Much has been written about the role commercial real estate (CRE) has played in the current banking crisis. The idea that CRE portfolios are the primary reason some community banks are in regulatory trouble is so prevalent that it makes one ask: Is anyone doing it right?
The answer is yes—many institutions are successfully making CRE loans, intelligently mitigating their risks and surviving regulatory examinations with their CAMEL ratings intact. How? We talked to several bankers and CRE experts and have compiled a list of the crucial elements of a successful, safe and sound CRE program. This is proof that it’s possible, even in these difficult economic times, to lend money on real estate projects without sacrificing loan quality or putting the bank’s capital at an unreasonable risk.
While this list is not a panacea for all situations that financial institutions are now facing—obviously a change of practice mid-stream won’t immediately pull an institution out of trouble; it can be a useful roadmap for building a strong and profitable CRE program. It could also be used as a check up for those considering a mid-course correction to head off future trouble.
- Know your Markets
Arguably the most important thing a CRE lender can do is to be aware of the market conditions in which he lends. The failure to accurately discern the change in markets quickly enough has been a leading cause of deteriorating portfolio conditions. Market conditions are an important element of loan policy and the bank’s long and short term strategy. Successful bankers we talked to subscribed to high quality market data as one of the best ways to have up to date information on the primary markets in which they were lending. Banks that receive market information regularly can adjust policies on loan-to-value ratios and on the types and locations of acceptable properties in order to mitigate their credit risk. For example, one banker reported that when more than half of the appraisals on new properties were coming in at less than the purchase price, the bank decided to lower its acceptable LTV on commercial property from 80% to 70%. This same institution carefully watches comparable sales and vacancy rates by geography and when these key data points begin falling in particular locations, the bank tightens its standards for loan requests secured by nearby properties, even declining to approve them if new construction would appear to make the market more saturated and drive vacancy rates lower. The old saying “Knowledge is Power” was never more appropriate.
- Know your Portfolio
All the bankers we spoke to who are successfully managing a CRE portfolio stressed that knowing as much as possible about their borrowers and real estate projects is the key to a successful examination. The best way to be credible to examiners and shareholders is to show that you are realistic about the current state of your CRE loans. Aggressively grade credits. If a loan should be downgraded—do it yourself; don’t wait until forced to do so by a regulator. Bankers with recent enforcement actions also echoed this advice. When examiners have to force the bank to own up to the state of its own loans, its credibility factor drops precipitously. Being credible requires a thorough knowledge of the properties, the borrowers and the markets. In other words, do your homework. It’s not a one-time assignment either—keeping up with changes is a constant job. Resources have to be allocated for that purpose. For higher risk loans—such as construction spec loans—know the current status of the owner’s marketing efforts, have written documentation of the actual absorption rates compared to those in the appraisal in the file, and document current market prices as compared to those in the appraisal. Nothing will replace the cold, hard facts when managing CRE in today’s economic climate. Also, in a more broad sense, keep detailed track of your real estate concentrations—by types of projects, by geographies and by loan type. Drill down below the generalities—-know how much you have invested in strip centers, in office buildings, in condominiums, in investment properties and where the properties are located—especially if they are in markets that vary greatly. Also it is helpful to document economic trends by type of property from year to year or even from month to month.
- Regularly Review and Test the Portfolio
You are the one who will benefit the most from rigorous loan review and stress testing your CRE portfolio. Whether you use internal resources or external ones for credit review, make sure that the reviewers are experienced, up to date on the latest examiner hot buttons and thoroughly document their process. We’ve seen loan review criticized in examinations when the reviewers are not up to date or independent enough. You can use expensive stress testing solutions for your CRE portfolio or your own spreadsheets and formulas—just as long as it works, i.e. the assumptions and conclusions are well documented and reasonable. Stress factors should be reviewed every time to make sure that they are consistent with general economic conditions and specific geographic market trends.
- Make a Contingency Plan for Each Loan
Insist that loan officers formulate plans for each of their CRE loans. Many CRE borrowers are under stress—some more than others. A change in market factors can significantly impact these stress factors. Although you don’t have a crystal ball, it is important to have a thoughtful and well-documented plan for each loan. Even if the loan is performing and does not appear to be in any trouble, make sure you document how you expect the loan to be repaid and what are the contingencies for avoiding any losses. The better documented your files with realistic scenarios for repayment in case the project does not cash flow as expected, the less difficulty you will have during an examination. Conducting the analysis required and documenting these plans on a loan-by-loan or borrower-by-borrower basis is time consuming, but it pays dividends during examinations. (To be fair one of our bankers told us that they are very careful when they document a loan file with a “plan” since anything in the file is discoverable in a lawsuit, so a balance is required here.)
- Set Goals and Stick to Them
The most successful organization set CRE concentration goals and did what it took to get meet them. Even if it takes a while—scrub the portfolio until you reach the goal. The strategy for your CRE portfolio should fit with the overall bank’s strategic plan and should be reviewed often to adjust for market conditions and the actual performance of the loans overall.
- Be Conservative—Risk Management Pays Off
Times have changed. Practices that used to be commonplace are now considered high risk and are not acceptable in many cases. Easy “gotchas” are things like including interest reserve (“interest carry”) on construction loans, relying on the property value and not the borrower’s or guarantor’s income, and using non-recourse notes. Change your policy to meet current regulatory expectations on higher risk practices and communicate this to everyone in the bank—make sure your borrowers understand the policies up front. One banker indicated that they changed their policy to prohibit 100% financing on anything. No matter what the loan-to-value ratio is—they require the borrower to put hard cash in the project. We also found that successful institutions count only on the guarantor’s global cash flow to underwrite all commercial construction loans, period. Using interest rate floors is another risk management tool used to protect against interest rate risk by successful CRE lenders.
- Manage the Exam Process
One of the crucial elements of successfully navigating CRE lending is the ability to manage the regulatory examination process. This is a tricky issue—regulatory practices and attitudes vary by agency and regionally as well. However, this advice is probably valid everywhere.
- Be prepared. Everyone we interviewed stated the importance of exam preparation. Document the files with memos that explain what the borrower and the project have done for the previous 18 months.
- Stay credible with examiners at all costs. This means that you have to be as honest as possible and, above all, don’t hide anything. Once you establish your credibility an examiner is more likely to listen and give credence to the arguments you make.
- Be knowledgeable—don’t let them find out something you don’t already know.
- Have your logic in place for every reserve calculation before the exam starts. You might not win every argument, but if you are prepared and can document your logic, you have a better chance.
- Be respectful, but challenge any unrealistic or arbitrary decisions—for example, in one case the examiners wanted to discount all appraisals by 20%, the bank convinced them that such a global decision was not reasonable
- Be proactive on every subject. For example, if you haven’t reached your concentration goals—have the reasons ready—don’t ignore it and wait for the exam team to ask you
Effectively navigating the CRE management process takes skill and endurance. However, it can be done, and the lessons from every crisis are important to incorporate as your bank and the industry moves forward.
CRE: Seven Strategies for Getting it Right by Lyn Farrell appeared in Community Banker magazine, March 2010.
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