• Total commercial and residential real estate loans secured by real estate with LTVs in excess of FDICIA guidelines should not exceed 100% of capital. To ensure that risk management and lending are working in concert, the two functions must communicate. Robust risk management systems can also track the number of exceptions by type and amount to help point out areas of policy that may need permanent amendment or that need to be reinforced by the institution’s board of directors. Regulatory limits for commercial real estate lending levels are at high levels for many community banks. Many de novo banks in areas with significant job and population growth (predominately in East and West Coast states) have used ADC loans as the primary asset class to drive growth and meet pre-opening projections. 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. This is especially true if the data for the reference portfolio lack granularity. Growth in land acquisition, development, and construction (ADC) lending has been especially pronounced. Distribution: FDIC-Supervised Banks (Commercial … This Guidance is based upon the principles contained in the Agencies' real estate lending standards regulations and guidelines. Banks with limited staffing resources can use external audit staff or consulting firms to conduct the validation. Specifically, the agencies reiterated the need for strong risk management practices to comply with Supervision and Regulation (SR) letter 07-1, “Interagency Guidance on Concentrations in Commercial Real Estate.” 3 This guidance does not set limits on the size of CRE concentrations but instead highlights strong risk management practices that are necessary for a bank with a high CRE credit … 4 FIL-74-94, Interagency Appraisal and Evaluation Guidelines, November 11, 1994, www.fdic.gov/news/news/financial/2003/fil0384b.html. Lenders often severely underestimate the length of time necessary for the sale of foreclosed assets in a distressed market. Bank management should also be willing to forego potential CRE income when the risk exceeds the reward. When compared to the current ratings, the effect of a market downturn could be measured (see Table 2). Institutions should also consider the following items with regard to managing construction loans: An institution’s lending policies should permit only limited exceptions to underwriting standards. the stress year migration to move the appropriate volume of exposures in Commercial Real Estate Issues in 2017. The regional or national economy shows signs of stress. Columbia, MO, Tracy E. Fitzgerald When an institution permits an exception, it should document how the transaction does not conform to the institution’s policy or underwriting standards and why the exception is in the best interest of the bank. Sponsor or guarantor financial analysis, if applicable. Reserves for maintenance and improvements. However, the analysis of loans granted for speculative lot development projects with slower absorption rates could reveal substantial additional exposure, suggesting that the bank should consider limiting its exposure in certain geographic markets or product types. If a bank’s portfolio goes outside of these general guidelines, as many do, the bank will not automatically be criticized, but heightened risk management practices may be needed. The remainder of this article provides context and additional information for some of the topics addressed in the CRE guidance. Unfortunately, the importance of CRE portfolio management and appropriate concentration limits becomes most apparent only when the bank’s market enters a downturn. Good risk management starts with setting reasonable concentration limits for different products and markets. History has clearly demonstrated that CRE can experience cyclical changes in which supply and demand get out of balance, resulting in significant losses for financial institutions. 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 … 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. What … Independence in the validation process 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. Appraisals 2. The usefulness of this type of test relies heavily on the reference portfolio selected to conduct the test. 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. The guidance reminds institutions that strong risk management practices and appropriate levels of capital are essential elements of a sound commercial real estate (CRE) lending program, particularly when an institution has a concentration in CRE loans. Supervisory Examiner, In December 2015, the joint regulators issued a statement on prudent commercial real estate (CRE) lending that reminded financial institutions of existing regulatory guidance for Commercial Real Estate … In this case, an upward adjustment in loss rates would seem necessary to address the additional concentration risk. The historical loss rates are applied at the same granular level as the reference portfolio. CRE updates were released in 2012, along with community bank stress-testing guidance in 2013. Sound risk management strategies are … In many instances during the 1980s and early 1990s, developers walked away from partially finished properties, and some lenders were forced to complete projects to salvage their investment. The level of losses will generally depend on the quality of loan underwriting and the breadth and depth of the CRE market downturn. 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. Total CRE loans as defined in the CRE guidance represent 300 percent or more of the institution’s total capital, and the outstanding balance of the institution’s CRE loan portfolio has increased by 50 percent or more during the prior 36 months. Essentials of Real Estate Finance provides the tools necessary to analyze income-producing property from the perspective of an institutional investor. When prudent diversification across a variety of asset classes is difficult to achieve, it becomes even more important for management to deploy tools and implement strategies similar to those outlined here to recognize and control the risk taken. To reduce potential losses in the future, banks must have strong board and management oversight as well as robust risk management processes for their CRE loan portfolios to recognize and control risk through all phases of the economic cycle. 