commercial real estate concentration guidance

When compared to the current ratings, the effect of a market downturn could be measured (see Table 2). 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. What â¦ Credit Underwriting Standards and Administration. Independent property inspections—There should be initial site visits and ongoing inspections during the construction phase. Attachment 1 provides the Federal Register notice of the guidance.2 Attachment provides the interagency guidance. Each year a percentage of credits (obligors in cases of banks with two-dimensional rating systems) improves, remains the same, or declines. The bank would use the results of For risk management purposes, a bank may develop stress scenarios customized to its circumstances to make assumptions about how its CRE portfolio would react. 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 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 Fedâs consumer compliance supervisory responsibilities. 5 See Interagency Guidelines for Real Estate Lending Policies: 12 CFR 365 and appendix A (FDIC); 12 CFR 34, subpart D and appendix A (OCC); 12 CFR 208, subpart E and appendix C (FRB); and 12 CFR 545 and 563 (OTS). The Federal Reserve Board's real estate lending standards are found in 12 CFR 208, subpart E. The "Interagency Guidelines for Real Estate Lending Policies" are located in Regulation H, subpart I, 12 CFR 208, appendix C. Commercial Real Estate Individuals outside the lending process should evaluate and validate the entire process. The proposed Guidance sets forth thresholds for assessing whether an institution has a CRE concentration and should employ heightened risk management practices. 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. 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). The Federal Reserve Boardâs real estate appraisal standards are found in Regulation H, subpart E, 12 CFR 208.50â51 for state member banks. As loan quality deteriorates, banks must expend significant resources, both human and monetary, for collection and, in some cases, foreclosure on the underlying collateral. 9 See Statistics on Depository Institutions at www2.fdic.gov/sdi/index.asp. Bank management should also be willing to forego potential CRE income when the risk exceeds the reward. In institutions with limited or only recent experience in CRE lending, the historical perspective required to conduct this sort of stress analysis would be based on external data that may or may not be applicable. Strong risk management practices and appropriate levels of capital are essential elements of a sound Commercial Real Estate (CRE) lending â¦ 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. Before making a commitment for financing, an institution will analyze sponsor and lender assumptions to determine the degree to which a project can withstand market fluctuations and still repay the loan. 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. the stress year migration to move the appropriate volume of exposures in Loan disbursement practices—They should be based on engineering or inspection reports, requirements for lien waivers from subcontractors, etc. In addition to providing supervisory guidance regarding residential real estate lending, this subsection also contains guidance on subprime lending. Identify the similarities or differences between the bank’s current portfolio and the historical reference portfolio, and adjust the loss rates appropriately. Banks with limited staffing resources can use external audit staff or consulting firms to conduct the validation. Larger banks often use rating systems that assign separate ratings for default risk and loss severity. As banks grow, this process is typically brought in-house. 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. This interagency supervisory guidance was developed to reinforce sound risk-management practices for institutions with high and increasing concentrations of commercial real estate loans on their balance â¦ The usefulness of this type of test relies heavily on the reference portfolio selected to conduct the test. Banks should hold capital and reserves commensurate with that risk to protect against the higher chance of loss. While it may be easy to manage a concentration during the good times, managing one once market demand has slowed is much more challenging. 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. At a minimum, the risk rating system should rank order risk in the portfolio and provide enough grades so that the vast majority of loans do not fall into just one grade. Concentrations, as previously noted, mean higher inherent risk. Consequently, the real benefit of implementing systems to identify and control CRE concentrations lies in limiting the level of risk brought on by those concentrations when markets begin to falter. Sound risk management strategies are â¦ If these data are not available, a bank might choose to apply conservative estimates of migrations to establish a stress year. Loan agreements, collateral documentation, and appraisal practices—Robust loan agreements and collateral documentation are expected. Senior Examination Specialist, These drivers could be LTV, rate type (fixed versus floating), debt coverage ratios, or large tenants that could create concentrations when aggregated. Another technique used by some banks with larger portfolios and more sophisticated internal data is to stress ratings migrations. It covers market monitoring and analysis, credit underwriting and administration, portfolio management, credit risk rating and review, and stress testing. Review of Monetary Policy Strategy, Tools, and Communications, Banking Applications & Legal Developments, Financial Market Utilities & Infrastructures. The level of CRE monitoring required can differ among institutions depending on exposure level or perceived risk in a product type or geographic area. â¢ Total commercial real estate loans should not exceed 300% of capital. Granularity is also necessary to provide an accurate assessment of portfolio risk. Many lenders found during the CRE downturn of the 1980s and early 1990s that the “first loss is the best loss,” meaning that it would have been cheaper in the long run to have disposed of distressed CRE assets earlier rather than later. 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. Communication must occur between lending and risk management functions. Commercial real estate (CRE) loans comprise a major portion of many banks’ loan portfolios. "Regulatory Guidance on Commercial Real Estate Risk" (April 2007) explains the guidance and the seven key areas. 