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Lending & Credit Risk CRE Lending Credit Risk Management Portfolio Risk & CECL Loan Review and Due Diligence Stress Testing

CRE risk: Lessons from recent earnings reports

Derek Hipp, CPA
August 2, 2023
Read Time: 0 min

CRE credit risk is in the spotlight

A structured approach to assessing commercial real estate risk helps banks and credit unions address inquiries about the health of CRE loans.

You might also like this on-demand webinar, "Stress testing & CECL efficiencies."

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Takeaway 1

The health of CRE loans and related credit risk is a focus of investors, board members, other stakeholders, and upcoming regulatory exams.

Takeaway 2

Financial institutions have been taking a three-pronged approach to identifying and quantifying risks associated with their CRE segments.

Takeaway 3

Financial institution management can focus on mitigating risk and understanding portfolio dynamics when the analysis is streamlined.

Be prepared

CRE credit concerns

During earnings season, financial institutions are facing increased scrutiny and inquiries regarding their commercial real estate (CRE) segments and credit performance. Results of recent reports are a reminder that all bank and credit union executives need to be prepared with key information and insights about CRE credit to effectively address many of the same questions from their own stakeholders and examiners. This article outlines a structured approach to ensuring management can confidently answer inquiries about the health of their CRE segments and related credit performance.

The health of CRE loans and related credit risk is a focus not only of investors, board members, and other stakeholders but also of upcoming regulatory exams. The scrutiny is understandable, given financial institutions’ exposure to commercial real estate and current economic and market forces.

Trepp Inc. estimates $1.45 trillion in CRE mortgages will have to be renegotiated by the end of 2025. The firm has said smaller banks hold almost 80% of commercial mortgages held by all banks, which means tracking credit performance is critical.

Based on a review of many of the investor calls so far by Abrigo’s bank advisory services team, financial institutions should be prepared to address some common key areas outlined in the questions below. Executive teams have either answered these questions during the call or included answers to them as part of their earnings releases and prepared comments.

CRE risk-related questions have included:

  1. What percentage of the total loan portfolio is made up of CRE?
  2. What percentage of CRE is made up of office loans?
  3. What is the average loan-to-value of office loans?
  4. How many of these loans are classified and what percentage of the CRE population are these?
  5. What, if any, reserve or losses have been shown in the CRE segment (specifically for office loans)?
  6. How many CRE loans are set to mature/renew in the next 6-24 months?
  7. What is the allowance coverage ratio on the total loan portfolio, the CRE loan portfolio, and the CRE office portfolio?
  8. What factors are changing in your CECL model to elicit these reactions?

3-pronged approach

Identifying and quantifying CRE risks

Most financial institutions have taken a three-pronged approach to identifying and quantifying risks associated with their CRE segments. The three pillars of risk management have been:

  • CRE stress testing
  • Loan reviews, and
  • The institution’s current expected credit loss, or CECL, process for estimating the allowance.

Stress testing

Stress testing the CRE portfolio allows an institution to assess its resilience under various economic scenarios. Executives should be prepared to discuss credit risk stress testing outcomes and their impact on risk management decisions.

Many companies discussed stress testing the portfolio and the associated results during earnings reports. Furthermore, the stress test results often had informed other risk management areas, such as where to conduct specific loan reviews and how they would reserve as part of the “reasonable and supportable forecast” element of CECL. Wells Fargo & Co. Chief Financial Officer Mike Santimassimo said of the institution’s office portfolio, “We've gone through a number of stress scenarios and feel like, at this point, we're appropriately reserved to be able to deal with what could be a number of different scenarios depending on how it plays out over time.”

Loan review

Financial institutions have highlighted that they have focused specific loan reviews on CRE-office loans and on CRE loans that will reprice or renew in the near term. Truist Financial Corp. Vice Chair and Chief Risk Officer Clarke R. Starnes III, for example, said the company took "an intentional focus on CRE office" during the quarter, leading to "an intense loan-by-loan review of almost our entire book." A thorough credit review process provides insights into potential risks and helps determine appropriate reserve levels. Financial institution executives who can share their loan-review process will be able to clarify steps taken to address identified risks.

CECL review

The results of stress testing and loan reviews often inform the CECL review process. Some institutions in recent earnings reports identified loans for downgrade based on specific stress tests or loan reviews conducted. Furthermore, scenarios conducted through CRE stress testing were noted to have either led to boosted weightings for downside economic scenarios or increased qualitative factors reserves.

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stress testing, loan review, and cecl work together to evaluate CRE credit risk

Better understanding of credit risk

Effective CRE risk management

The three-pronged approach to evaluating CRE risk described above promotes a better understanding of a financial institution’s portfolio dynamics. Abrigo has the only portfolio risk management solution in the industry that can combine all three pillars in one platform. When loan review software, credit stress testing software, and CECL software can communicate with each other about data and assumptions, it streamlines the analysis process. It enables financial institution management to focus on mitigating risk and understanding the dynamics of the portfolio, as opposed to focusing on how to operationalize this approach.

Effective CRE risk management

Financial institutions must be adequately prepared to address questions related to their CRE segments and credit performance. The environment may be challenging. But adopting a structured approach that includes stress testing, loan review, and CECL review enables executives to be proactive, responding with clarity and accuracy. And leveraging the appropriate risk management tools allows institutions to streamline managing CRE-related risks effectively so they can confidently navigate the challenges presented by the current environment and instill confidence in stakeholders and regulators.

Bankers trust Abrigo advisors to help them with stress testing, calculating the allowance for credit losses, and loan reviews.

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About the Author

Derek Hipp, CPA

Director, Advisory Services
Derek has over 12 years of experience in public accounting and consulting, specializing in financial institutions. He is a co-founder of the ValuCast™ suite of software solutions and is a leader on Abrigo’s, formerly Valuant, consulting and product delivery services. Derek specializes in Day 1 valuation and due diligence services,

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About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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