Managing Commercial Real Estate Concentrations In a Challenging Environment
Samantha: Hello,this is Samantha Shares.
This episode covers an advisory Letter
issued by the F D I C on Managing
Commercial Real Estate Concentrations
in a Challenging Economic Environment.
These principles apply to all
financial institutions which
is why we are sharing it here.
Both were issued December eighteenth.
The following is an audio version of
that advisory and the press release.
This podcast is educational
and is not legal advice.
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And now the advisory letter.
Summary:
The F D I C is issuing this advisory
to reemphasize the importance of strong
capital, appropriate Credit loss allowance
levels, and robust Credit risk-management
practices for institutions with commercial
real estate (C R E) concentrations.
It also conveys several key risk
management practices for institutions
to consider in managing C R E
loan concentrations in the current
challenging economic environment.
Additionally, the advisory reemphasizes
the importance of effectively managing
liquidity and funding risks, which can
compound lending risks, particularly
for C R E-concentrated institutions.
This advisory replaces the TWO THOUSAND
EIGHT advisory: Managing Commercial
Real Estate Concentrations in a
Challenging Environment (issued March
SEVENTEENTH , TWO THOUSAND EIGHT).
Statement of Applicability: The
contents of, and material referenced
in, this letter apply to all F D I
C-supervised financial institutions.
Editorial note: N C U A examiners often
refer credit unions to F D I C guidance.
Highlights:
The F D I C is issuing this letter to
reemphasize the importance of strong
capital and credit loss allowance
levels, as well as robust credit risk
management practices, for institutions
with concentrated C R E exposures.
Institutions with significant C R E
concentrations are advised to consider
the risk management principles discussed
in the joint Guidance on Concentrations
in Commercial Real Estate Lending, Sound
Risk Management Practices (issued December
6, two thousand and six6), and the
Interagency Policy Statement on Allowances
for credit Losses (Revised April twenty
seven, two thousand and twenty three).
The advisory also identifies key
risk-management actions for financial
institutions with significant C R
E concentrations to manage through
changes in market conditions:
Maintain strong capital levels,
Ensure that credit loss
allowances are appropriate,
Manage construction and development (C
AND D) and C R E loan portfolios closely,
Maintain updated financial
and analytical information,
Bolster the loan workout
infrastructure, and
Maintain adequate liquidity
and diverse funding sources.
Institutions are encouraged to continue
making C R E credit available in their
communities using prudent lending
standards that rely on strong underwriting
and loan administration practices.
The full text of the letter follows.
Managing Commercial Real
Estate Concentrations in a
Challenging Economic Environment
This advisory to insured state
non-member banks and savings associations
reemphasizes the importance of strong
capital, appropriate Credit loss allowance
levels, and robust Credit risk-management
practices when managing commercial
real estate (C R E) concentrations.
This advisory replaces an advisory
issued in TWO THOUSAND EIGHT1 that
emphasized these same points during a
time when C R E market conditions had
weakened, most notably in the construction
and development (C AND D) sector.
This advisory conveys several key
risk management practices for F D I
C-supervised institutions to consider in
managing C R E loan concentrations in the
current challenging economic environment.
The advisory also continues to emphasize
the importance of effectively managing
liquidity and funding risks, which can
compound lending risks, particularly
for C R E- concentrated institutions.
This advisory does not create
new risk management principles;
however, it does update and build
upon previously issued guidance.
Previous Challenging Economic Environments
The F D I C recognizes that financial
institutions play a critical role in
the economic vitality of the communities
they serve by providing Credit for
businesses, often for C R E purposes,
including real estate development.
However, concentrations in C
R E lending add dimensions of
risk that warrant attention.
C R E lending concentrations, combined
with weak risk management practices,
contributed significantly to past asset
quality problems and bank failures.
One example is the banking and thrift
crisis of the 1980s and early 1990s.2
Bank decisions to loosen C R E lending
standards during the 1980s were based
primarily on the assumption that real
estate values (collateral values)
would continue to rise in the future
as they had in the then recent past.
Another example is the banking crisis
of TWO THOUSAND EIGHT to twenty thirteen
which impacted the many financial
institutions that had greatly increased
their holdings of, and concentrations
in, in particular, loans to finance
the development and construction of
real estate (C AND D loans) in the
period leading up to the crisis.
In these crises, when C R E markets
deteriorated, poor management
of C R E lending concentrations
led to increased Credit losses.
Further, many C R E- concentrated
institutions that failed also relied
on funding sources other than stable
deposits and had lower levels of capital.
