US Banks are increasing their exposure to commercial real estate and increased competitive pressures are contributing significantly to historically low capitalization rates and rising property values. Influenced in part by the continuing strong demand for such credit and the reassuring trends in asset-quality metrics many institutions’ CRE concentration levels have been rising.
A CRE loan refers to a loan where the use of funds is to acquire, develop, construct, improve, or refinance real property and where the primary source of repayment is the sale of the real property or the revenues from third-party rent or lease payments. CRE loans do not include ordinary business loans and lines of credit in which real estate is taken as collateral. Financial institutions with concentrations in owner-occupied CRE loans also should implement appropriate risk management processes.
Between 2011 and 2015, multi-family loans at insured depository institutions increased 45 percent and comprised 17 percent of all CRE loans held by financial institutions, and prices for multi-family properties rose to record levels while capitalization rates fell to record lows. At the same time, other indicators of CRE market conditions (such as vacancy and absorption rates) and portfolio asset quality indicators (such as non-performing loan and charge-off rates) do not currently indicate weaknesses in the quality of CRE portfolios.
During 2016, supervisors from the banking agencies will continue to pay special attention to potential risks associated with CRE lending.
The regualtors have jointly issued a statement to remind financial institutions of existing regulatory guidance on prudent risk management practices for commercial real estate (CRE) lending activity through economic cycles. They say that historical evidence demonstrates that financial institutions with weak risk management and high CRE credit concentrations are exposed to a greater risk of loss and failure. In general, financial institutions that succeeded during difficult economic cycles took the following actions, which are consistent with supervisory expectations:
- established adequate and appropriate loan policies, underwriting standards, credit risk management practices, and concentration limits that were approved by the board or a designated committee; lending strategies, such as plans to increase lending in a particular market or property type, limits for credit and other asset concentrations, and processes for assessing whether lending strategies and policies continued to be appropriate in light of changing market conditions; and strategies to ensure capital adequacy and allowance for loan losses that supported an institution’s lending strategy and were consistent with the level and nature of inherent risk in the CRE portfolio.
- conducted global cash flow analyses based on reasonable (not speculative) rental rates, sales projections, and operating expenses to ensure the borrower had sufficient repayment capacity to service all loan obligations.
- performed market and scenario analyses of their CRE loan portfolio to quantify the potential impact of changing economic conditions on asset quality, earnings, and capital.
- provided their boards and management with information to assess whether the lending strategy and policies continued to be appropriate in light of changes in market conditions.
- assessed the ongoing ability of the borrower and the project to service all debt as loans converted from interest-only to amortizing payments or during periods of rising interest rates.
- implemented procedures to monitor the potential volatility in the supply and demand for lots, retail and office space, and multi-family units during business cycles.
- maintained management information systems that provided the board and management with sufficient information to identify, measure, monitor, and manage concentration risk.
- implemented processes for reviewing appraisal reports for sufficient information to support an appropriate market value conclusion based on reasonable market rental rates, absorption periods, and expenses.
