While the banking market is extensively considered as more durable today than it was heading into the financial crisis of 2007-2009,1 the business realty (CRE) landscape has actually changed substantially given that the onset of the COVID-19 pandemic. This brand-new landscape, one characterized by a greater rates of interest environment and hybrid work, will affect CRE market conditions. Given that community and local banks tend to have higher CRE concentrations than big firms (Figure 1), smaller banks need to stay abreast of current trends, emerging threat elements, and chances to improve CRE concentration risk management.2,3

Several current market forums conducted by the Federal Reserve System and specific Reserve Banks have discussed various elements of CRE. This short article intends to aggregate essential takeaways from these numerous forums, in addition to from our current supervisory experiences, and to share noteworthy patterns in the CRE market and pertinent threat factors. Further, this post attends to the importance of proactively managing concentration danger in an extremely dynamic credit environment and supplies a number of finest practices that highlight how threat supervisors can think of Supervision and Regulation (SR) letter 07-1, "Interagency Guidance on Concentrations in Commercial Real Estate," 4 in today's landscape.

Market Conditions and Trends

Context

Let's put all of this into viewpoint. As of December 31, 2022, 31 percent of the insured depository organizations reported a concentration in CRE loans.5 Most of these banks were neighborhood and local banks, making them a crucial funding source for CRE credit.6 This figure is lower than it was during the monetary crisis of 2007-2009, but it has been increasing over the past year (the November 2022 Supervision and Regulation Report mentioned that it was 28 percent on June 30, 2022). Throughout 2022, CRE performance metrics held up well, and loaning activity stayed robust. However, there were indications of credit degeneration, as CRE loans 30-89 days overdue increased year over year for CRE-concentrated banks (Figure 2). That stated, unpaid metrics are lagging indicators of a customer's monetary hardship. Therefore, it is crucial for banks to carry out and keep proactive risk management practices - discussed in more detail later in this post - that can alert bank management to weakening performance.

Noteworthy Trends

The majority of the buzz in the CRE space coming out of the pandemic has been around the workplace sector, and for good factor. A current research study from business teachers at Columbia University and New york city University found that the value of U.S. office buildings might plunge 39 percent, or $454 billion, in the coming years.7 This may be triggered by recent patterns, such as renters not restoring their leases as workers go fully remote or renters renewing their leases for less space. In some extreme examples, companies are offering up area that they rented just months previously - a clear indication of how rapidly the marketplace can kip down some places. The struggle to fill empty workplace is a nationwide pattern. The national vacancy rate is at a record 19.1 percent - Chicago, Houston, and San Francisco are all above 20 percent - and the amount of workplace rented in the United States in the third quarter of 2022 was nearly a third listed below the quarterly average for 2018 and 2019.

Despite record jobs, banks have actually benefited hence far from workplace loans supported by prolonged leases that insulate them from unexpected wear and tear in their portfolios. Recently, some big banks have started to offer their office loans to restrict their direct exposure.8 The sizable quantity of office financial obligation developing in the next one to 3 years could develop maturity and re-finance dangers for banks, depending on the monetary stability and health of their debtors.9

In addition to recent actions taken by large firms, patterns in the CRE bond market are another essential indicator of market belief related to CRE and, specifically, to the workplace sector. For circumstances, the stock prices of big openly traded property owners and designers are close to or below their pandemic lows, underperforming the more comprehensive stock market by a substantial margin. Some bonds backed by workplace loans are likewise showing indications of stress. The Wall Street Journal published a post highlighting this pattern and the pressure on genuine estate worths, keeping in mind that this activity in the CRE bond market is the most recent indication that the increasing interest rates are impacting the commercial residential or commercial property sector.10 Real estate funds usually base their valuations on appraisals, which can be sluggish to show developing market conditions. This has kept fund assessments high, even as the genuine estate market has deteriorated, underscoring the challenges that numerous community banks face in determining the existing market worth of CRE residential or commercial properties.

