Portfolio Risk & CECL Stress Testing

CRE risk management: Identify and manage concentration risk

Jacob Lowe

February 14, 2024

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Find commercial real estate risks in the loan portfolio

Sound risk management practices in commercial real estate lending help lenders manage CRE credit losses and protect the portfolio's profitability.

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Manage credit losses

The commercial real estate (CRE) landscape is in constant flux, but in recent months, several indicators signal shifts in risk and opportunity for financial institutions.

Effective CRE risk management at a bank or credit union involves a dynamic approach that adapts to changing market fundamentals. This approach to managing commercial real estate risk prudently includes setting and periodically adjusting concentration limits for different products and markets.

Reducing exposure levels may face resistance from managers and loan officers concerned about short-term earnings. However, when CRE lending is a significant revenue source, failure to adjust concentration levels amid warning signs can lead to excessive loan losses. The severity of these losses depends on loan underwriting quality and the depth of the downturn in the CRE market or specific segments of it.

Below is a look at some recent indicators that point to potential market risks in the CRE credit environment. Also provided are suggestions for evaluating exposure-related risks for CRE concentrations and managing them using CRE stress testing. Sound risk management practices in commercial real estate lending help lenders manage CRE credit losses and protect the profitability of the financial institution’s loan portfolio.

“Sound risk management practices in commercial real estate lending help lenders manage CRE credit losses and protect the profitability of the financial institution’s loan portfolio.”

CRE trends and indicators

Construction companies are still struggling to cope with the impacts of higher interest rates and costs, and they are paying more to attract and retain workers, according to the Associated General Contractors of America (AGC).

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In AGC’s 2024 outlook report, 64% of contractors named rising interest rates and financing costs as one of their biggest concerns. Given the importance of cash flow management in construction, these pressures may point to underlying construction lending risks that may outweigh returns.

In addition, banks in the Federal Reserve’s latest Senior Loan Officer Opinion Survey reported tightening underwriting standards for all types of CRE loans. In fact, the net percentage of banks reporting tighter standards is comparable to those reported at the height of the COVID pandemic. The tightening of CRE credit could potentially impact liquidity within the CRE market. Should companies have less access to funds, this could cause further strain on CRE purchasing and development.

chart showing lenders tightening CRE lending standards for CRE risk management

Source: Senior Loan Officer Opinion Survey on Bank Lending Practices via FRED

Finally, excess vacant office space relative to market demand hints at oversupply and the need for managing CRE loan portfolio risk. CBRE stated recently that the share of U.S. office buildings with an occupancy rate over 95% declined to 60% in Q2 2023 from 63% in Q1 2020, or pre-pandemic.

Bar chart showing share of U.S. office buildings by percentage leased - CBRE

Source: CBRE

Apply scenario tests to CRE

Market monitoring and commercial real estate risk analysis are indispensable to sound CRE risk management. But their true value emerges when these insights prompt adjustments in commercial real estate concentration limits and exposures in response to shifting market conditions.

Identifying indicators that suggest CRE markets are at or near a peak is crucial. While there are no specific examples that are prescribed triggers, the observations above illustrate the need for banks to consider concrete indicators when evaluating commercial real estate risks in specific markets.

For example, during the 2008 Subprime Mortgage Crisis, commercial real estate prices fell drastically by 30 percent year over year. This indicator could be utilized as a benchmark point in stress testing practices to showcase a decline in collateral value representative of a historical recession.

Chart of commercial real estate prices over the year

Source: FRED

CRE stress testing: Avoid credit losses by examining vulnerabilities

Stress testing is integral to managing risks in CRE lending for community financial institutions. It serves as a proactive approach to evaluate how various stressors impact a bank's portfolio, helping assess vulnerabilities and identify areas needing risk mitigation. Some of these stressors include interest and vacancy rates or a decline in collateral values.

Regulators have determined that institutions with 100% of total capital in loans tied to construction and development or total CRE loans of 300% or more risk-based capital should conduct an annual stress test. Even if an institution doesn’t meet those thresholds for required stress testing, regulators increasingly expect lenders to manage CRE loan portfolios closely.

As the FDIC’s December 2023 advisory to institutions on managing CRE concentrations said:

“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.”

Stress testing aids in understanding the potential impact of adverse market conditions on loan portfolios with commercial real estate concentrations, enabling banks to make informed decisions about exposure levels and prepare strategies for mitigating risks. CRE stress testing, in particular, is a timely risk management practice.

Conclusion

Stress testing is not merely a regulatory requirement but a strategic imperative for community financial institutions entrenched in commercial real estate (CRE) lending. It serves as a vital compass, guiding institutions through the intricate terrain of market fluctuations and economic uncertainties. By meticulously evaluating stressors such as interest rates, vacancy rates, and collateral values, stress testing enables banks to identify vulnerabilities, assess potential impacts, and formulate informed strategies for risk mitigation.

Moreover, beyond safeguarding against potential losses, stress testing fosters a culture of adaptability and resilience. It equips financial institutions with the foresight needed to set agile concentration limits, make timely adjustments to exposures, and navigate the nuanced challenges inherent in the ever-evolving CRE landscape. In essence, stress testing is not just a risk management practice; it is a cornerstone for long-term financial sustainability, allowing institutions to thrive amid the dynamic currents of the CRE market and emerge stronger in the face of economic fluctuations.

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"Stress testing: Managing capital levels and credit risk."

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