Credit Underwriting Standards and Administration. Loan agreements should clearly communicate draw schedules, release provisions, and repayment requirements. This includes meaningful information on CRE portfolio characteristics relevant to the institution’s lending strategy, underwriting standards, and risk tolerances. Obtain historical loss rates on CRE loans (the “reference portfolio”) at the most granular level available. 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. The guidance “focuses on those CRE loans for which the cash flow from the real estate is the primary source of repayment rather than loans to a borrower for which real estate collateral is taken as a secondary source of repayment or through abundance of caution.” 6 The target of the guidance, then, generally would include development and construction loans for which repayment is dependent upon … In banks with more limited CRE lending experience, the data may be at higher levels, such as all types of ADC loans or even all CRE loans. A well-diversified bank is, in general, better insulated against market downturns. In addition to providing supervisory guidance regarding residential real estate lending, this subsection also contains guidance on subprime lending. The FDIC has historical CRE data that could be used to construct loss rates, although the FDIC data lacks much granularity.9. Adjustments to the historical loss rates may be necessary to account for differences in the current portfolio. The regional or national economy shows signs of stress. 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. 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. Sponsor/developer experience level—Institutions should establish standards to ensure that the sponsor/developer as well as the underlying contractor has a proven track record and sufficient experience in the market and in the property type being developed to complete the proposed project. A bank can have significant diversification within its CRE portfolio or have a concentration within a specific CRE category. 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. • Total construction, land development, and other land loans … Risk rating systems can vary greatly between community and large banks. The guidance states, “in evaluating CRE concentrations, the Agencies will consider the institution’s own analysis of its CRE portfolio, including consideration of factors such as: These factors could mitigate the risk posed by the concentration. Individuals outside the lending process should evaluate and validate the entire process. Thus far, the examples cited have not necessarily been related to a particular, perhaps local, event. 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. Banks and thrifts must now follow federal appraisal regulations, and regulators require banks to establish an effective real estate appraisal and evaluation program to ensure independence and improve quality.3 4. Posted on 9/6/2017. While loan-level sensitivity analysis is a valuable tool for all banks originating CRE loans, this type of analysis could be performed on a portfolio-wide basis. Analysis covers testing the common assumptions and combinations of assumptions shown in Table 1. 1 Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, Federal Register, Vol. The Federal Reserve Board’s real estate appraisal standards are found in Regulation H, subpart E, 12 CFR 208.50–51 for state member banks. Figure 1. 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. A granular rating system that effectively rank orders risk should aid management in identifying the exposures that should be reduced or eliminated if a CRE downturn appears to be on the horizon. Institutions involved in construction and development lending have a greater need to monitor CRE markets, as conditions can change dramatically between the time an institution makes a loan commitment and the time a project is completed. The key is to have someone other than the original credit analyst attempt to come to the same conclusion using the tools provided by policy. In addition, many banks do not have the resources to search hard copy files and backfill data into their systems. 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. 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. An Analysis of the Impact of the Commercial Real Estate Concentration Guidance (Washington, D.C.: April 2013). Speculators drive prices to unwarranted levels (e.g., home prices increase by 30 percent year-over-year for an extended period, while inventory is expected to grow to unprecedented levels). Concentrations of credit exposures add a dimension of risk that compounds the risk inherent in individual loans. Generally, the longer a bank has been a CRE lender, the more granular the loss data. Regulators have removed a key commercial real estate concentration limit for New York Community Bancorp in Westbury, N.Y. 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. The guidance provides supervisory criteria, including numerical indicators, for identifying institutions with potentially significant CRE loan concentrations that may warrant greater supervisory scrutiny. Another technique used by some banks with larger portfolios and more sophisticated internal data is to stress ratings migrations. Portfolio diversification across property types. They may have separate legacy systems that do not aggregate data efficiently, if at all. Loss rates may lag the downturn by a number of months or years. 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 federal banking regulators have issued statements and guidance encouraging banks to continue lending to creditworthy borrowers and explaining how banks can work with troubled borrowers. 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. Another major expense often overlooked is the opportunity cost of holding a large volume of nonearning assets. Risk ratings should be accurate and uniformly applied across product lines and geographic areas. A CRE concentration increases the importance of sound lending policies. 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 … 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. This is especially true if the data for the reference portfolio lack granularity. Loan disbursement practices—They should be based on engineering or inspection reports, requirements for lien waivers from subcontractors, etc. Much has changed in CRE lending since the last downturn. Appraisals 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). 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. Reiteration of Interagency Guidance on CRE-Commercial Real Estate Concentrations has had limited impact on Banking Industry. 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. 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