In addition, the CRE outlook is being affected by greater dependence on remote work, which is subsequently impacting the use case for big office complex. Many industrial office developers are viewing the shifts in how and where individuals work - and the accompanying trends in the office sector - as opportunities to think about alternate usages for office residential or commercial properties. Therefore, banks ought to consider the possible implications of this remote work pattern on the demand for office and, in turn, the asset quality of their workplace loans.

Key Risk Factors to Watch

A confluence of factors has led to several key threats impacting the CRE sector that are worth highlighting.

Maturity/refinance threat: Many fixed-rate office loans will be maturing in the next couple of years. Borrowers that were locked into low interest rates might face payment difficulties when their loans reprice at much greater rates - in some cases, double the original rate. Also, future refinance activity might require an extra equity contribution, possibly producing more financial strain for debtors. Some banks have begun using bridge financing to tide over certain debtors up until rates reverse course.
Increasing danger to net operating income (NOI): Market participants are pointing out increasing expenses for products such as utilities, residential or commercial property taxes, maintenance, insurance coverage, and labor as an issue because of increased inflation levels. Inflation might cause a building's operating expense to increase faster than rental income, putting pressure on NOI.
Declining possession worth: CRE residential or commercial properties have actually recently experienced significant cost changes relative to pre-pandemic times. An Ask the Fed session on CRE kept in mind that appraisals (industrial/office) are down from peak pricing by as much as 30 percent in some sectors.11 This causes a concern for the loan-to-value (LTV) ratio at origination and can easily put banks over their policy limitations or risk appetite. Another element impacting asset values is low and delayed capitalization (cap) rates. Industry participants are having a difficult time identifying cap rates in the present environment because of bad information, fewer transactions, rapid rate movements, and the uncertain rate of interest path. If cap rates stay low and interest rates surpass them, it could cause an unfavorable take advantage of circumstance for customers. However, financiers expect to see increases in cap rates, which will negatively affect assessments, according to the CRE services and investment company Coldwell Banker Richard Ellis (CBRE).12

Modernizing Concentration Risk Management

Background

In early 2007, after observing the trend of increasing concentrations in CRE for several years, the federal banking companies launched SR letter 07-1, "Interagency Guidance on Concentrations in Commercial Real Estate." 13 While the guidance did not set limitations on bank CRE concentration levels, it motivated banks to enhance their threat management in order to handle and control CRE concentration risks.

Key Elements to a Robust CRE Risk Management Program

Many banks have since taken steps to align their CRE risk management structure with the crucial elements from the assistance:

- Board and management oversight
- Portfolio management
- Management details system (MIS).
- Market analysis.
- Credit underwriting requirements.
- Portfolio tension testing and level of sensitivity analysis.
- Credit danger evaluation function

Over 15 years later, these foundational components still form the basis of a robust CRE threat management program. An efficient risk management program develops with the changing risk profile of an organization. The following subsections expand on 5 of the seven elements noted in SR letter 07-1 and aim to highlight some finest practices worth thinking about in this dynamic market environment that might improve and strengthen a bank's existing structure.

Management Information System

A robust MIS supplies a bank's board of directors and management with the tools required to proactively monitor and handle CRE concentration threat. While numerous banks currently have an MIS that stratifies the CRE portfolio by market, residential or commercial property, and area, management may wish to consider extra methods to section the CRE loan portfolio. For example, management might think about reporting customers dealing with increased refinance danger due to rate of interest fluctuations. This information would assist a bank in recognizing prospective refinance danger, could help make sure the accuracy of danger ratings, and would assist in proactive conversations with prospective issue borrowers.

Similarly, management may want to review transactions financed during the realty assessment peak to determine residential or commercial properties that may currently be more conscious near-term valuation pressure or stabilization. Additionally, incorporating information points, such as cap rates, into existing MIS could offer useful information to the bank management and bank lenders.

Some banks have actually implemented a boosted MIS by using centralized lease tracking systems that track lease expirations. This type of information (especially appropriate for office and retail areas) supplies information that enables lending institutions to take a proactive technique to monitoring for possible concerns for a specific CRE loan.

