The complexity and volatility of the commercial real estate (CRE) market — particularly in relation to residential real estate — demands that financial institutions participating in CRE scrutinize their investments more frequently and fervently.
Build your commercial real estate portfolio on a foundation of stone, underpinned by strong risk management practices and appropriate levels of capital. And, as the Office of the Comptroller of the Currency advises, dedicate adequate resources to conduct stress tests. These allow you to establish and support risk appetite and tolerances, set concentration limits in various property types, adjust underwriting standards, and recalibrate strategies with the aid of documentation and in-market statistics.
There isn’t a one-size-fits-all formula for stress tests. Rather, every credit union and bank should craft a method suitable to its size, risk profile, business strategy, and sophistication. Yet risks inherent in certain types of commercial real estate lending, and certain elements of stress tests, are universal.
Be sure to differentiate your commercial real estate portfolio into two classes: Loans where repayment is dependent on the rental income — or the sale or refinancing — of the real estate held as collateral, and loans tied to cash flow based on the business occupying the real estate. One requires greater concentration on real estate trends, while the other demands close attention to industry trends and the borrower’s books.
Because it can take up to two years for losses to materialize after an economic downturn, build a projection model of at least that length. As the OCC notes, the economy lagged for more than six quarters during the Great Recession before commercial credit quality indicators bottomed out. Further, it took nearly 10 quarters for loan charge-off rates to return to historical norms.
Three stress testing approaches might be valid, depending on your CRE portfolio’s strengths and weaknesses:
- Bottom-up analysis can identify weaknesses in individual loans.
- Segmentation can differentiate risk depending on the type of loan, whether that be in broad strokes — from often dependable multi-family housing to speculative commercial real estate construction — or a deeper dive into loan pools with similar characteristics, such as geography or collateral type.
- Reverse stress testing offers a more existential view, challenging assumptions about the market and your risk tolerance. Start with specific, disastrous scenarios and work backwards to determine what events or forces could cause that outcome. Then address those scenarios by creating mitigation strategies or contingency plans.
Be mindful that examiners possess — and regularly exercise — discretion based on a financial institution’s loan portfolio characteristics, rigor of risk management processes, and level of capital. Also, expect closer supervisory review if you’ve experienced recent, substantial growth in commercial real estate lending, regardless of concentration levels. Likewise, banks and credit unions with concentration levels that wouldn’t otherwise attract interest might be more highly scrutinized if they carry high risk profiles. Be particularly cognizant of maintaining adequate capital as a buffer against unexpected losses.
Per Federal Reserve recommendations, stratify the CRE portfolio by property type, geographic market, tenant concentrations, tenant industries, developer concentrations, and risk rating. Other categories to consider include loan structure, debt service coverage, and loan-to-value limits. And just as with other lending channels, closely monitor credit risk migrations.
You must also consider market analysis as it affects your CRE portfolio. Such analysis can prove particularly effective for financial institutions seeking to extend or widen their portfolio in new markets, or into new property types. Search for valuable information within published research data, from real estate agents and appraisers, the property taxing authority, and local contractors and development groups.
Specific property types warrant various concerns, per guidance from the Federal Reserve Bank of Philadelphia:
Residential land acquisition and development. Be on guard for a decline in demand, which results in longer sellout periods or slumping sales prices. To enact the most relevant stress test, lengthen the absorption rate — regardless of whether the developer has a formal lot sales agreement with a third-party builder. Note that slower sellout and absorption rates can translate into inadequate interest reserves.
Multifamily residential. Stay abreast of vacancies and rent concessions. Factor in the fallout from regional economic forces such as the loss of a large employer, or the shuttering or diminishing of a nearby military base. That can also trigger an influx of condominium conversions, which saturates the market.
Leased commercial office. Properties with tenants in volatile business sectors should be evaluated for increased vacancy rates, declining rent, and shorter-term leases.
Industrial, warehouse, and distribution. The most pressing concern here is tenant credit risk. The best defense is to be cognizant of concentration risk among any one industry, group of industries, or single borrower or borrowing entity.
Leased retail. No sector is as heavily influenced by consumer confidence. Again, monitor concentration levels, and watch for vacancy and rent reduction requests.
The board of directors at your financial institution should be charged with oversight of commercial real estate portfolio, and setting policies that compel notification and reports when certain thresholds are met, whether those thresholds be remedial or signal opportunities. Commission independent analysis to ensure the validity and proper scope of your self-analysis.
Most important, apply the results of stress testing to future underwriting and decision making for your commercial real estate lending portfolio.