Part 3: OCC CRE Update—Property & Loan Types--Buy Now & Sell Later?
Part 3: OCC CRE Update—Property Types and Loan Types
Introduction: Buy Now and Sell Later?
Will Rogers advised, “Don’t wait to buy real estate, buy real estate and wait.” Most real estate investors would agree, and that’s why their banks end up in real estate lending. However, bankers need to keep abreast of changes in the regulatory world and retrain as necessary, especially when the OCC updates its real estate guidance. On March 29, 2022, The Office of the Comptroller of the Currency (OCC) issued version 2.0 of its "Commercial Real Estate Lending" booklet of the Comptroller's Handbook. This booklet discusses risks and risk management practices associated with commercial real estate and provides examiners with a framework for evaluating commercial real estate (CRE) lending activities.
The updated booklet replaces version 1.1 of the booklet of the same title issued in January 2017. Also rescinded is OCC Bulletin 2013-19, "Commercial Real Estate Lending: Comptroller's Handbook Revisions and Rescissions," which had updated version 1.0 of the booklet in August 2013. This latest "Commercial Real Estate Lending" booklet applies to the OCC's supervision of community banks, and “Banks" refers collectively to national banks, federal savings associations, and federal branches and agencies of foreign banking organizations engaged in commercial real estate lending.
The updated 2.0 version:
The OCC’s booklet, “Commercial Real Estate Lending,” is used by OCC examiners in connection with their examination and supervision of national banks, federal savings associations (FSA), and federal branches and agencies of foreign banking organizations (collectively, banks). Each bank is different and may present specific risks and issues, so, examiners are expected to apply the information in this booklet consistent with each bank’s individual circumstances. When it is necessary to distinguish between them, national banks and FSAs and covered savings associations (CSA) are referred to separately. A primary driver of this summary series has been to apprise bankers of its contents and to offer readers the opportunity to compare the contents with their own CRE lending policies.
Part 1 of this summary series provided an overview of the update as well as additional detail on roles of credit risk review and internal audit advising readers that the two functions should be independent but that internal audit still has the right to audit credit risk review. Part 2’s emphasis was on supervisory loan-to-value (LTV) limits. Both Mark Twain and Will Rogers advised that we should buy land because “they ain’t make any more of the stuff.” The inevitable rise in land values has always been attractive, but after the real estate bubbles of the 1970’s and 1980’s, they drew their own lines in the dirt, and they have refreshed those lines in this update. Part 3 continues the task of providing more details on specific sections, and the section under review in Part 3 is “property types and loan types:”
Property Types and Loan Types
One reason for delving into this section is that commercial real estate lending policies are expected to indicate the types of CRE lending the organization intends to pursue, and this section provides useful descriptions of each. After all, why not regulatorily define your property types to simplify and expedite examinations?
In addition to geographic considerations, markets can be defined by property type. A bank’s CRE lending strategy may target one or more of the five primary CRE sectors: office, retail, industrial, hospitality, and residential including multifamily and one- to four-family residential development and construction. Although all sectors are influenced by economic conditions, some sectors are more sensitive to certain economic factors than others. For example, the demand for office space depends on office-related employment, which tends to be concentrated in the finance, insurance, technology, and CRE industries, as well as some categories of services, particularly business services. Demand for retail space is affected by local employment levels and consumer spending, as well as trends in online shopping. Demand for industrial space tends to be influenced by proximity to labor, transportation infrastructure, local tax rates, population centers, and the presence of a similar or related industry. The hospitality sector is affected locally by the level of business activity but is also influenced by consumer spending, the cost of travel, and the strength of the U.S. dollar. In the residential sector, demand is heavily influenced by the local quality of life, demographics, affordability of homeownership, the rate of household formations, and local employment conditions. Banks are expected to monitor the conditions in the markets where they are active. So here is Guidance’s list of property types and loan types:
1-Acqusition, Development, and Construction (ADC) Loans
2- Unsecured working capital loans to finance real estate
3- Land acquisition loans
4- Land development loans
5- Tract development loans
6- Commercial construction loans
7- Bridge loans
8- Permanent loan commitments
9- Commitments issued before completion and lease-up—stand-by and forward commitments
So let’s tackle them one by one.
1-Acquisition, Development, and Construction (ADC) Loans
In its simplest form, ADC loans may finance the land acquisition, land preparation, and construction of a single residential or commercial building. Often, however, ADC lending finances a single- or multiple-phase development of many units. ADC lending is highly specialized and warrants a thorough understanding of its inherent risks.
