While the banking market is commonly considered as more resilient today than it was heading into the financial crisis of 2007-2009,1 the business realty (CRE) landscape has altered significantly since the onset of the COVID-19 pandemic. This new landscape, one defined by a higher rates of interest environment and hybrid work, will affect CRE market conditions. Given that neighborhood and regional banks tend to have greater CRE concentrations than large firms (Figure 1), smaller sized banks need to remain abreast of existing patterns, emerging risk aspects, and chances to update CRE concentration risk management.2,3
Several current market online forums carried out by the Federal Reserve System and specific Reserve Banks have discussed various aspects of CRE. This post aims to aggregate crucial takeaways from these various online forums, as well as from our recent supervisory experiences, and to share notable trends in the CRE market and relevant danger factors. Further, this article attends to the significance of proactively handling concentration danger in a highly vibrant credit environment and provides several best practices that show how risk supervisors can consider Supervision and Regulation (SR) letter 07-1, "Interagency Guidance on Concentrations in Commercial Real Estate," 4 in today's landscape.
Market Conditions and Trends
Context
Let's put all of this into viewpoint. As of December 31, 2022, 31 percent of the insured depository organizations reported a concentration in CRE loans.5 Most of these financial organizations were neighborhood and local banks, making them an important financing source for CRE credit.6 This figure is lower than it was during the monetary crisis of 2007-2009, however it has actually been increasing over the past year (the November 2022 Supervision and Regulation Report stated that it was 28 percent on June 30, 2022). Throughout 2022, CRE efficiency metrics held up well, and lending activity remained robust. However, there were indications of credit deterioration, as CRE loans 30-89 days past due increased year over year for CRE-concentrated banks (Figure 2). That stated, past due metrics are lagging indicators of a borrower's financial challenge. Therefore, it is critical for banks to implement and keep proactive risk management practices - talked about in more information later on in this article - that can inform bank management to deteriorating efficiency.
Noteworthy Trends
Most of the buzz in the CRE area coming out of the pandemic has been around the workplace sector, and for great reason. A recent study from service professors at Columbia University and New york city University discovered that the worth of U.S. office complex could plunge 39 percent, or $454 billion, in the coming years.7 This may be triggered by recent patterns, such as renters not restoring their leases as workers go totally remote or renters restoring their leases for less area. In some severe examples, companies are offering up space that they leased only months previously - a clear indication of how quickly the marketplace can turn in some locations. The struggle to fill empty office is a national trend. The national job rate is at a record 19.1 percent - Chicago, Houston, and San Francisco are all above 20 percent - and the amount of workplace area rented in the United States in the 3rd quarter of 2022 was almost a third listed below the quarterly average for 2018 and 2019.
Despite record jobs, banks have actually benefited hence far from office loans supported by prolonged leases that insulate them from unexpected wear and tear in their portfolios. Recently, some large banks have actually started to offer their office loans to limit their exposure.8 The substantial amount of workplace financial obligation maturing in the next one to 3 years could produce maturity and refinance threats for banks, depending upon the monetary stability and health of their customers.9
In addition to recent actions taken by large firms, trends in the CRE bond market are another essential indicator of market belief related to CRE and, particularly, to the workplace sector. For example, the stock rates of large openly traded property managers and developers are close to or listed below their pandemic lows, underperforming the broader stock exchange by a substantial margin. Some bonds backed by workplace loans are likewise showing signs of stress. The Wall Street Journal released a short article highlighting this trend and the pressure on realty worths, keeping in mind that this activity in the CRE bond market is the current sign that the increasing interest rates are affecting the business residential or commercial property sector.10 Property funds normally base their valuations on appraisals, which can be sluggish to show evolving market conditions. This has kept fund assessments high, even as the property market has actually degraded, underscoring the challenges that many community banks deal with in figuring out the existing market price of CRE residential or commercial properties.
In addition, the CRE outlook is being impacted by greater dependence on remote work, which is consequently impacting the use case for big workplace structures. Many business workplace developers are seeing the shifts in how and where individuals work - and the accompanying patterns in the workplace sector - as chances to consider alternate uses for workplace residential or commercial properties. Therefore, banks must think about the prospective ramifications of this remote work pattern on the need for office and, in turn, the property quality of their office loans.