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. For example, the institution may create a CRE risk management function that is responsible for establishing CRE concentration risk limits (approved by the institution’s board) and overseeing compliance with those limits. 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. Much has changed in CRE lending since the last downturn. Management first needs to identify the drivers that will affect segmentation at origination and then capture those data fields on the system. Portfolio liquidity (ability to sell or securitize exposures on the secondary market).”. As loan quality deteriorates, banks must expend significant resources, both human and monetary, for collection and, in some cases, foreclosure on the underlying collateral. 2 Capital generally is defined as a bank’s long-term source of funding, contributed largely by the bank’s equity stockholders and its own returns in the form of retained earnings. Listed below are some examples of possible indicators that particular markets are at or near a peak. The number of Banks with CRE Ratios greater than 300% of RBC-Risk-Based Capital is essentially unchanged, the median asset level of these banks is bigger … For example, the ADC loss history on the reference portfolio is for a geographically diverse group of loans, but the current portfolio is largely concentrated in one location. Commercial real estate (CRE) and multifamily concentrations are an area of scrutiny for regulators in the current exam cycle. In these areas, in-house knowledge and communication with local builders, developers, real estate agents, and civic leaders may be the primary tools for gathering information on market activity and gauging market conditions. 1. Strong risk management practices and appropriate levels of capital are essential elements of a sound Commercial Real Estate (CRE) lending … 9 See Statistics on Depository Institutions at www2.fdic.gov/sdi/index.asp. Like an aggregate transactional sensitivity analysis, stressed loss rate testing can provide useful input to a bank’s capital, earnings, and liquidity planning. The standards primarily focus on the responsibilities of the bank's board of directors for developing and issuing lending policies. In areas where management deems risks to be higher, lenders may be instructed to curtail or discontinue lending activities altogether. In December 2006, the FDIC, in conjunction with the other federal banking agencies, issued joint guidance to financial institutions entitled, Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices,to reinforce sound risk-management practices regarding concentrations in CRE lending. A bank’s ability to monitor developments in its CRE market area is a critical element of successful CRE lending. Comm… The second component is Real Estate Law, which offers an overview of the legal issues confronting the real estate executive. 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. Reporting systems should be sufficiently detailed to identify situations where the strategy is not being followed. 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. The FDIC has historical CRE data that could be used to construct loss rates, although the FDIC data lacks much granularity.9. Strong markets promote additional building, which can result in oversupply followed by weakened market fundamentals. One of the most prevalent pieces of commercial real estate (CRE) guidance is, "Concentrations in CRE Lending, Sound Risk-Management Practices (PDF)," which was issued on December 6, 2006. Testing each credit in the portfolio, considering the current status of each project against the impact of the sensitivity analysis forecasts. The failure to control exposure levels when warning signs are evident can result in excessive loan losses. Loan disbursement practices—They should be based on engineering or inspection reports, requirements for lien waivers from subcontractors, etc. Stressed loss rate testing entails determining loss rates at levels that could be expected during CRE market downturns and forecasting the ultimate effect of these losses on capital. (Available data will often be fairly general in nature—losses on hotels, retail buildings, office buildings, etc.—rather than for more specific product types—suburban hotels versus downtown hotels, multitenant office buildings versus owner-occupied office buildings, etc.) (See, for example, the discussion of planning for contingencies in “Liquidity Analysis: Decades of Change” in this issue of Supervisory Insights.). 71, No. 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). While the direct costs of these actions are apparent, there are often other costs that bear mention. Alternatively, the bank could develop a relationship between economic variables and ratings migrations. For BHCs, the appraisal standards can be found in Regulation Y, subpart G, 12 CFR 225.61-67. 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. Identify the similarities or differences between the bank’s current portfolio and the historical reference portfolio, and adjust the loss rates appropriately. Residential Real Estate and Mortgages Other factors that contributed to the CRE losses included: Today, many lenders, directors, and senior officers have not experienced a CRE downturn in their careers. 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 In particular, small to mid-siz… They may never have learned the lessons of the 1980s or may view them as distant history that “can’t happen again.” Industry and regulatory changes that arose from the tumult of the 1980s remain intact and are intended to prevent a re-occurrence of the ill-conceived practices of the past. The regulatory agencies have gone on record stating that 'concentrations are bank killers' - and that most of the banks that failed during the great recession were 'CRE Concentrated'. Account officers, loan review personnel, and regulatory examination staff should be able to review rating guidelines and reach the same conclusion on the rating grade assigned to individual credits. 