Regulatory guidance on commercial real estate risk: mind the gap for great guidance on good lending

This article describes the key elements of an interagency guidance issued in December 2006 regarding concentrations in commercial real estate lending and sound risk management practices. The guidance can be used to identify possible gaps in an institution's commercial real estate risk management policies and procedures, as well as practices and processes. The article concludes with some options and reference resources for plugging those gaps.

The German philosopher Georg Wilhelm Hegel advised that order is the first requisite of liberty, and here in the land of liberty, we bankers enjoy considerable order. For the continuing good of the order, on December 12, 2006, the FDIC, OCC, and Federal Reserve published their final guidance on concentrations in commercial real estate. Absent the OTC (1), these agencies have observed that commercial real estate (CRE) concentrations (2) have been rising over the past several years and, in their collective opinion, "have reached levels that could create safety and soundness concerns in the event of a significant downturn." (3)

Small to mid-size institutions have been especially attracted to the profit potential of CRE lending, yet past history has shown the CRE markets rapidly reverse their fortunes during economic downturns. A bank's ability to survive CRE recessions depends on the adequacy of its risk management practices and capital levels (4), but the agencies are concerned that the typical bank with a high CRE concentration may not have the policies and procedures to manage the risk. Consequently, the agencies have issued this latest guidance for helping banks manage their CRE risk. (5)

Concentration Growth and the Final Guidance: Up, Up, and Away

The agencies' concern about CRE concentration stems from exponential growth in CRE relative to risk-based capital among smaller banks in just under three years:

Bank size ($millions) December 31, 2003 September 30, 2006

100-1,000 156% 318%
1,000-10,000 127% 300%

At the same time, surveys of banker practices as well as examination results indicate that high-concentration institutions have relaxed their underwriting standards in response to stiff competition, and many banks lack appropriate policies and procedures to manage the related CRE risk. (6)

CRE concentration criteria. The agencies will employ two ratios and a growth measure "as a screen for identifying institutions with potential CRE concentration risk ... that, if breached by a bank, may invite greater regulatory scrutiny to ensure the bank has in place heightened risk management practices and capital levels." (7)

* Total reported loans for construction, land development, and other land add up to 100% or more of total risk-based capital.

* Total commercial real estate loans meet or exceed 300% of capital.

* Outstanding CRE loans have grown 50% or more over the past three years.

The guidance is aimed at CRE loans for which the cash flow from the real estate is the primary source of repayment, not at loans for which real estate collateral is taken as a secondary source of repayment or through an abundance of caution. Their risk profiles are sensitive to the condition of the market and its drivers--capitalization rates, vacancy rates, rental rates, and so on. They derive 50% or more of their repayment source from third-party, nonaffiliated rental income or from the proceeds of the sale, refinancing, or permanent financing of the property. Therefore, the following loans fall within the parameters of the guidance:

* Land development and construction loans, including one- to four-family residential and commercial construction loans and other land loans.

* Loans secured by multifamily property and nonfarm, nonresidential property where the primary source of repayment is derived from rental income associated with the property.

* Also subject to the guidance are loans to real estate investment trusts (REITs) and unsecured loans to developers if repayment depends on the performance of the CRE market.

Excluded from the guidance are loans secured by nonfarm, nonresidential properties where the primary source of repayment is the cash flow from the ongoing operations and activities conducted by the party, or affiliate of the party, who owns the property. So, the guidance is aimed at 1) borrowing real estate developers and investors (REDI borrowers) and 2) co-REDI borrowers (e.g., the doctor who decides to build, own, and operate a shopping center)--but not at owner-occupied borrowers. (8)

While these new measures have generated considerable debate between bankers and regulators, the guidance is now in place, so bankers must learn to live with it. In fact, the guidance actually provides an opportunity for financial institutions to compare their individual CRE risk management practices with the final guidance, identify any gaps, and then try to plug them.