2-Unsecured working capital loans to finance real estate
A developer may wish to borrow on an unsecured basis, often in the form of a line of credit, to acquire a building site, eliminate title impediments, pay architect or commitment fees, or meet minimum working capital requirements established by other construction lenders. Repayment of an unsecured loan used for these purposes may come from the first draw against a construction loan. If so, the bank extending such an unsecured loan typically requires the construction loan agreement to permit repayment of the working capital loan on the first draw. As with other unsecured credit, the bank should identify adequate sources of repayment and the intended timing of repayment. Many banks avoid making unsecured loans to an illiquid or highly leveraged borrower or when the source of repayment depends on assets in which the bank has no collateral interest. It is generally not prudent for a bank to extend unsecured working capital loans to fund a developer’s equity investment in a project or to cover cost overruns, as overruns may be indicative of an undercapitalized project or an inexperienced or unskilled developer. Because such loans are inherently risky, the bank should employ personnel with the necessary expertise to evaluate and manage the risk before engaging in this type of lending.
3-Land acquisition loans
Land acquisition loans finance the acquisition of undeveloped land. These loans are often made in conjunction with land or lot development and construction loans. In some cases, these loans may be made for speculative purposes without plans to immediately develop the property. Such loans are among the riskiest types of CRE loans. Undeveloped land generates no cash flow in most cases and requires other sources of funds to service the debt. Analyzing the borrower’s or guarantor’s ability to service the debt and the plans for repayment are important components of analyzing loans that finance land with no immediate and well-defined development plans. Land loans made for speculative purposes should require considerable equity and be extended infrequently.
4-Land development loans
Land development loans fund the preparation of land for construction, which may include infrastructure improvements required for future development, such as sewer and water pipes, utility cables, grading, and street construction. Often, acquisition and development loans are extended together to finance both the acquisition and development of land.
5-Tract development loans
A tract development is a project with five or more units that is constructed as a single development. A unit may refer to a residential building lot, a detached single-family home, an attached single-family home, or a residence in a condominium. Tract developments may include other multiple-unit developments, such as office or industrial parks. Besides the site improvements previously cited, these loans may finance construction of common amenities or infrastructure, such as clubhouses and recreational facilities. The source of repayment for these loans may be proceeds from the sale of lots to other developers or from the proceeds of a construction facility extended to the original developer to finance construction of for-sale or for-lease units. Repayment of these loans is discussed further in the “Acquisition, Development, and Construction Policies” section of the Guidance
6-Commercial construction loans
Commercial construction loans finance the construction or renovation of non-one-to four-family properties for owner occupancy, lease, or sale. Property types and projects include apartments, office buildings, retail centers, hotels, and industrial and mixed-use developments. Prudent underwriting includes considering the source and timing of the repayment of construction financing and determining whether the projected net operating income (NOI) of the completed project supports the expected value upon completion.
Loans to finance repositioning or rehabilitation In addition to new construction, a bank might finance the acquisition of an underperforming property that the borrower intends to improve, typically by performing physical upgrades or curing deferred maintenance and improving the management. The borrower’s objective to enhance a property’s value necessitates that the bank closely examine the borrower’s assumptions to determine the likelihood that the projections can be realized and assess the borrower’s ability to achieve its objective. An evaluation of the borrower’s track record with similar properties should be a critical consideration. Banks might also finance an older property’s rehabilitation, modernization, or conversion to another use that may involve extensive improvements or modifications. In such cases, it is important for the bank to review the construction budget. The bank typically obtains an independent evaluation of the budget’s adequacy from a qualified engineer or architect. It can be more difficult to accurately estimate the costs of these kinds of projects than for new construction because of unobservable conditions.
7-Bridge loans
A bridge loan provides short-term financing to allow newly constructed or acquired commercial properties to reach stabilization. Bridge loans are usually written for a period of up to three years and allow for the lease-up and income stabilization necessary to enable either sale or qualification for permanent financing. Income and value assumptions should be well supported and carefully analyzed.
8-Permanent loan commitments
Although not a type of ADC loan, commitments for permanent financing often play an important role in ADC financing. Permanent loans, also referred to as take-outs, are term loans that replace construction loans. Permanent financing may be provided by either the construction lender or another lender. In addition to banks, permanent financing is often provided by nonbank entities, such as life insurance companies and pension funds, and through commercial mortgage-backed securitizations (CMBS). Commitments for take-out financing may be provided before or after construction completion and lease-up.