Key Risk Factors to Watch
A confluence of aspects has actually caused numerous crucial risks impacting the CRE sector that deserve highlighting.
Maturity/refinance threat: Many fixed-rate office loans will be maturing in the next couple of years. Borrowers that were locked into low interest rates might face payment difficulties when their loans reprice at much higher rates - in many cases, double the initial rate. Also, future re-finance activity might need an additional equity contribution, potentially developing more monetary stress for debtors. Some banks have actually started providing bridge financing to tide over specific debtors until rates reverse course.
Increasing danger to net operating earnings (NOI): Market individuals are citing increasing expenses for products such as utilities, residential or commercial property taxes, maintenance, insurance, and labor as a concern due to the fact that of heightened inflation levels. Inflation might cause a building's operating expense to rise faster than rental earnings, putting pressure on NOI.
Declining property value: CRE residential or commercial properties have just recently experienced substantial cost changes relative to pre-pandemic times. An Ask the Fed session on CRE kept in mind that assessments (industrial/office) are down from peak rates by as much as 30 percent in some sectors.11 This triggers a concern for the loan-to-value (LTV) ratio at origination and can easily put banks over their policy limits or risk cravings. Another factor affecting asset worths is low and delayed capitalization (cap) rates. Industry individuals are having a tough time identifying cap rates in the present environment due to the fact that of poor data, less transactions, quick rate motions, and the unpredictable rate of interest course. If cap rates stay low and rates of interest surpass them, it might result in an unfavorable leverage scenario for borrowers. However, financiers anticipate to see boosts in cap rates, which will negatively affect assessments, according to the CRE services and investment firm Coldwell Banker Richard Ellis (CBRE).12
Modernizing Concentration Risk Management
Background
In early 2007, after observing the trend of increasing concentrations in CRE for numerous years, the federal banking companies released SR letter 07-1, "Interagency Guidance on Concentrations in Commercial Real Estate." 13 While the assistance did not set limits on bank CRE concentration levels, it encouraged banks to boost their danger management in order to manage and manage CRE concentration dangers.
Crucial element to a Robust CRE Risk Management Program
Many banks have since taken steps to align their CRE threat management structure with the crucial elements from the assistance:
- Board and management oversight
- Portfolio management
- Management info system (MIS).
- Market analysis.
- Credit underwriting requirements.
- Portfolio stress testing and sensitivity analysis.
- Credit danger evaluation function
Over 15 years later, these foundational elements still form the basis of a robust CRE threat management program. An efficient danger management program evolves with the changing threat profile of an institution. The following subsections broaden on 5 of the 7 elements kept in mind in SR letter 07-1 and goal to highlight some best practices worth considering in this dynamic market environment that might update and strengthen a bank's existing framework.
Management Information System
A robust MIS provides a bank's board of directors and management with the tools needed to proactively keep track of and manage CRE concentration threat. While many banks currently have an MIS that stratifies the CRE portfolio by market, residential or commercial property, and location, management may want to consider additional ways to section the CRE loan portfolio. For instance, management might think about reporting borrowers facing increased re-finance danger due to interest rate variations. This info would aid a bank in determining prospective re-finance risk, could help guarantee the accuracy of threat ratings, and would facilitate proactive discussions with prospective problem customers.
Similarly, management might want to evaluate deals funded throughout the property evaluation peak to identify residential or commercial properties that might currently be more conscious near-term assessment pressure or stabilization. Additionally, including data points, such as cap rates, into existing MIS might supply beneficial details to the bank management and bank loan providers.
Some banks have actually executed an enhanced MIS by utilizing centralized lease monitoring systems that track lease expirations. This type of information (particularly pertinent for workplace and retail areas) offers information that permits loan providers to take a proactive method to keeping an eye on for possible problems for a specific CRE loan.
