Part 4: OCC CRE Summary--Commercial Real Estate Lending Risks--Shovel-Ready Risk Ready to Go!

Introduction: Cheap Price, Costly Risk?

Comedian Steven Wright once admitted, “I bought a cheap piece of land . . . It was on someone else’s property.”  That is one of the risks in real estate that banks must mitigate, along with a number of other risks in real estate lending. Moreover, 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 Also rescinded is OCC Bulletin 2013-19, "Commercial Real Estate Lending: Comptroller's Handbook Revisions and Rescissions," which had updated version 1.0 of the booklet in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:

• reflects changes to laws and regulations since this booklet was last updated in 2017
• reflects OCC issuances published and rescinded since this booklet was last updated
• includes clarifying edits regarding supervisory guidance, sound risk management practices, and legal language.
• revises certain content for general clarity

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.

·       Overview and role of credit risk review and internal audit (Part 1)

·       Supervisory LTV limits (Part 2)

·       Property types and loan types (Part 3)

·       Risks associated with CRE lending (Part 4)

·       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

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 continued the task of providing more details on specific sections, and the section under review in Part 3 is “property types and loan types:” Now, this Part 4 addresses the risks associated with CRE lending.

Risks Associated With CRE Lending: Let Me Count the 8 Ways

From a supervisory perspective, risk is the potential that events will have an adverse effect on a bank’s current or projected financial condition and resilience. The OCC has defined eight categories of risk for bank supervision purposes: credit, interest rate, liquidity, operational, compliance, strategic, reputation, and price. These categories are not mutually exclusive; any product or service may expose a bank to multiple risks. Risks also may be interdependent and may be positively or negatively correlated. Examiners are expected to be aware of and assess this interdependence. Concentrations can accumulate within and across products, business lines, geographic areas, countries, and legal entities. You can refer to the “Bank Supervision Process” booklet of the Comptroller’s Handbook for an expanded discussion of banking risks and their definitions, but let’s now explore each of these eight CRE lending risks:

1-Credit Risk. Credit risk is the risk to current or projected financial condition and resilience arising from an obligor’s failure to meet the terms of any contract with the bank or otherwise perform as agreed. Factors that can affect a bank’s likelihood of receiving full repayment for CRE loans include the following.

·       Construction Issues- Banks financing construction face the risk from a borrower’s inability to successfully complete a proposed project on time, according to construction plans, and within budget. Cost overruns can erode a borrower’s equity in the project and reduce the bank’s collateral margin or can result in total costs that exceed the property’s value when completed. Overruns can be caused by inaccurate budgets, site or environmental issues, increases in materials or transportation expenses, material or labor shortages, substandard work performed by the borrower’s employees or subcontractors that must be redone to satisfy contract performance conditions or meet local building codes, increased interest expense, or delays caused by inclement weather. Projects that rehabilitate or extensively modify existing buildings can be exceptionally vulnerable to overruns because these costs can be difficult to estimate.

·       Market Conditions- A property’s performance can be hurt by tenants’ deteriorating credit and lease expirations in times of softening demand caused by economic deterioration from over-supply conditions or changing consumer and business preferences. As the economic climate deteriorates, tenants could reduce their space needs or just  cease operations and paying rent altogether. Properties with shorter lease terms are vulnerable to declining market values as rents decline and leases are renewed at lower rental rates. If expiring leases cause project cash flows to decline, developers could be unable to meet scheduled mortgage payments and other critical obligations, such as property taxes and maintenance. Even if borrowers are able to meet their payment obligations, they could find it difficult to refinance their balloon payment amount at maturity because of declines in property value. The risk from changing market conditions can be considerable in ADC financing of “for-sale” developments. Adverse changes in the market occurring between the start of development and completion can result in slower sales rates and lower sales prices that could threaten timely and full repayment. Risk posed by changing market conditions is magnified in banks with significant CRE concentrations. For properties under construction, demand from prospective tenants or purchasers may erode after construction begins because of a general economic slowdown or an increase in the supply of competing properties. Properties with longer construction periods are also more vulnerable to market changes because of longer lead time from initial project start to actual delivery. If actual rental rates achieved during lease-up are lower than those projected, a project’s viability can be threatened by a failure to generate income sufficient to support its debt and the expected collateral value. A decline in demand or increase in the supply of for sale properties can threaten full principal repayment.

·       Concentration Risk- Concentration risk is the risk posed by a bank’s exposure to groups or classes of credit exposures sharing common risk characteristics or sensitivities to economic, financial, or business developments. Concentrations add a dimension of risk that compounds the risk inherent in individual loans. The “Concentrations of Credit Risk Management” section of this OCC guidance discusses prudent practices in managing risk posed by concentrations.