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 risks posed by concentrations of credit risk in general, and Commercial Real Estate concentrations in particular, have long been an area of focus for bank regulators. The policies should provide clear and measurable underwriting standards that enable lending staff to evaluate all relevant credit and market factors. A bank’s ability to monitor developments in its CRE market area is a critical element of successful CRE lending. Regulators have removed a key commercial real estate concentration limit for New York Community Bancorp in Westbury, N.Y. An institution’s lending policies should communicate the level of risk acceptable to its board of directors. Risk rating systems can vary greatly between community and large banks. A well-diversified bank is, in general, better insulated against market downturns. CRE loan segmentations (to determine diversification within a portfolio), Established concentration limits (for CRE in aggregate as well as by subcategory), Presold (considered lowest risk, but purchaser deposit amounts should be considered), Speculative (no sales contract or prelease agreement exists), Portfolio or borrower aging (age of CRE inventory by portfolio or borrower), Aggregate by market (CRE inventory broken down by market or submarket), Aggregate by price range (CRE inventory broken down by price range), Borrower concentration reports, including guidance line (informal, uncommitted) limits, Loan underwriting exception reports (CRE loans requiring loan policy exception approvals), Number and volume of exceptions by nature, justification, and trends, Performance of exception loans compared with loans underwritten within guidelines. The Interagency CRE Statement reminds financial institutions to re-examine existing regulations and guidance related to Commercial Real Estate (CRE) lending. Analysis covers testing the common assumptions and combinations of assumptions shown in Table 1. Developing sensitivity analysis forecasts, such as increased vacancy rates in the market by product type, slower absorption rates, reduced sales prices, higher capitalization rates, or higher interest rates. 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. Regulators and bank management must not become complacent or static in their approach to risk management; they must continually evolve and change as the environment changes and new risks appear. The second component is Real Estate Law, which offers an overview of the legal issues confronting the real estate executive. Much has changed in CRE lending since the last downturn. The CRE guidance recognizes that diversification can be achieved within CRE portfolios and differentiates risk in different types of CRE loans. A CRE concentration increases the importance of sound lending policies. Once risk management has compiled the information, it must deliver its market analysis back to the lending staff. Reference Commercial real estate (CRE), such as office towers, shopping centers, and apartment buildings, makes up approximately one-third of the total value of U.S. real estate. Following are examples of the types of stress tests commonly used in banks. Strong markets promote additional building, which can result in oversupply followed by weakened market fundamentals. 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. The FDIC has historical CRE data that could be used to construct loss rates, although the FDIC data lacks much granularity.9. Real estate investors who really want control over their investments must dig into the industry, know their market and understand the risks and â¦ Stress testing can also inform management of the institution’s specific vulnerabilities to CRE markets and indicate where actions should be taken to mitigate those risks. Concentrations of credit exposures add a dimension of risk that compounds the risk inherent in individual loans. 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). In markets where demand is very strong, management may instruct lending staff to pursue additional opportunities and adjust pricing and other terms to attract additional business. CRE updates were released in 2012, along with community bank stress-testing guidance in 2013. The bank should have a management information system (MIS) that provides sufficient information to measure, monitor, and control CRE concentration risk. 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. Additional costs accrue during the holding period, including property taxes and the cost of sales, maintenance, and security. (2) Total commercial real estate loans as defined in this Guidance represent 300 percent or more of the institutionâs total capital, and the outstanding balance of the institutionâs commercial real estate loan portfolio has increased by 50 percent or more during the prior 36 months. Portfolio liquidity (ability to sell or securitize exposures on the secondary market).”. Managing Commercial Real Estate Concentrations. The guidance is not intended to limit banks' CRE lending, as the agencies recognize that banks serve a vital role in their communities by supplying credit for business and real estate development. 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. See section titled “Loans in Excess of the Supervisory Loan-to-Value Limits.”. Learn if your bank is insured, view locations, track history, and more. The remainder of this article provides context and additional information for some of the topics addressed in the CRE guidance. Such an analysis would measure the depth and breadth of the portfolio’s vulnerability to changes in real estate markets and interest rates. In this case, an upward adjustment in loss rates would seem necessary to address the additional concentration risk. While not providing specific information for managing CRE concentrations, it should inform management of the possible level of the bank’s exposure if a CRE downturn were to occur. While measuring risk-based capital, growth and asset quality across these various concentration segments is a great starting point, the guidance recommends: Incorporating this concentration analysis within the allowance for loan and lease loss (ALLL) calculations, Aggregating the impact of each tested credit to determine the vulnerability within the portfolio. For example, a community bank might assume layoffs at a major employer and measure the anticipated results on new housing demand and other CRE property performance. Commâ¦ Reiteration of Interagency Guidance on CRE-Commercial Real Estate Concentrations has had limited impact on Banking Industry. Essentials of Real Estate Finance provides the tools necessary to analyze income-producing property from the perspective of an institutional investor. In addition to the changes regarding appraisals, the federal banking agencies, along with the Office of Thrift Supervision (OTS), have established underwriting and risk management requirements.5 A pillar of these requirements is loan-to-value (LTV) limits for different CRE property types. A heat map can serve as a quick reference to identify whether the strategy for a particular market or product type is to grow, maintain, or reduce exposure. 3. No matter the form of the market analysis, management must convey its strategy to lending staff in a timely manner and maintain sufficient oversight of lending activity to ensure that the loans being originated are consistent with management’s strategy. The Guidance reminds institutions â¦ Many institutions will want to expand the level of information captured to specifically include underwriting characteristics, such as LTVs, debt service coverage levels, speculative versus presold units, etc., to allow for more enhanced reporting and analysis. A common delivery method is to provide lenders with a “heat map” that details management’s view of the demand for product types in each geographic market and directs lenders’ degree of aggressiveness for those products. 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