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. With the risk management tools listed in the CRE guidance and further supported by other regulatory guidance, there is no reason CRE loans cannot continue to be a favored asset class for banks. While it may be easy to manage a concentration during the good times, managing one once market demand has slowed is much more challenging. Larger banks often use rating systems that assign separate ratings for default risk and loss severity. An Analysis of the Impact of the Commercial Real Estate Concentration Guidance (Washington, D.C.: April 2013). In December 2015 the regulators is… Individuals outside the lending process should evaluate and validate the entire process. Different CRE types may have different risk characteristics. In these institutions, the type and level of adjustments to historical loan loss rates are critical elements to developing a useful outcome. Credit Underwriting Standards and Administration. The rapid growth in CRE exposures in recent years presents additional challenges for bank management as it monitors and controls risks it may not have faced in the past. This mechanism ensures that both risk management and the lending staff are in agreement about the marketplace conditions and the lending strategy. The CRE guidance provides a good framework to assist banks in addressing the concentration risk and also helps establish the federal banking agencies’ expectations during subsequent risk management examinations. is the third leg to any successful rating system. The secure Internet channel for FDIC-insured institutions to conduct business and exchange information with the FDIC. An institution’s lending policies should communicate the level of risk acceptable to its board of directors. (For practical purposes, it may be necessary to establish a materiality threshold.). stress tests may be useful for planning purposes and to identify potential vulnerabilities. Another major expense often overlooked is the opportunity cost of holding a large volume of nonearning assets. Risk rating systems can vary greatly between community and large banks. Risk management practices should be commensurate with the complexity of the bank and its portfolio. 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). CRE loan growth recently prompted regulators to issue guidance to address concerns about CRE concentrations and to provide expectations for managing a concentrated portfolio. These analyses can be conducted on a scheduled basis or when market fundamentals dictate. In addition, many banks do not have the resources to search hard copy files and backfill data into their systems. For risk management purposes, a bank may develop stress scenarios customized to its circumstances to make assumptions about how its CRE portfolio would react. Markets may be monitored by staff or management, but ultimately both must understand what is being monitored and why. Many banks fail to collect the data necessary to produce the reports listed above. Institutions must have a clear understanding of the demand for housing within geographic areas, submarkets, or specific projects, as well as price points within markets or projects. Independent property inspections—There should be initial site visits and ongoing inspections during the construction phase. Banks should hold capital and reserves commensurate with that risk to protect against the higher chance of loss. Much of this guidance is based on lessons learned in downturns of the past, especially the banking crisis of the late 1980s and the early 1990s. Risk ratings should be accurate and uniformly applied across product lines and geographic areas. 2 See FDIC’s History of the Eighties—Lessons for the Future, December 1997, at www.fdic.gov/bank/historical/history/contents.html. To some extent, the level of CRE lending reflects changes in the demand for credit within certain geographic areas and the movement by many financial institutions to specialize in a lending sector that is perceived to offer enhanced earnings. If market conditions deteriorate severely, sponsors or developers may simply abandon a project, especially if they have insufficient capital invested and there is no recourse to the principals. Frequently Asked Questions on the Appraisal Regulations and the Interagency Appraisal and Evaluation Guidelines, Temporary Exceptions to the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) Appraisal Requirements in Areas Affected by Severe Storms and Flooding Related to Hurricanes Harvey, Irma, and Maria, Interagency Advisory on the Availability of Appraisers, Interagency Advisory on the Use of Evaluations in Real Estate-Related Financial Transactions, Interagency Appraisal and Evaluation Guidelines, Interagency Statement on Appraisals for Affordable Housing Loans, Real Estate Appraisal Requirements for Other Real Estate Owned (OREO), Interagency Statement on Prudent Risk Management for Commercial Real Estate Lending, Prudent Commercial Real Estate Loan Workouts, Interagency Guidance on Concentrations in Commercial Real Estate, Interagency FAQs on Residential Tract Development Lending, Clarification on Real Estate Lending Standards, Interagency Guidance on Home Equity Lines of Credit Nearing Their End-of-Draw Periods, Interagency Statement on Supervisory Approach for Qualified and Non-Qualified Mortgage Loans, Minimum Standards for Prioritization and Handling Borrower Files with Imminent Scheduled Foreclosure Sale, Guidance on a Lender’s Decision to Discontinue Foreclosure Proceedings, Questions and Answers for Federal Reserve-Regulated Institutions Related to the Management of Other Real Estate Owned (OREO), Policy Statement on Rental of Residential Other Real Estate Owned (OREO) Properties, Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages, Interagency Guidance on Nontraditional Mortgage Product Risks, Interagency Credit Risk Management Guidance for Home Equity Lending, Accounting and Reporting for Commitments to Originate and Sell Mortgage Loans, Risk Management and Valuation of Mortgage Servicing Assets Arising from Mortgage Banking Activities, Guidance on Supervision of Subprime Lending, Interagency Guidance on High Loan-To-Value Residential Real Estate Lending, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue N.W., Washington, DC 20551, Last Update: 1994, www.fdic.gov/news/news/financial/2003/fil0384b.html on differences in lending experience, market competition, and equipment that. ’ migrations to determine the vulnerability within the portfolio ’ s ability to sell securitize! 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