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From Banking and Finance Law Daily, December 18, 2015

Regulators express concern over risky commercial real estate lending trends

By Richard A. Roth, J.D.

Banks and savings associations need to take care that their commercial real estate lending activities comply with regulatory guidance on risk management, the federal regulatory agencies are emphasizing. According to a joint statement by the Federal Reserve Board, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation, competitive pressures are leading lenders to ease their underwriting standards and loan terms and also are resulting in increasing concentrations in CRE loans. The resulting higher risk could expose financial institutions to a higher risk of failure (FIL-62-2015).

Commercial real estate lending refers to loans used to buy, develop, build, or refinance real estate, when sales or leases are expected to fund the loan payments. While the interagency statement does not address owner-occupied CRE, lenders with concentrations in related loans also are expected to have appropriate risk management processes.

Market conditions. CRE markets are showing substantial growth right now, the statement says. Property values are rising at the same time that capitalization rates are falling. Indicators such as vacancy rates and problem loan rates are not showing weaknesses in CRE portfolios, the agencies say, and loan demand is strong. As a result, many financial institutions have rising concentration levels in CRE loans.

Information developed through examinations and other avenues shows that underwriting standards such as loan covenants, times to maturity, guarantor requirements, and extended interest-only payment periods are declining, the interagency statement says. Also, some lenders are making more underwriting policy exceptions and are not adequately watching market conditions.

Risk management practices. The interagency statement draws attention to a number of specific practices the agencies say are characteristic of lenders that have been successful when economic cycles turn. In addition to ensuring that board members and managers have the information they need, lenders need to have adequate internal processes and should monitor market conditions.

Internally, lenders should establish loan policies, underwriting standards, concentration limits, and other procedures. These should include ways to ensure adequate capital and allowances for loan losses. Cash flow analyses should be based on realistic rental and sales rates and operating expenses in order to ensure that borrowers have the ability to service all of their loans if market conditions change.

Lenders also need to analyze their CRE portfolios against the market to understand how changing circumstances could affect their asset quality, earnings, and capital. They should monitor changes in demand for CRE. Also, lenders should review appraisals to be sure that estimates of real estate market values are based on reasonable rent, absorption period, and expense projections.

The joint statement says that examiners will be looking closely at CRE lending in the upcoming year to determine whether financial institutions are complying with relevant risk management guidance. Institutions with risk management practices or capital strategies that do not measure up may be required to create plans for better CRE portfolio monitoring, to tighten their underwriting standards, or to raise more capital.

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