Current Challenging Economic
Environment and Real Estate Conditions
Recent weaknesses in the current
economic environment and in fundamentals
related to various C R E sectors have
increased the F D I C’s overall concern
for state nonmember institutions
with concentrations of C R E loans.
C R E market and lending conditions
have been significantly influenced by
governmental and societal responses to the
pandemic, rapidly rising interest rates,
and the prolonged inverted yield curve.
Also, C R E investment property
capitalization rates have not kept
pace with recent rapid increase
in long-term interest rates, which
leads to concerns about general
over-valuation of underlying collateral.
C R E vacancy rates are rising,
most notably in the office
sector, but also in multi-family.
Office vacancy rates are affected
by the demand for traditional
office space, which has slowed due
to the popularity of remote work.
Office attendance is approximately
50 percent of its pre-pandemic level.
In addition to large amounts of
available space, high levels of office
loans and office leases are maturing
or expiring in the next few years.
The multi-family sector vacancy rate
is also high in some markets, due
in part to potential overbuilding.
Rapid absorption of multi-family
space experienced in twenty twenty
one has since slowed, while the pace
of new construction remains brisk.
Refinancing office and multi-family loans
could be challenging in an environment
of pressured rent growth, higher interest
rates, and lower property values,
particularly for those institutions
with C R E concentrations in areas with
surplus office and multi-family space.
The F D I C’s concern also extends to
the subset of banks with elevated C AND
D concentrations, which subset has risen
in recent quarters, but remains well
below the two thousand and seven peak.
Banks with significant exposure to
C AND D loans had substantial Credit
losses during the TWO THOUSAND
EIGHT-two thousand thirteen banking
crisis, and banks currently engaged
in C AND D lending could be affected
by weaknesses in the current economic
environment and real estate fundamentals.
The F D I C continues to be concerned
that institutions with concentrated C
R E exposures may be vulnerable to real
estate downturns and is reminding such
F D I C-supervised institutions of the
importance of ensuring that Credit risk
management practices are strong, reliable
funding sources are in place and liquidity
contingency plans are robust, property
valuation policies and procedures capture
changes to property values, capital and
allowance for Credit losses (A C L) levels
are appropriate, and workout processes
are well-defined and ready to be deployed.
It is strongly recommended that, as market
conditions warrant, institutions with C R
E concentrations (particularly in office
lending) increase capital to provide
ample protection from unexpected losses
if market conditions deteriorate further.
Managing C R E Concentrations
In December two thousand six, the F D
I C and the other prudential regulators
issued Concentrations in Commercial
Real Estate Lending, Sound Risk
Management Practices (C R E Guidance).
Institutions with significant C R
E concentrations are reminded that
strong risk management, governance,
capital, and appropriate ACL levels
are needed to help mitigate risks.
Institutions with overall Credit risk
management processes that reflect
consideration of the principles of
the two thousand six C R E Guidance
are better positioned to manage
through adverse economic environments.
The principles in the two thousand
six C R E guidance remain relevant,
particularly in challenging economic
environments, and particularly for
institutions engaged in significant C R
E lending strategies to help them remain
healthy and profitable while continuing to
serve the Credit needs of the community.
The F D I C has identified six key
risk-management actions to help
institutions with significant C AND
D and C R E concentrations manage
through changes in market conditions:
Maintain Strong Capital Levels
Capital provides institutions with
protection against unexpected losses,
particularly in stressed markets.
Institutions with significant C AND
D and C R E exposures may require
more capital because of uncertainty
about market conditions causing an
elevated risk of unexpected losses.
As market conditions warrant, proactive
directorates and management take steps
to increase capital levels to support
significant C R E concentrations and
mitigate the impact of potential loss.
Maintenance of an appropriate level
of capital to protect an institution
from unexpected losses related to
C AND D and C R E concentrations
is an important consideration
when contemplating cash dividends.
Ensure that Credit Loss
Allowances are Appropriate
Institutions are expected to determine
their A C L’s in accordance with
U S generally accepted accounting
principles (GAAP) and regulatory
reporting instructions, relevant
supervisory guidance, their
stated policies and procedures,
and management’s best judgment.
Prudent Credit management includes
periodic, at least quarterly, analysis
of the collectability of C R E and all
other exposures and maintenance of A
C L’s at a level that is appropriate
to cover expected Credit losses on
individually evaluated loans, as
well as expected Credit losses in
the remainder of the loan portfolio.
In reviewing their A C L methodology,
institutions with significant C AND D
and C R E concentrations are advised
to consult recent supervisory guidance.
In accordance with GAAP, management
should consider the effects of past
events, current conditions, and reasonable
and supportable forecasts on the
collectability of the institution’s loans.