9-Commitments issued before completion and lease-up usually fall into one of two categories: standby commitments and forward commitments.
Standby commitment provides back-up financing in case the borrower cannot obtain permanent financing. Fees are usually required at commitment with additional fees due if the commitment is funded. The fee structure and interest rate may often be intended to dissuade the borrower from exercising the commitment and to encourage obtaining other sources of funding. Borrowers may sometimes obtain standby commitments to fulfill a construction lender’s requirement for a committed take-out. Construction lenders who rely on standby commitments typically review the terms and consider the likelihood that the project will meet the criteria for funding. Lenders also typically investigate the willingness and ability of the issuer to fund.
Forward commitment for permanent financing provides a commitment to refinance a construction loan upon future completion and, almost always, lease-up. Forward commitments allow a permanent lender, frequently a life insurance company, to originate the loan earlier in the development process and usually provide the borrower the ability to lock in a fixed rate in advance of funding. These commitments tend to be more prevalent when competition for loans among permanent lenders is high and in greater demand among borrowers in periods of rising interest rates. As with standby commitments, the willingness and ability of the lender to fund and the conditions for funding should be carefully considered. While construction lenders consider standby or forward commitments useful, these commitments may mitigate little of the risk that the lender assumes in making the construction loan. Although these commitments can provide interest rate protection and some indication that the project meets permanent-market criteria, they require the completion of construction and, in most cases, are subject to performance criteria such as lease-up to break even or better with leases at minimum rental rates. Underwriting would ordinarily include analysis of the risk should the take-out commitment not be funded.
Summary and Closing: Type Casting?
Mark Twain explained: “Definite speech means clarity of mind.” The purpose of this part of the overall summary of the OCC CRE Guidance has been to share the regulatory definitions of property and loan types to clarify your own policy definitions of property and loan types complies with those of your regulatory agency improves communication with it as well as providing your own lenders with clear definitions. Of course, if there are any other issues or topics related to the revised guidance you would like to explore, please contact me via LinkedIn, or if you are looking for CRE reporting assistance, let me suggest you contact Dicom’s SVP of Sales and Marketing, Jim Xander, at jxander@dicomsoftware.com or at 407-246-8060. Dicom is in the loan review reporting systems business and should be able to assist.
Introduction: Buy Now and Sell Later?
Will Rogers advised, “Don’t wait to buy real estate, buy real estate and wait.” Most real estate investors would agree, and that’s why their banks end up in real estate lending. However, bankers need to keep abreast of changes in the regulatory world and retrain as necessary, especially when the OCC updates its real estate guidance. On March 29, 2022, The Office of the Comptroller of the Currency (OCC) issued version 2.0 of its "Commercial Real Estate Lending" booklet of the Comptroller's Handbook. This booklet discusses risks and risk management practices associated with commercial real estate and provides examiners with a framework for evaluating commercial real estate (CRE) lending activities.
The updated booklet replaces version 1.1 of the booklet of the same title issued in January 2017. Also rescinded is OCC Bulletin 2013-19, "Commercial Real Estate Lending: Comptroller's Handbook Revisions and Rescissions," which had updated version 1.0 of the booklet in August 2013. This latest "Commercial Real Estate Lending" booklet applies to the OCC's supervision of community banks, and “Banks" refers collectively to national banks, federal savings associations, and federal branches and agencies of foreign banking organizations engaged in commercial real estate lending.
The updated 2.0 version:
Recommended by LinkedIn
The OCC’s booklet, “Commercial Real Estate Lending,” is used by OCC examiners in connection with their examination and supervision of national banks, federal savings associations (FSA), and federal branches and agencies of foreign banking organizations (collectively, banks). Each bank is different and may present specific risks and issues, so, examiners are expected to apply the information in this booklet consistent with each bank’s individual circumstances. When it is necessary to distinguish between them, national banks and FSAs and covered savings associations (CSA) are referred to separately. A primary driver of this summary series has been to apprise bankers of its contents and to offer readers the opportunity to compare the contents with their own CRE lending policies.