·       Regulatory Changes- At the national or local level, changes in tax legislation, zoning, environmental regulation, or similar external conditions may affect property values and the economic feasibility of existing and proposed CRE projects.

·       Interest Rates- Changes in interest rates affect the cost of construction and the financial viability of a CRE project, and consequently a bank’s credit risk. A project with floating rate debt and fixed rents is vulnerable to increasing interest rates and eroding repayment capacity. Interest rate changes may also result in changing capitalization rate affecting a property’s value. Although borrowers can hedge their interest rate risk by using interest rate derivatives, mitigation is difficult and less effective for construction facilities because of the changes in the outstanding loan amount during development and the loans’ relatively short tenors.

·       Environmental Liability- Environmental contamination can hurt a property’s usability and can result in the loss of tenants, reduction in rental income, and the inability to develop, market, or refinance properties. Fines for not complying with environmental regulations can be significant. Because federal and many state regulations impose liability on the owners of contaminated CRE, current and past property owners can be responsible for the cost of cleanup, even if they did not contribute to the contamination. Costs to mitigate contamination may decrease the collateral’s value or render it worthless. The borrower’s cost to remediate a contaminated property could severely impair the borrower’s ability to repay the loan. Some property types posing an elevated level of environment liability include gas stations, auto repair shops, and dry cleaners.

2-Interest Rate Risk. Interest rate risk is the risk to current or projected financial condition and resilience arising from movements in interest rates. Interest rate risk results

·       from differences between the timing of rate changes and the timing of cash flows (repricing risk);

·       from changing rate relationships among different yield curves affecting bank activities (basis risk);

·       from changing rate relationships across the spectrum of maturities (yield curve risk);

·       and from interest-related options embedded in bank products (options risk).

The level of interest rate risk associated with the bank’s CRE lending activities depends on the composition of its loan portfolio and the degree to which the structure of its loans, such as tenor, pricing, and amortization, expose the bank’s revenue to changes in interest rates. CRE financing can expose the bank to interest rate risk in the form of repricing, options, basis, and yield curve risk:

·       Repricing risk arises when there are differences in rate reset periods for the CRE loan and the liability funding the CRE loan. For example, the bank’s net interest margin can be hurt in  decreasing rate environment if a floating rate CRE loan repriced annually is funded by a certificate of deposit with a 24-month maturity. 

·       If there are no prepayment penalties, CRE financing can expose the bank to options risk in a decreasing rate scenario. For example, when rates decrease, borrowers might prepay the loan and refinance at a lower rate and reducing the bank’s net interest margin.

·       Basis risk arises from the imperfect correlations between different indexes used to price the CRE loan and the liability funding the loan. For example, a 50-basis point increase in a local index that a bank uses to price deposits may not always result in a 50-basis increase in the bank’s prime index that it uses to price the CRE loan.

·       A bank with a portfolio of fixed- or variable-rate CRE loans with long reset periods could be exposed to yield curve risk. For example, if the yield curve shifts upward, the value of a fixed CRE loan or a CRE loan with a long rate reset period would decline and reduce its price in the secondary market.

·       

3-Liquidity Risk.  Liquidity risk is the risk to current or projected financial condition and resilience arising from an inability to meet obligations when they come due. Liquidity risk includes the inability to access funding sources or manage fluctuations in funding levels including unfunded commitments. CRE loans are ordinarily illiquid, but converting CRE loans to cash is possible by:

(1) the bank using the loan as collateral for borrowings;

(2) the bank selling the loan to an investor (either on a participation, whole-loan, or portfolio basis);

(3) the bank securitizing the loan;

(4) the borrower refinancing the loan with another lender; or

(5) normal borrower repayment.

Nevertheless, sales of CRE loan sales can be difficult because of their lack of homogeneity. Unlike consumer loans, the due diligence process can be time-consuming and expensive for a prospective purchaser because of variations in property type, location desirability, tenant quality and other rent roll characteristics, underwriting, loan structures, and documentation. CRE loans tend to be even less liquid in times of market stress when potential funding sources diminish as lenders allocate fewer funds for originating or refinancing CRE. This can also make the sale of loans or their refinance by other lenders as a strategy to manage concentrations ineffective.

ADC loans are particularly illiquid because of their short tenor and because the full collateral value is not realized until the project is completed and reaches a stabilized level of occupancy or is ready for sale. Although the sale of loans through securitization can provide liquidity, there are differences in securitizing loans to be held by the bank versus those originated to be securitized. CRE loans originated for securitization employ underwriting, structures, and documentation that conform to market standards providing efficient due diligence and resulting in better pricing.  However, loans originated to be held in the bank’s portfolio may not meet external market standards and so make securitization of these assets inefficient and likely to result in prices materially discounted to book value. Further, market disruptions after origination and before sale can reduce the liquidity of loans originated for securitization.

