In their attempts to answer the question that never goes away—“How to drive portfolio growth in the current lending environment?”—many financial institutions have turned to commercial real estate. That’s led to intense competition to win deals. But along with the ever-present question comes an ever-present imperative: Banks growing their CRE portfolios must satisfy regulators’ concerns over loan risk management.
Meanwhile, this much remains true: Commercial real estate is the largest lending category for U.S. banks and has experienced tremendous growth—especially since the financial crisis.
“Since the trough in CRE lending in mid-2012, CRE loans outstanding have increased to $3.6 trillion and now represent 19.8 percent of national GDP,” according to researchers with the Federal Reserve Bank of Philadelphia. And over the past 20 years, the share of CRE loans in midsize and small bank portfolios has roughly doubled, the researchers said.
Regulators have been prompted to more closely scrutinize to provide CRE loan concentrations based on three factors:
- CRE loan growth
- competitive pressures, and
- looser underwriting standards
As a result, they’ve had and to warn lenders of the importance of “identifying, measuring, monitoring, and managing concentration risk in CRE lending activities.” As recently as July 2016, Comptroller of the Currency Thomas Curry said, “Our exams found looser underwriting standards with less-restrictive covenants, extended maturities, longer interest-only periods, limited guarantor requirements, and deficient-stress testing practices.”
Growing loans, growing scrutiny
The robust nature of CRE loans is illustrated in the graph below:
So in the face of federal cautions, financial institutions across the U.S. remain committed to expanding commercial real estate portfolios. At the 2016 Sageworks Risk Management Summit, 42 percent of respondents named CRE lending their primary focus for loan portfolio expansion.
I believe banks—especially community and regional banks—should expect regulators to focus on CRE during upcoming examinations. Perhaps more than ever, regulators are really making sure that banks identify and quantify their risk—and understand it as well. Scrutiny of the CRE portfolio is a certainty.
What does that mean? Simply, financial institutions that plan to further increase CRE portfolios must balance growth, profitability and risk management throughout the life of the loans to satisfy regulators and stakeholders. But that established, how do they do this?
Striking the balance: Moderation through origination
Of course, reviewing the borrower’s cash flow rather than the property value alone remains critical to understanding their ability to repay the loan. Besides traditional metrics used to evaluate borrowers, many banks employ “debt yield” to evaluate how the borrower’s cash flow might repay the loan. Debt yield is calculated as “net operating income, divided by first mortgage debt, times 100.” Unlike the debt-service coverage ratio, debt yield focuses on the ability to pay off the loan and doesn’t allow loan-structure adjustments to mask potential weaknesses.
As regional accounting firm MCM CPAs & Advisors notes, using the debt yield helps the lender “focus on determining a proper loan amount that will provide the bank with a sufficient cash-on-cash return on its loan to mitigate the associated credit and collateral risk. Usually a debt yield of at least two times a loan’s interest rate and 200 basis points above the property’s cap rate provides a premium large enough to give the bank a solid comfort level.” In other words, it protects profitability and provides risk management.
Strategy, consistency and pricing methodology
Developing and consistently applying loan-pricing strategies helps banks remain profitable. A pricing methodology can provide a strategic advantage over competitors when it accounts for risk and profitability. Indeed, a recent webinar found that only 35 percent of participants were confident they correctly price loans across the institution—while nearly one in four acknowledged they underprice loans. At the end of the day, you compete on price but don’t price to another bank’s methodologies.
Stress testing may seem reactive. But when approached as proactive it can serve as a good portfolio management tool. Many institutions use stress testing to aid with capital planning and application lifecycle management (ALM)
Perhaps your bank already does $500 million in CRE. But what if you want to reach $600 million? Are you sufficiently capitalized to do that? Stress testing will tell you if you can handle it. It also proves to examiners that you can manage and recognize your portfolio risks.
Managing the CRE portfolio long after origination represents an important aspect of satisfying regulators and stakeholders. The message is that the financial institution balances growth opportunities, profitability, safety and soundness.
It’s a tough balancing act, to be sure. But in the face of ever-present questions from regulators, it will provide the soundest of answers.
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Robert Ashbaugh is a senior risk management consultant at Sageworks and is responsible for assisting financial institutions with their risk management needs. Rob has more than twenty years of capital markets and commercial banking experience as both a portfolio manager and risk manager.