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The Commercial Real Estate Dilemma and Its Impact on Bank Risk Management

Banks that are heavily invested in the troubled CRE market now face a variety of complex risks, from the remote work trend to rising inflation to the uncertain future of office space. Which risks present the greatest threat, and can banks take proactive steps to mitigate them?

Friday, July 14, 2023

By Clifford Rossi

Now more than ever, banks need to bolster their commercial real estate (CRE) risk management capabilities, as more and more cracks have emerged in CRE portfolios. Several market factors are driving this requirement, including banking instability and a longer timeline of elevated interest rates; the clash between the Federal Reserve’s monetary policy and aggressive inflation; and the repositioning of the American workforce (via remote work) in the wake of the pandemic.

There are, of course, various steps banks can take to manage CRE risk more effectively in today’s market. But before we discuss these strategies, we need to first identify the most significant CRE risks and examine the scope of the problem.

Identifying CRE Risks

Commercial banks hold about 60% of all CRE loans in the U.S., with 43% held by banks with total assets less than $100 billion. Moreover, for 168 banks, nonfarm residential real estate loans account for nearly half of their assets, according to a March 2023 bank call report issued by the FDIC. For these firms, managing their CRE exposures is paramount.

Rising credit losses and liquidations are expected in the CRE sector. Complicating matters further is the fact that the banks with the greatest CRE exposure tend to be quite small, averaging $1.16 billion in assets.

CRE risk exposure varies by property type, with office buildings feeling the most pain. Vacancy rates have risen to 12.5% (reflecting the change in the post-pandemic, work-from-home world), while community and regional banks account for 30% of all office property lending.

Hundreds of banks are also taking more than the recommended amount of risk for CRE investments. Indeed, according to a recent study by Trepp, 763 banks are now exceeding regulatory guidance for ratios of CRE to capital. What’s more, higher lending rates and reduced cash flows (with a large segment of CRE loans expected to be refinanced) could spell real trouble for some banks over the next few years.

Tips for Managing CRE Risk in a Volatile Market

Banks with significant CRE exposures can and should take multiple steps to proactively prepare for the expected softening of this sector. The first step is to reassess the amount of credit exposure your organization has from each property type; taking into account factors such as the property’s class (A, B or C) can dramatically change a loan’s risk profile.

To better determine CRE loan performance, one must employ a proper capitalization rate and regularly update debt service coverage ratios (DSCRs). Keeping abreast of important changes in local market conditions, meanwhile, is critical to understanding property cash flow.  

Likewise critical at this time is comprehending important changes in the risk profile of CRE loan obligors, such as their debt load and their capacity to repay any obligation under stress. Key components of this exercise include (1) examining exposure from multiple loans to one obligor;(2) understanding the terms and conditions on outstanding loans; and (3) paying close attention to both loan performance and any refinancing risk that may present a repayment challenge.

Clifford RossiClifford Rossi

After the property, obligor and loan terms are evaluated, updates to risk ratings can be performed. Material changes in the distribution of CRE risk ratings are informative in understanding any deterioration in credit performance.

At this stage, managing the bank’s watchlist of problem credits becomes even more important; banks should never let their guard down, even if current delinquencies appear low and manageable.

A vigilant loan review process can also keep production, valuation and underwriting units on their toes and on the lookout for any changes in credit performance. In fact, loan officers can provide some of the best risk intel, given their ongoing customer relationships and local market knowledge.

Banks should also redouble their portfolio management activities using stress tests, for example, to examine what would happen to vacancy rates, net operating income and DSCRs under an economic downturn scenario.

Another important scenario to test is the impact of a “higher-for-longer” rate environment on refinancing risk. Morgan Stanley analysts have forecast a 40% drop in commercial property prices one of the most bearish commercial property predictions. Combined with higher interest rates, that type of deterioration will impact refinancings by forcing many borrowers to put up more equity to maintain leverage requirements.  

However, in many cases, such equity increases may not be possible, so sharpening forbearance and modification strategies to limit foreclosures must be a component of heightened risk management strategies. Reexamining geographic, property, obligor and other concentrations and associated policies can shape the portfolio to align with long-term risk objectives, helping to identify potential pockets of risk that may need greater attention.  

Lastly, small banks that are part of loan syndications need to take a more proactive role in understanding how agent banks are administering – on their behalf – the required activities of participating lenders in the syndication.

Parting Thoughts

Volatile banking conditions today should remind us that unexpected events, such as the pandemic, can have significant, lingering consequences. Indeed, the banking industry is already facing a bevy of threats (e.g., interest-rate and liquidity risk and escalating inflation in the wake of the COVID-19 crisis) – and more are on the horizon.

Large banks were undoubtedly hoping for a return to normal following the pandemic, but some were caught off guard by the Fed’s delayed, but aggressive, rate-hiking response to higher inflation. What’s more, unusually high exposure to interest rate risk begat a liquidity crisis at several regional banks, eventually leading to their downfall.

Now banks face another potential liquidity risk tremor from CRE credit risk – one that was unimaginable just a few years ago. To forestall any existential threat, banks with sizable CRE exposure must aggressively and actively redouble their risk management practices.

 

Clifford Rossi (PhD) is the Director of the Smith Enterprise Risk Consortium at the University of Maryland (UMD) and a Professor-of-the-Practice and Executive-in-Residence at UMD’s Robert H. Smith School of Business. Before joining academia, he spent 25-plus years in the financial sector, as both a C-level risk executive at several top financial institutions and a federal banking regulator. He is the former managing director and CRO of Citigroup’s Consumer Lending Group.




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