction and development, including residential properties and loans secured by nonfarm residential properties. Moreover, this growth has been primarily in community and regional banks.

The data reveals that commercial real estate lending remains a primary activity of most Third District banks. As evidenced by the growth in commercial real estate lending in the Third District, there is increased potential for concentration risk. Since the CRE growth trend is expected to continue, banks must actively monitor and effectively manage their concentration risk.

Real Estate Lending Policies
The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) mandated the creation and adoption of uniform regulations for real estate lending standards. These standards are included in the Interagency Guidelines for Real Estate Lending Policies, Regulation H, part 208, appendix C (12 CFR 208, appendix C).1

The Federal Reserve’s Regulation H requires an institution to establish real estate lending policies that are (1) consistent with safe and sound lending practices, (2) appropriate to the size of the institution and the nature and scope of its operations, and (3) reviewed and approved by the bank’s board of directors at least annually.

At a minimum, CRE lending polices should include the following criteria:

  • Clear loan portfolio diversification standards
  • Prudent underwriting standards that are clear and measurable
  • Effective real estate loan administration procedures
  • Sound documentation, approval, and reporting requirements that effectively monitor compliance with the bank’s real estate lending policies
  • Regular stress testing of the real estate portfolio

To maintain an effective lending function, the bank’s board of directors should establish policies to guide the function. An effective lending policy sets standards, guidelines, and limitations that reflect the bank’s overall mission and business strategy. It should be clearly communicated to both management and lending personnel to ensure adherence to the policy.

Policies governing a bank’s real estate lending activities must include prudent underwriting standards, strong internal controls, and an effective loan documentation program. On an ongoing basis, credit risk management processes should be established that include effective credit review and classification procedures and a methodology for ensuring that the allowance for loan and lease losses (ALLL) is maintained at an adequate level.

Concentrations of Credit
Real estate lending policies also should include guidelines for diversification of risk within the portfolio. Federal Reserve System examiners consider concentrations of credit generally to consist of direct or indirect extensions of credit and contingent obligations that, when aggregated, exceed 25 percent of the bank’s capital structure (tier 1 capital plus the ALLL). A concentration exists when the credit extensions or other obligations possess similar risk characteristics.

In general, loans to related groups of borrowers, loans collateralized by a single security or by securities which have common characteristics, and loans to borrowers that have common characteristics within an industry are considered to be homogenous for risk purposes when determining that a concentration exists.

Examiners expect banking organizations to have in place effective policies, systems, and internal controls to monitor and manage concentration risk. The bank’s board of directors is responsible for establishing appropriate risk parameters and for measuring exposure, as well as for evaluating the methods used by management to control and manage concentration risk. To effectively manage the risk, it is important to identify key characteristics that will define a concentration.

To monitor CRE concentration risk, examiners gain an understanding of the bank’s internal policies and the systems and controls used to manage and monitor concentration risk. If concentrations exit, examiners will evaluate the bank’s ability to effectively manage the risk and, if necessary, to reduce its exposure.

For institutions with high CRE concentration, particularly in CRE lending areas that are considered more risky, such as construction and development lending and other loans where the principal source of repayment is dependent upon the sale or refinancing of the property, there may be an even higher level of scrutiny.

Examiners evaluate the processes for identification and sound risk management of concentrations ranging from MIS to portfolio management and diversification techniques. Sound practices should encompass pricing strategies with the goal of improving margins, house limits based on objective quantification of risk, and the effective use of capital.

CRE Today
In general, current real estate underwriting and risk management practices are considered to be materially better than in the late 1980s and early 1990s, and there is presently no evidence of emerging systemic problems in the banking sector. With changing economic conditions, significant increases in interest rates and increasing competition create pressure on underwriting standards. Consequently lenders must remain vigilant.

In particular, we have begun to see some recent deals that could lead to unprofitable or unsustainable pricing, terms concessions, and ultimately lower portfolio quality. At this stage of the credit cycle, market realities may require institutions to compete aggressively on price, but we support being disciplined around the structure of loans.

Based on continued growth in real estate lending, changes in CRE markets, and some evidence of poorly managed concentrations at some institutions, bank supervisors will continue to monitor the activity closely. Supervisors will continue to track the growth in concentrations through surveillance and other early warning indicators and through transaction testing of quality and underwriting at banking organizations with significant core exposures.

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.