Market Analysis

As kept in mind previously, market conditions, and the resulting credit risk, vary across locations and residential or commercial property types. To the degree that data and details are readily available to an organization, bank management might consider further segmenting market analysis data to finest identify trends and threat factors. In large markets, such as Washington, D.C., or Atlanta, a more granular breakdown by submarkets (e.g., main enterprise zone or suburban) might be relevant.

However, in more rural counties, where readily available data are restricted, banks might consider engaging with their local appraisal firms, contractors, or other neighborhood advancement groups for pattern data or anecdotes. Additionally, the Federal Reserve Bank of St. Louis preserves the Federal Reserve Economic Data (FRED), a public database with time series details at the county and national levels.14

The very best market analysis is not done in a vacuum. If significant patterns are recognized, they might inform a bank's financing method or be incorporated into stress testing and capital preparation.

Credit Underwriting Standards

During periods of market pressure, it becomes increasingly essential for lending institutions to completely comprehend the financial condition of borrowers. Performing global cash circulation analyses can ensure that banks learn about commitments their customers may have to other financial institutions to reduce the risk of loss. Lenders ought to also consider whether low cap rates are pumping up residential or commercial property valuations, and they ought to thoroughly examine appraisals to comprehend presumptions and development forecasts. An effective loan underwriting procedure thinks about stress/sensitivity analyses to much better record the prospective changes in market conditions that could impact the capability of CRE residential or commercial properties to generate adequate money circulation to cover financial obligation service. For instance, in addition to the usual criteria (financial obligation service protection ratio and LTV ratio), a stress test might include a breakeven analysis for a residential or commercial property's net operating income by increasing business expenses or reducing rents.

A sound threat management process ought to determine and keep track of exceptions to a bank's loaning policies, such as loans with longer interest-only durations on supported CRE residential or commercial properties, a greater reliance on guarantor support, nonrecourse loans, or other deviations from internal loan policies. In addition, a bank's MIS must offer sufficient info for a bank's board of directors and senior management to assess risks in CRE loan portfolios and determine the volume and trend of exceptions to loan policies.

Additionally, as residential or commercial property conversions (believe office to multifamily) continue to turn up in significant markets, lenders might have proactive discussions with real estate financiers, owners, and operators about alternative usages of realty area. Identifying alternative prepare for a residential or commercial property early might assist banks get ahead of the curve and minimize the threat of loss.

Portfolio Stress Testing and Sensitivity Analysis

Since the start of the pandemic, lots of banks have actually revamped their stress tests to focus more heavily on the CRE residential or commercial properties most adversely affected, such as hotels, workplace area, and retail. While this focus may still be appropriate in some geographical areas, reliable tension tests need to progress to consider new kinds of post-pandemic situations. As gone over in the CRE-related Ask the Fed webinar discussed earlier, 54 percent of the respondents noted that the leading CRE issue for their bank was maturity/refinance danger, followed by negative take advantage of (18 percent) and the inability to properly develop CRE values (14 percent). Adjusting present stress tests to capture the worst of these issues could provide insightful details to inform capital planning. This process could also provide loan officers details about debtors who are especially vulnerable to interest rate increases and, thus, proactively inform workout methods for these debtors.

Board and Management Oversight

As with any risk stripe, a bank's board of directors is eventually accountable for setting the danger appetite for the organization. For CRE concentration risk management, this means establishing policies, procedures, danger limits, and financing techniques. Further, directors and management need a relevant MIS that offers enough information to assess a bank's CRE risk exposure. While all of the items pointed out earlier have the possible to strengthen a bank's concentration threat management framework, the bank's board of directors is accountable for developing the threat profile of the institution. Further, an effective board approves policies, such as the tactical strategy and capital strategy, that line up with the risk profile of the institution by considering concentration limitations and sublimits, along with underwriting requirements.

Community banks continue to hold considerable concentrations of CRE, while various market indications and emerging patterns point to a mixed performance that depends on residential or commercial property types and location. As market gamers adjust to today's evolving environment, bankers need to remain alert to changes in CRE market conditions and the danger profiles of their CRE loan portfolios. Adapting concentration danger management practices in this changing landscape will guarantee that banks are ready to weather any potential storms on the horizon.