Market Analysis
As noted formerly, market conditions, and the resulting credit risk, differ across geographies and residential or commercial property types. To the extent that data and details are available to an institution, bank management might consider further segmenting market analysis information to best identify patterns and danger elements. In big markets, such as Washington, D.C., or Atlanta, a more granular breakdown by submarkets (e.g., central service district or suburban) might matter.
However, in more rural counties, where available information are limited, banks might think about engaging with their local appraisal firms, professionals, or other community advancement groups for pattern data or anecdotes. Additionally, the Federal Reserve Bank of St. Louis maintains the Federal Reserve Economic Data (FRED), a public database with time series details at the county and nationwide levels.14
The finest market analysis is not done in a vacuum. If significant trends are determined, they might inform a bank's loaning strategy or be included into stress screening and capital preparation.
Credit Underwriting Standards
During durations of market pressure, it ends up being increasingly important for lending institutions to completely comprehend the financial condition of customers. Performing global capital analyses can guarantee that banks understand about dedications their borrowers may have to other banks to lessen the threat of loss. Lenders should also think about whether low cap rates are inflating residential or commercial property valuations, and they must thoroughly examine appraisals to comprehend assumptions and growth forecasts. An efficient loan underwriting process considers stress/sensitivity analyses to better record the prospective changes in market conditions that could impact the capability of CRE residential or commercial properties to generate adequate cash circulation to cover debt service. For instance, in addition to the usual criteria (financial obligation service coverage ratio and LTV ratio), a stress test may include a breakeven analysis for a residential or commercial property's net operating income by increasing business expenses or reducing rents.
A sound danger management process ought to recognize and keep track of exceptions to a bank's financing policies, such as loans with longer interest-only durations on supported CRE residential or commercial properties, a higher dependence on guarantor assistance, nonrecourse loans, or other discrepancies from internal loan policies. In addition, a bank's MIS need to provide adequate details for a bank's board of directors and senior management to assess risks in CRE loan portfolios and recognize the volume and pattern of exceptions to loan policies.
Additionally, as residential or commercial property conversions (believe office to multifamily) continue to appear in major markets, lenders could have proactive discussions with investor, owners, and operators about alternative uses of genuine estate space. Identifying alternative strategies for a residential or commercial property early could help banks get ahead of the curve and lessen the danger of loss.
Portfolio Stress Testing and Sensitivity Analysis
Since the onset of the pandemic, lots of banks have actually revamped their stress tests to focus more heavily on the CRE residential or commercial properties most adversely affected, such as hotels, office space, and retail. While this focus might still be relevant in some geographic areas, efficient stress tests need to progress to consider new types of post-pandemic situations. As discussed in the CRE-related Ask the Fed webinar discussed previously, 54 percent of the respondents kept in mind that the leading CRE concern for their bank was maturity/refinance risk, followed by negative utilize (18 percent) and the failure to precisely establish CRE values (14 percent). Adjusting existing tension tests to record the worst of these concerns might supply informative details to notify capital preparation. This procedure might also offer loan officers details about borrowers who are specifically vulnerable to interest rate increases and, hence, proactively notify exercise techniques for these customers.
Board and Management Oversight
Similar to any danger stripe, a bank's board of directors is ultimately responsible for setting the threat cravings for the organization. For CRE concentration risk management, this means developing policies, procedures, threat limits, and loaning strategies. Further, directors and management need an appropriate MIS that offers enough information to evaluate a bank's CRE risk direct exposure. While all of the items pointed out earlier have the potential to strengthen a bank's concentration danger management structure, the bank's board of directors is accountable for developing the risk profile of the organization. Further, an effective board authorizes policies, such as the strategic plan and capital strategy, that line up with the threat profile of the organization by thinking about concentration limitations and sublimits, as well as underwriting requirements.
Community banks continue to hold substantial concentrations of CRE, while many market indications and emerging patterns indicate a mixed efficiency that is dependent on residential or commercial property types and location. As market gamers adapt to today's developing environment, lenders need to stay alert to modifications in CRE market conditions and the danger profiles of their CRE loan portfolios. Adapting concentration threat management practices in this altering landscape will make sure that banks are prepared to weather any prospective storms on the horizon.