Specifically, GAAP requires management
to use relevant forward-looking
information and expectations drawn from
reasonable and supportable forecasts
when estimating expected Credit losses.
While historical loss information
generally provides a basis for an
institution’s assessment of expected
Credit losses, management should consider
whether further adjustments to historical
loss information are needed to reflect
the extent to which current conditions
and reasonable and supportable forecasts
differ from the conditions that existed
during the historical loss period.
Manage C AND D and C R E
Loan Portfolios Closely
Consistent with Parts 3 6 4 and 3 6 5
of the F D I C Rules and Regulations and
their appendices, institutions should
maintain prudent lending standards
and Credit administration practices
that consider the risks of material
C AND D and C R E concentrations.
This includes management information
systems that provide the board and
management with relevant data on
concentrations levels and related market
conditions, including for concentration
or market segments, as appropriate.
Portfolio and loan level stress tests or
sensitivity analysis can be an invaluable
tool in identifying and quantifying the
impact of changing economic conditions
and changing loan level fundamentals on
asset quality, earnings, and capital.
Applying adverse scenarios while
conducting stress tests or sensitivity
analysis helps banks adjust risk
management processes, capital planning,
liquidity management, collateral valuation
processes, and workout procedures to
prepare for Credit risk problems before
they impact earnings and capital.
Additionally, appropriate risk
management practices include maintaining
a strong Credit review and risk
rating system12 that identifies
deteriorating Credit trends early.
It is important for institutions to
effectively manage interest reserves
and loan accommodations,14 reflecting
the borrower’s condition accurately in
loan ratings and documented reviews.
Maintain Updated Financial
and Analytical Information
Prudent institutions with C R
E and/or C AND D concentrations
maintain recent borrower financial
statements, including property cash
flow statements, rent rolls, guarantor
personal statements, tax return data,
and other income property performance
information to better understand their
borrowers’ ability to repay and overall
financial condition and enable timely
identification of adverse trends.
Such institutions emphasize global
financial analysis of obligors,
including in relation to pending loan
maturities and lease expirations,
as well as the concentration of
individual property owners, builders,
or developers in a loan portfolio.
As real estate market and individual
property conditions change, it is
important for management to consider
the continued relevance of appraisals
and evaluations performed during prior
economic or market and interest rate
conditions, and update collateral
valuation information as necessary.15
Maintaining updated financial and
analytical information provides key
inputs to foster meaningful stress testing
or scenario analysis described above.
Bolster the Loan Workout Infrastructure
Well prepared institutions ensure they
have sufficient staff and appropriate
skill sets to properly manage an
increase in problem loans and workouts.
Likewise, institutions that have a
ready network of legal, appraisal,
real estate brokerage, and property
management professionals to handle
additional prospective workouts are better
situated for more positive outcomes.
Maintain Adequate Liquidity
and Diverse Funding Sources
Since liquidity and funding risks may
be compounded in challenging interest
rate and economic environments, it is
important for institutions to have a
comprehensive management process for
identifying, measuring, monitoring, and
controlling liquidity and funding risks.
Recent industry events have underscored
risks related to relying on funding
concentrations, such as high levels of
uninsured deposits, and the importance
of robust liquidity risk management
and contingency funding planning.
Institutions that have identified
appropriate levels of cash and cash
equivalents, that have identified and
are able to use a stable and diverse
range of funding mechanisms, and that
have identified and tested sources
of contingent liquidity, including
establishing and testing access to
the Federal Reserve Discount Window,
are better positioned to profitably
support C R E concentrations.
As with any asset exposure,
significant C R E concentrations
can lead to losses and capital
deficiencies in a stressed environment.
The F D I C’s examiners recognize the
challenges facing institutions in the
current C R E environment, and will expect
each board of directors and management
team to strive for strong capital and
appropriate A C L levels, and to implement
robust Credit risk-management practices.
Institutions are encouraged to continue
making C AND D and C R E Credit available
in their communities using prudent lending
standards that rely on strong underwriting
and loan administration practices.
The Appendix includes selected F D I
C regulations, supervisory guidance,
and other relevant information
for additional details about
matters discussed in this advisory.
Refer to the F D I C’s regulations,
supervisory guidance, and other
information for additional details about
matters discussed in this Advisory.
This concludes the F D I C advisory
Letter on managing commercial
real estate concentrations in a
challenging economic environment.
F Y I, the co author of the NCU A's
Commercial loan rule is a member of our
team at Credit Union Exam Solutions.
If your Credit union could use assistance
with your exam, reach out to Mark Treichel
on LinkedIn, or at mark Treichel dot com.
This is Samantha Shares and
we Thank you for listening.
