Insufficient Stress Testing Leads to Increased CRE Concentration Risk Management Warnings

While commercial real estate lending is increasing, underwriting standards have been decreasing. Many banks are not following best practices for managing concentration risk, particularly in stress testing, Office of the Comptroller of the Currency Thomas J. Curry warns.

As a result, the OCC elevated CRE concentration risk management to “an area of emphasis” in its latest Semi-Annual Risk Perspective.  The OCC says that CRE portfolios have seen rapid growth, “particularly among small banks.”  The decision to emphasize CRE concentration risk management follows a statement from all three prudential regulators late last year that they would “pay special attention to potential risks associated with CRE lending” in 2016.  Regulators said they could ask banks to raise additional capital to mitigate the risk associated with CRE strategies or exposures.

“At the same time we are seeing this high growth, our exams found looser underwriting standards with less-restrictive covenants, extended maturities, longer interest-only periods, limited guarantor requirements, and deficient stress testing practices,” Curry said in announcing the new emphasis.

Proper stress testing is crucial to managing CRE concentrations, Invictus Consulting Group Co-founder Adam Mustafa cautioned banks in a June webinar. “Stress testing is the right tool for the job. It’s the tool, not the job,” Mustafa said. “Most banks think of it as an end game. Think of it instead as a tool to provide insights and the ability to show regulators that you can handle CRE concentrations and their impact on capital.” Mustafa pointed out five ways banks are misusing stress testing. (See June issue of Bank Insights for more details.)

CRE concentration risk management best practices also include global cash flow analyses, an understanding of lifetime repayment capacities, proper appraisal reviews and ongoing monitoring of supply and demand. Banks must ensure that they have the right policies, underwriting standards and risk management policies to let the board monitor the concentration risk and understand the CRE limits. Appropriate lending, capital and ALLL strategies are crucial.

The OCC reported that at the end of last year, 406 banks had CRE portfolios that had grown more than 50 percent in the prior three years, and more than 180 of those banks had at least doubled their CRE portfolios.

Community banks, particularly in the East, have CRE past-due rates higher than in many parts of the U.S., according to a Federal Deposit Insurance Corp’s New York regional office teleconference in July.  The FDIC also reported that the multi-family market “may be approaching oversupply,” especially in some metro urban areas and in New York.  The OCC said multi-family lending is “a significant concentration (25 percent or more of capital) and a fast-growing loan category for more than one in seven banks with growth of 10 percent or more.”

Many banks in the U.S. have CRE concentration levels above the 300 percent level that often triggers regulatory scrutiny, particularly in New Jersey, Florida, California, Washington, Oregon and Arizona.

“Commercial property values have recently exceeded pre-crisis peaks,” the FDIC noted. “Despite positive rent growth, net operating income has not kept pace with price appreciation, pushing capitalization rates below pre-crisis troughs.” The FDIC also noted “strong inflows” from foreign capital into commercial real estate.

The OCC noted that apartments are “at a more advanced stage of the vacancy rate cycle than other commercial property types.” The OCC expects the national apartment vacancy rate to increase by nearly 1 percentage point over the next two years. Markets with the most new construction could see higher vacancy rates and slower rent and net operating income growth.

“Allowance for loan and lease loss (ALLL) levels and methods may not be sufficiently addressing the risks presented by loan growth, easing in underwriting practices, and layering of credit risk,” the OCC reported. The OCC urged banks to “evaluate concentration risk management thoroughly.”

The FDIC reported the most common weaknesses its examiners are finding in CRE concentration risk management:

• Insufficient stress testing
• Outdated market analyses that conflict with the bank’s strategic plans
• Excessive limits
• Poor concentration reporting and board documentation
• Lax underwriting and insufficient loan policy exception programs
• Appraisal review programs without sufficient expertise or independence
• No CRE contingency plans
• Insufficient ALLL analyses that fail to consider CRE risks
• No CRE internal loan review
• Limited construction loan oversight

M&A can be an attractive solution to CRE issues for some community banks. Acquisitive banks, however, need to take special notice of the CRE concentration regulatory warning.  Many potential acquisitions will result in a crossing of the 300% threshold, especially if they are cash-heavy transactions and are dilutive to tangible book value.  Acquiring banks must be prepared to demonstrate that they have the capital management infrastructure to manage concentration risk.