Part 1 of this summary series provided an overview of the update as well as additional detail on roles of credit risk review and internal audit advising readers that the two functions should be independent but that internal audit still has the right to audit credit risk review. Part 2’s emphasis was on supervisory loan-to-value (LTV) limits. Both Mark Twain and Will Rogers advised that we should buy land because “they ain’t make any more of the stuff.” The inevitable rise in land values has always been attractive, but after the real estate bubbles of the 1970’s and 1980’s, they drew their own lines in the dirt, and they have refreshed those lines in this update. Part 3 continues the task of providing more details on specific sections, and the section under review in Part 3 is “property types and loan types:”
· Property types and loan types
· Risks associated with CRE lending
· Management and board oversight
· Loan policies, underwriting standards, underwriting practices, and exceptions to policy
· Credit administration
· Risk-rating CRE loans
· Appraisals and evaluations
· Environmental risk management
· Workout and restructuring
· Concentration risk management
· Third party risk management
Property Types and Loan Types
One reason for delving into this section is that commercial real estate lending policies are expected to indicate the types of CRE lending the organization intends to pursue, and this section provides useful descriptions of each. After all, why not regulatorily define your property types to simplify and expedite examinations?
In addition to geographic considerations, markets can be defined by property type. A bank’s CRE lending strategy may target one or more of the five primary CRE sectors: office, retail, industrial, hospitality, and residential including multifamily and one- to four-family residential development and construction. Although all sectors are influenced by economic conditions, some sectors are more sensitive to certain economic factors than others. For example, the demand for office space depends on office-related employment, which tends to be concentrated in the finance, insurance, technology, and CRE industries, as well as some categories of services, particularly business services. Demand for retail space is affected by local employment levels and consumer spending, as well as trends in online shopping. Demand for industrial space tends to be influenced by proximity to labor, transportation infrastructure, local tax rates, population centers, and the presence of a similar or related industry. The hospitality sector is affected locally by the level of business activity but is also influenced by consumer spending, the cost of travel, and the strength of the U.S. dollar. In the residential sector, demand is heavily influenced by the local quality of life, demographics, affordability of homeownership, the rate of household formations, and local employment conditions. Banks are expected to monitor the conditions in the markets where they are active. So here is Guidance’s list of property types and loan types:
1-Acqusition, Development, and Construction (ADC) Loans
2- Unsecured working capital loans to finance real estate
3- Land acquisition loans
4- Land development loans
5- Tract development loans
6- Commercial construction loans
7- Bridge loans
8- Permanent loan commitments
9- Commitments issued before completion and lease-up—stand-by and forward commitments
So let’s tackle them one by one.
1-Acquisition, Development, and Construction (ADC) Loans
In its simplest form, ADC loans may finance the land acquisition, land preparation, and construction of a single residential or commercial building. Often, however, ADC lending finances a single- or multiple-phase development of many units. ADC lending is highly specialized and warrants a thorough understanding of its inherent risks.
2-Unsecured working capital loans to finance real estate
A developer may wish to borrow on an unsecured basis, often in the form of a line of credit, to acquire a building site, eliminate title impediments, pay architect or commitment fees, or meet minimum working capital requirements established by other construction lenders. Repayment of an unsecured loan used for these purposes may come from the first draw against a construction loan. If so, the bank extending such an unsecured loan typically requires the construction loan agreement to permit repayment of the working capital loan on the first draw. As with other unsecured credit, the bank should identify adequate sources of repayment and the intended timing of repayment. Many banks avoid making unsecured loans to an illiquid or highly leveraged borrower or when the source of repayment depends on assets in which the bank has no collateral interest. It is generally not prudent for a bank to extend unsecured working capital loans to fund a developer’s equity investment in a project or to cover cost overruns, as overruns may be indicative of an undercapitalized project or an inexperienced or unskilled developer. Because such loans are inherently risky, the bank should employ personnel with the necessary expertise to evaluate and manage the risk before engaging in this type of lending.
3-Land acquisition loans
Land acquisition loans finance the acquisition of undeveloped land. These loans are often made in conjunction with land or lot development and construction loans. In some cases, these loans may be made for speculative purposes without plans to immediately develop the property. Such loans are among the riskiest types of CRE loans. Undeveloped land generates no cash flow in most cases and requires other sources of funds to service the debt. Analyzing the borrower’s or guarantor’s ability to service the debt and the plans for repayment are important components of analyzing loans that finance land with no immediate and well-defined development plans. Land loans made for speculative purposes should require considerable equity and be extended infrequently.
4-Land development loans
Land development loans fund the preparation of land for construction, which may include infrastructure improvements required for future development, such as sewer and water pipes, utility cables, grading, and street construction. Often, acquisition and development loans are extended together to finance both the acquisition and development of land.
