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Over the last several years, the level of commercial real estate loans at supervised banking institutions has been rising. Because levels are approaching points that have historically resulted in safety and soundness issues during periods of economic and market downturns, the Interagency Guidance on Concentrations in Commercial Real Estate (guidance) was issued earlier this year to "remind institutions that strong risk management practices and appropriate levels of capital are important elements of a sound CRE lending program."1 Accordingly, the guidance provides a number of best practices an institution can undertake to manage the risk associated with elevated CRE loan levels on its balance sheet.
In order to assist institutions and examiners with a general point of reference in determining when a CRE concentration has reached a level where increased examiner focus and risk management practices may be warranted, the guidance provides two primary criteria. It should be noted that the guidance stresses that these criteria should serve as preliminary screens and are provided as "high-level indicators to identify institutions potentially exposed to CRE concentration risk." They are not set as de facto CRE lending limits. These criteria are as follows:
The guidance emphasizes that CRE loans include those loans where the primary source of repayment is the cash flow from real estate collateral, such as through rental income or the sale of real estate. Examples of loans which would apply would be those secured by multi-family apartment complexes, multi-tenant commercial office buildings, retail strip malls, and self-storage facilities, as well as loans associated with construction and land development or planned tract housing development.
Loans to REITS and unsecured loans to developers should also be considered if their performance is closely linked to the CRE market. Loans for owner-occupied real estate (subject to the 50 percent rule) or real estate taken as an abundance of caution are not considered when evaluating CRE concentration levels.
An institution that determines that a CRE concentration is present is encouraged to review its risk management practices to ensure that they adequately address the potential risk inherent in the portfolio. Bank management and examiners alike should consider the adequacy and presence of the following seven key elements in determining whether an institution's risk management practices are appropriate in light of the level and nature of the bank's CRE concentration risk.
Board and Management Oversight
The board of directors has ultimate responsibility for ensuring that CRE lending activities reflect the bank's appetite for risk and overall strategic goals. Continual monitoring of concentration levels for adverse trends is also important. The board of directors or a committee of board members should establish policy guidelines that outline acceptable levels of CRE exposure and should ensure that management implements procedures and controls to monitor compliance with those policies and procedures. The board should also be reviewing information and reports that identify the nature and level of risk of CRE concentrations and changes in market conditions, and it should periodically review and approve CRE risk exposure limits based on these changes.
Institutions should evaluate their portfolio analysis practices to ensure that they adequately reveal concentrations of loans that may be similarly affected by cyclical changes in the CRE market. In general, portfolio analysis and management strategies should include a regular evaluation of the loan portfolio mix and the correlation between sectors, markets, and geographic or economic sectors (e.g., all loans dependent upon the construction industry or all speculative loans). Contingency planning is important as well, and institutions should consider ways by which they might reduce exposure or mitigate concentrations. Contingency plans that include securitizations should be complemented by periodic review of the portfolio's marketability, including an evaluation of secondary market access and the underlying underwriting standards of this source.
Management Information Systems
Management information systems play a key role in providing a proactive approach to adequately managing concentration risk by ensuring that negative portfolio trends are known ahead of time. A financial institution's information systems should provide management with sufficient information to identify, measure, and monitor loan portfolio characteristics on both the macro and micro levels. By not only identifying the gross level of total CRE loans against total capital, but by also stratifying the CRE portfolio into more detailed segments, management can target those markets, property types, or loan types which warrant the most focus and attention. Examples of portfolio stratification include tracking portfolio composition by property type, geographic market, tenant or developer concentrations, and quantitative metrics like LTV levels, debt service coverage levels, vacancy rates, absorption rates, and property sales trends. The adequacy of an MIS should be evaluated on an ongoing basis to ensure its relevance amid changes in risk dynamics.
A program of ongoing market analysis will provide board members, management, and lenders with information needed to anticipate downturns in the overall market and in varying sectors or geographic regions. Institutions should perform periodic market analyses based on both geographic distinctions and the various property types within the CRE portfolio. An institution's strategic planning should reflect the results of its market analysis. Decisions to expand CRE lending activities into new markets, increase activities in existing markets, or introduce new CRE lending products should be supported by adequate market analysis. The guidance does not highlight specific requirements for market analysis, but emphasizes that it should demonstrate that an institution "understands the economic and business factors" that could influence the markets that it serves.
Credit Underwriting Standards
Credit underwriting standards should reflect actual and anticipated changes in the economic and business climate. Banking institutions with high CRE concentrations in their loan portfolios should review and re-evaluate the adequacy and appropriateness of present credit underwriting standards. For example, an institution with a strong historical C&I portfolio that has experienced migration into CRE lending should consider aligning credit underwriting standards to reflect the specialized nature of CRE lending, in addition to any increased risk associated with the types of CRE loans originated.
An institution's underwriting standards should reflect the level of risk that is acceptable to the board of directors. It should provide the lending staff with a framework to adequately evaluate fundamental credit factors such as debt repayment, collateral, guarantor and management strength, and industry/geographic considerations. Credit underwriting standards should also be based on formalized policies and procedures outlining elements such as loan terms, collateral valuation requirements and methodologies, LTV limits, feasibility study and sensitivity analysis requirements, equity requirements, and minimum cash flow/debt coverage requirements. For banks involved in construction lending, policies and procedures which reflect the specialized nature and potential increased risk during construction phases should be maintained. Policies and procedures should address loan disbursement monitoring, construction and inspection documentation, and ongoing project status reports such as sales/lease absorption and actual-to-budget performance.
Portfolio Stress Testing and Sensitivity Analysis
Portfolio risk management should be supported by periodically stress testing the portfolio, which will help management understand the impact that changing economic conditions may have on overall asset quality, earnings, and capital. Stress testing helps to set tolerance limits during strategic planning and to promote proactive versus reactive alternative strategies when unforeseen changes in the economic environment occur.
At a minimum, stress testing should be relevant to the institution and should reflect the size, complexity, and risk characteristics of the portfolio by emphasizing the more vulnerable segments of a CRE portfolio. Increased vacancy rates, slower absorption/sellout rates, and the repayment impact of loan re-pricing are just a few considerations that should be made. In general, the sophistication level of the stress testing models or practices should be in line with the overall inherent risk in the portfolio and the institution's size and resources.
Credit Risk Review Function
Continued oversight of the bank's CRE portfolio can also be accomplished through a formalized and independent credit risk review function. A strong credit risk review function, either in-house or outsourced to a qualified third-party vendor, assists management with an assessment of emerging risks; provides a system for early identification of problem loans; and identifies potential weaknesses in underwriting, portfolio management, or documentation quality. At a minimum, the credit risk review function should include a risk rating system that is risk-sensitive and objective, promotes portfolio review intervals, and provides for the ongoing review of the appropriateness of the overall credit risk rating system and credit risk review function.
In summary, the new guidance provides institutions and examiners with criteria that serve as a point of reference in identifying a concentration that may warrant enhanced review and oversight. It also provides suggested risk management best practices to help institutions assess, monitor, and control potential vulnerabilities to economic and market fluctuations so losses can be minimized and capital levels can be sustained. Bankers and examiners are encouraged to refer to the formal guidance for additional information.
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.