* The authors thank Bryson Alexander, research analyst, Federal Reserve Bank of Richmond; Brian Bailey, commercial realty subject matter specialist and senior policy advisor, Federal Reserve Bank of Atlanta; and Kevin Brown, advanced examiner, Federal Reserve Bank of Richmond, for their contributions to this article.
1 The November 2022 Financial Stability Report released by the Board of Governors highlighted numerous crucial actions taken by the Federal Reserve following the 2007-2009 financial crisis that have actually promoted the strength of financial organizations. This report is offered at www.federalreserve.gov/publications/files/financial-stability-report-20221104.pdf.
2 See Kyle Binder, Emily Greenwald, Sam Schulhofer-Wohl, and Alejandro H. Drexler, "Bank Exposure to Commercial Property and the COVID-19 Pandemic," Federal Reserve Bank of Chicago, 2021, available at www.chicagofed.org/publications/chicago-fed-letter/2021/463.
3 The November 2022 Supervision and Regulation Report launched by the Board of Governors defines concentrations as follows: "A bank is considered concentrated if its building and construction and land advancement loans to tier 1 capital plus reserves is greater than or equal to one hundred percent or if its total CRE loans (consisting of owner-occupied loans) to tier 1 capital plus reserves is higher than or equal to 300 percent." Note that this method of measurement is more conservative than what is laid out in Supervision and Regulation (SR) letter 07-1, "Interagency Guidance on Concentrations in Commercial Real Estate," due to the fact that it consists of owner-occupied loans and does rule out the 50 percent growth rate throughout the previous 36 months. SR letter 07-1 is readily available at www.federalreserve.gov/boarddocs/srletters/2007/SR0701.htm, and the November 2022 Supervision and Regulation Report is offered at www.federalreserve.gov/publications/files/202211-supervision-and-regulation-report.pdf.
4 See SR letter 07-1, offered at www.federalreserve.gov/boarddocs/srletters/2007/SR0701.htm.
5 Using Call Report information, we discovered that, since December 31, 2022, 31 percent of all banks had building and construction and land development loans to tier 1 capital plus reserves higher than or equal to 100 percent and/or total CRE loans (consisting of owner-occupied loans) to tier 1 capital plus reserves higher than 300 percent. As kept in mind in footnote 3, this is a more conservative procedure than the SR letter 07-1 step since it includes owner-occupied loans and does rule out the 50 percent growth rate throughout the previous 36 months.
6 See the November 2022 Supervision and Regulation Report.
7 See Arpit Gupta, Vrinda Mittal, and Stijn Van Nieuwerburgh, "Work from Home and the Office Real Estate Apocalypse," November 26, 2022, offered at https://dx.doi.org/10.2139/ssrn.4124698.
8 See Natalie Wong and John Gittelsohn, "Wall Street Banks Are Exploring Sales of Office Loans in the U.S.," American Banker, November 11, 2022, offered at www.americanbanker.com/articles/wall-street-banks-are-exploring-sales-of-office-loans-in-the-u-s.
9 An Ask the Fed session presented by Brian Bailey on November 16, 2022, highlighted the substantial volume of workplace loans at repaired and drifting rates set to mature in the coming years. In 2023 alone, nearly $30.2 billion in floating rate and $32.3 billion in fixed rate office loans will grow. This Ask the Fed session is offered at https://bsr.stlouisfed.org/askthefed/Home/ArchiveCall/329.
10 See Konrad Putzier and Peter Grant, "Investors Yank Money from Commercial-Property Funds, Pressuring Real-Estate Values," Wall Street Journal, December 6, 2022, available at www.wsj.com/articles/investors-yank-money-from-commercial-property-funds-pressuring-real-estate-values-11670293325.
11 See the November 16, 2022, Ask the Fed session, which was presented by Brian Bailey and is offered at https://bsr.stlouisfed.org/askthefed/Home/ArchiveCall/329.
12 See "U.S. Cap Rate Survey H1 2022," CBRE, 2022, readily available at www.cbre.com/insights/reports/us-cap-rate-survey-h1-2022.