5-Tract development loans
A tract development is a project with five or more units that is constructed as a single development. A unit may refer to a residential building lot, a detached single-family home, an attached single-family home, or a residence in a condominium. Tract developments may include other multiple-unit developments, such as office or industrial parks. Besides the site improvements previously cited, these loans may finance construction of common amenities or infrastructure, such as clubhouses and recreational facilities. The source of repayment for these loans may be proceeds from the sale of lots to other developers or from the proceeds of a construction facility extended to the original developer to finance construction of for-sale or for-lease units. Repayment of these loans is discussed further in the “Acquisition, Development, and Construction Policies” section of the Guidance
6-Commercial construction loans
Commercial construction loans finance the construction or renovation of non-one-to four-family properties for owner occupancy, lease, or sale. Property types and projects include apartments, office buildings, retail centers, hotels, and industrial and mixed-use developments. Prudent underwriting includes considering the source and timing of the repayment of construction financing and determining whether the projected net operating income (NOI) of the completed project supports the expected value upon completion.
Loans to finance repositioning or rehabilitation In addition to new construction, a bank might finance the acquisition of an underperforming property that the borrower intends to improve, typically by performing physical upgrades or curing deferred maintenance and improving the management. The borrower’s objective to enhance a property’s value necessitates that the bank closely examine the borrower’s assumptions to determine the likelihood that the projections can be realized and assess the borrower’s ability to achieve its objective. An evaluation of the borrower’s track record with similar properties should be a critical consideration. Banks might also finance an older property’s rehabilitation, modernization, or conversion to another use that may involve extensive improvements or modifications. In such cases, it is important for the bank to review the construction budget. The bank typically obtains an independent evaluation of the budget’s adequacy from a qualified engineer or architect. It can be more difficult to accurately estimate the costs of these kinds of projects than for new construction because of unobservable conditions.
7-Bridge loans
A bridge loan provides short-term financing to allow newly constructed or acquired commercial properties to reach stabilization. Bridge loans are usually written for a period of up to three years and allow for the lease-up and income stabilization necessary to enable either sale or qualification for permanent financing. Income and value assumptions should be well supported and carefully analyzed.
8-Permanent loan commitments
Although not a type of ADC loan, commitments for permanent financing often play an important role in ADC financing. Permanent loans, also referred to as take-outs, are term loans that replace construction loans. Permanent financing may be provided by either the construction lender or another lender. In addition to banks, permanent financing is often provided by nonbank entities, such as life insurance companies and pension funds, and through commercial mortgage-backed securitizations (CMBS). Commitments for take-out financing may be provided before or after construction completion and lease-up.
9-Commitments issued before completion and lease-up usually fall into one of two categories: standby commitments and forward commitments.
Standby commitment provides back-up financing in case the borrower cannot obtain permanent financing. Fees are usually required at commitment with additional fees due if the commitment is funded. The fee structure and interest rate may often be intended to dissuade the borrower from exercising the commitment and to encourage obtaining other sources of funding. Borrowers may sometimes obtain standby commitments to fulfill a construction lender’s requirement for a committed take-out. Construction lenders who rely on standby commitments typically review the terms and consider the likelihood that the project will meet the criteria for funding. Lenders also typically investigate the willingness and ability of the issuer to fund.
Forward commitment for permanent financing provides a commitment to refinance a construction loan upon future completion and, almost always, lease-up. Forward commitments allow a permanent lender, frequently a life insurance company, to originate the loan earlier in the development process and usually provide the borrower the ability to lock in a fixed rate in advance of funding. These commitments tend to be more prevalent when competition for loans among permanent lenders is high and in greater demand among borrowers in periods of rising interest rates. As with standby commitments, the willingness and ability of the lender to fund and the conditions for funding should be carefully considered. While construction lenders consider standby or forward commitments useful, these commitments may mitigate little of the risk that the lender assumes in making the construction loan. Although these commitments can provide interest rate protection and some indication that the project meets permanent-market criteria, they require the completion of construction and, in most cases, are subject to performance criteria such as lease-up to break even or better with leases at minimum rental rates. Underwriting would ordinarily include analysis of the risk should the take-out commitment not be funded.
Summary and Closing: Type Casting?
Mark Twain explained: “Definite speech means clarity of mind.” The purpose of this part of the overall summary of the OCC CRE Guidance has been to share the regulatory definitions of property and loan types to clarify your own policy definitions of property and loan types complies with those of your regulatory agency improves communication with it as well as providing your own lenders with clear definitions. Of course, if there are any other issues or topics related to the revised guidance you would like to explore, please let us know by contacting Dicom’s SVP of Sales and Marketing, Jim Xander, at jxander@dicomsoftware.com or at 407-246-8060.