4-Operational Risk.  Operational risk is the risk to current or projected financial condition and resilience arising from inadequate or failed internal processes or systems, human errors or misconduct, or adverse external events. An effective risk management system, including proper inter controls, helps control operational risk exposures. Effective policies, procedures, internal controls, audits, third-party risk management, business continuity planning, management information systems (MIS), and reporting are important aspects of managing operational risk.

CRE lending, particularly ADC, carries higher operational risk than many other types of lending. Ineffective processes can introduce significant operational risks that also affect the bank’s exposure to other risks. For example, failure to properly monitor construction progress and manage the disbursement of loan proceeds is a control weakness that increases the bank’s credit risk. Failure to confirm that property taxes, property insurance premiums, and workers and suppliers are paid can threaten its collateral interests. Operational risk increases when the bank does not have sufficient management and staff with the knowledge and experience to identify, measure, monitor, and control the risks unique to CRE. Examiners usually assess operational risk by evaluating the adequacy of governance and risk management of all activities in the origination and management of CRE lending, including the engagement of any third parties in the processes.

5-Compliance Risk.  Compliance risk is the risk to current or projected financial condition and resilience arising from violations of laws or regulations, or from nonconformance with prescribed practices, internal bank policies and procedures, or ethical standards. Failure to comply with laws and regulations pertaining to CRE lending threaten serious risk to a bank’s earnings and capital. For example, failure to comply with lending limit regulations can expose the bank’s capital to excessive risk. There are also consumer protection-related regulations applicable to CRE lending that include fair lending, flood insurance, building and zoning requirements, and consumer disclosures. Failure to comply with environmental laws and regulations can generate significant liability exceeding the value of the bank’s collateral. Although this liability typically manifests itself when a bank takes title to the collateral in satisfaction of debt, a bank most often undertakes this risk at origination by not implementing appropriate controls to mitigate potential environmental issues.

6-Strategic Risk.  Strategic risk is the risk to current or projected financial condition and resilience arising from adverse business decisions, poor implementation of business decisions, or lack of responsiveness to changes in the banking industry and operating environment. The board of directors’ failure to establish prudent CRE lending objectives that are compatible with the bank’s risk appetite or strategic plan and to provide effective oversight of CRE lending activities can increase a bank’s risk profile and affect interdependent risks, such as credit and reputation risks. Imprudent CRE lending can result in significant loan losses and has been a cause of failure in banks with significant CRE exposure. Insufficient staffing can also increase strategic risk. For example, strategic risk increases when the bank does not have sufficient management and staff with the knowledge and experience to identify, measure, monitor, and control the risks unique to CRE.

7-Reputation Risk.  Reputation risk is the risk to current or projected financial condition and resilience arising from negative public opinion. Failure to meet the needs of the community (including failure to consider impacts of a financed project on the community), inefficient loan delivery systems, and lender liability lawsuits are some of the factors that may tarnish the bank’s reputation. Imprudent risk-taking in CRE lending, or significant control weaknesses, can cause a bank to experience excessive losses or to foreclose on assets, rendering the bank unable to continue providing needed CRE financing in the market that the bank serves.

8-Price Risk.  Price risk is the risk to current or projected financial condition and resilience arising from changes in the value of either trading portfolios or other obligations entered into as part of distributing risk. For loans secured by CRE, price risk can occur upon a bank’s foreclosure or physical possession of a property and the consequent booking of the collateral into other real estate owned (OREO). During the holding period, OREO must be carried at fair value less estimated costs to sell. Economic trends that compelled the bank’s acquisition of the property as OREO could continue to decrease the property’s value and reduce proceeds from the property’s sale.

Summary and Closing: Know Your Risks

Abe Lincoln observed: “The best thing about the future is that it comes one day at a time.” But don’t wait too long--the purpose of this fourth part of the overall summary of the OCC CRE Guidance has been to disclose and describe the regulatory community’s view of the risks they see in CRE lending. It would be prudent for the loan review team to get ahead of the curve by reviewing and recommending revisions as you deem necessary  for your organization’s own CRE lending policies in addressing how to  identify, manage, and monitor these risks. 

For you loan reviewers looking for some software support in your commercial real estate lending assignments, contact Dicom Software's SVP of Sales and Marketing, Jim Xander at jxander@dicomsoftware.com or at 407-246-8060. If you are interested in other credit and lending issues related to the OCC's revised guidance, you can reach me via LinkedIn or at dev.strischek@devonrisk.com.