* The authors thank Bryson Alexander, research expert, Federal Reserve Bank of Richmond; Brian Bailey, commercial property subject matter expert and senior policy advisor, Federal Reserve Bank of Atlanta; and Kevin Brown, advanced inspector, Federal Reserve Bank of Richmond, for their contributions to this post.

1 The November 2022 Financial Stability Report released by the Board of Governors highlighted numerous key actions taken by the Federal Reserve following the 2007-2009 financial crisis that have promoted the resilience of monetary organizations. This report is readily available at www.federalreserve.gov/publications/files/financial-stability-report-20221104.pdf.
2 See Kyle Binder, Emily Greenwald, Sam Schulhofer-Wohl, and Alejandro H. Drexler, "Bank Exposure to Commercial Realty and the COVID-19 Pandemic," Federal Reserve Bank of Chicago, 2021, available at www.chicagofed.org/publications/chicago-fed-letter/2021/463.
3 The November 2022 Supervision and Regulation Report released by the Board of Governors specifies concentrations as follows: "A bank is thought about concentrated if its construction and land advancement loans to tier 1 capital plus reserves is higher than or equivalent to one hundred percent or if its overall CRE loans (consisting of owner-occupied loans) to tier 1 capital plus reserves is higher than or equal to 300 percent." Note that this technique of measurement is more conservative than what is detailed in Supervision and Regulation (SR) letter 07-1, "Interagency Guidance on Concentrations in Commercial Real Estate," because it includes owner-occupied loans and does rule out the half growth rate throughout the previous 36 months. SR letter 07-1 is available at www.federalreserve.gov/boarddocs/srletters/2007/SR0701.htm, and the November 2022 Supervision and Regulation Report is available at www.federalreserve.gov/publications/files/202211-supervision-and-regulation-report.pdf.
4 See SR letter 07-1, readily available at www.federalreserve.gov/boarddocs/srletters/2007/SR0701.htm.

5 Using Call Report data, we discovered that, since December 31, 2022, 31 percent of all monetary institutions had building and land advancement loans to tier 1 capital plus reserves greater than or equal to one hundred percent and/or total CRE loans (including owner-occupied loans) to tier 1 capital plus reserves higher than 300 percent. As kept in mind in footnote 3, this is a more conservative measure than the SR letter 07-1 measure because it includes owner-occupied loans and does rule out the 50 percent development rate throughout the previous 36 months.
6 See the November 2022 Supervision and Regulation Report.

7 See Arpit Gupta, Vrinda Mittal, and Stijn Van Nieuwerburgh, "Work from Home and the Office Real Estate Apocalypse," November 26, 2022, available at https://dx.doi.org/10.2139/ssrn.4124698.
8 See Natalie Wong and John Gittelsohn, "Wall Street Banks Are Exploring Sales of Office Loans in the U.S.," American Banker, November 11, 2022, available at www.americanbanker.com/articles/wall-street-banks-are-exploring-sales-of-office-loans-in-the-u-s.
9 An Ask the Fed session provided by Brian Bailey on November 16, 2022, highlighted the significant volume of workplace loans at fixed and floating rates set to develop in the coming years. In 2023 alone, almost $30.2 billion in drifting rate and $32.3 billion in fixed rate workplace loans will grow. This Ask the Fed session is readily available at https://bsr.stlouisfed.org/askthefed/Home/ArchiveCall/329.
10 See Konrad Putzier and Peter Grant, "Investors Yank Money from Commercial-Property Funds, Pressuring Real-Estate Values," Wall Street Journal, December 6, 2022, offered at www.wsj.com/articles/investors-yank-money-from-commercial-property-funds-pressuring-real-estate-values-11670293325.
11 See the November 16, 2022, Ask the Fed session, which was presented by Brian Bailey and is offered at https://bsr.stlouisfed.org/askthefed/Home/ArchiveCall/329.
12 See "U.S. Cap Rate Survey H1 2022," CBRE, 2022, readily available at www.cbre.com/insights/reports/us-cap-rate-survey-h1-2022.