While the banking industry is widely deemed more resistant today than it was heading into the financial crisis of 2007-2009,1 the industrial realty (CRE) landscape has changed substantially considering that the onset of the COVID-19 pandemic. This new landscape, one defined by a greater interest rate environment and hybrid work, will influence CRE market conditions. Considered that community and local banks tend to have greater CRE concentrations than big companies (Figure 1), smaller banks must stay abreast of present patterns, emerging danger aspects, and chances to update CRE concentration threat management.2,3
simpli.com
Several recent market forums carried out by the Federal Reserve System and individual Reserve Banks have actually discussed various elements of CRE. This post intends to aggregate crucial takeaways from these numerous online forums, as well as from our current supervisory experiences, and to share noteworthy patterns in the CRE market and pertinent danger aspects. Further, this post deals with the significance of proactively managing concentration danger in an extremely vibrant credit environment and provides several finest practices that illustrate how danger managers can consider 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. Since December 31, 2022, 31 percent of the insured depository organizations reported a concentration in CRE loans.5 Most of these monetary organizations were community and local banks, making them a critical financing source for CRE credit.6 This figure is lower than it was throughout the financial 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 financing activity remained robust. However, there were indications of credit deterioration, as CRE loans 30-89 days overdue increased year over year for CRE-concentrated banks (Figure 2). That said, past due metrics are lagging indicators of a customer's financial challenge. Therefore, it is crucial for banks to implement and maintain proactive risk management practices - discussed in more information later in this post - that can signal bank management to degrading efficiency.

Noteworthy Trends

Most of the buzz in the CRE area coming out of the pandemic has been around the workplace sector, and for good factor. A recent research study from organization teachers at Columbia University and New York University discovered that the worth of U.S. workplace structures might plunge 39 percent, or $454 billion, in the coming years.7 This may be brought on by recent trends, such as occupants not restoring their leases as employees go fully remote or tenants renewing their leases for less area. In some extreme examples, companies are quiting space that they rented just months previously - a clear indication of how rapidly the market can kip down some places. The struggle to fill empty workplace is a national pattern. The national vacancy rate is at a record 19.1 percent - Chicago, Houston, and San Francisco are all above 20 percent - and the quantity of office area rented in the United States in the 3rd quarter of 2022 was nearly a 3rd below the quarterly average for 2018 and 2019.

Despite record jobs, banks have actually benefited so far from office loans supported by lengthy leases that insulate them from unexpected degeneration in their portfolios. Recently, some big banks have started to sell their workplace loans to restrict their direct exposure.8 The substantial amount of office financial obligation growing in the next one to three years might create maturity and re-finance threats for banks, depending upon the financial stability and health of their borrowers.9

In addition to recent actions taken by big firms, trends in the CRE bond market are another important indicator of market sentiment related to CRE and, specifically, to the office sector. For example, the stock costs of large publicly traded property owners and developers are close to or below their pandemic lows, underperforming the broader stock exchange by a substantial margin. Some bonds backed by office loans are also showing signs of tension. The Wall Street Journal released an article highlighting this trend and the pressure on real estate values, keeping in mind that this activity in the CRE bond market is the newest indication that the increasing rate of interest are affecting the business residential or commercial property sector.10 Real estate funds typically base their assessments on appraisals, which can be sluggish to show progressing market conditions. This has actually kept fund appraisals high, even as the realty market has degraded, underscoring the obstacles that numerous community banks face in figuring out the existing market price of CRE residential or commercial properties.

In addition, the CRE outlook is being impacted by higher dependence on remote work, which is subsequently affecting the use case for large office complex. Many commercial office developers are seeing the shifts in how and where individuals work - and the accompanying trends in the office sector - as opportunities to consider alternate usages for office residential or commercial properties. Therefore, banks ought to consider the prospective ramifications of this remote work trend on the need for workplace and, in turn, the property quality of their office loans.

Key Risk Factors to Watch

A confluence of elements has caused several key dangers affecting the CRE sector that are worth highlighting.

Maturity/refinance risk: Many fixed-rate office loans will be developing in the next couple of years. Borrowers that were locked into low interest rates might deal with payment challenges when their loans reprice at much greater rates - in some cases, double the initial rate. Also, future re-finance activity might require an extra equity contribution, potentially developing more monetary strain for debtors. Some banks have actually started offering bridge financing to tide over certain debtors until rates reverse course. Increasing risk to net operating earnings (NOI): Market individuals are citing increasing expenses for items such as utilities, residential or commercial property taxes, upkeep, insurance, and labor as a concern because of heightened inflation levels. Inflation might trigger a building's operating costs to rise faster than rental income, putting pressure on NOI. Declining asset value: CRE residential or commercial properties have just recently experienced considerable cost modifications relative to pre-pandemic times. An Ask the Fed session on CRE noted that valuations (industrial/office) are down from peak rates by as much as 30 percent in some sectors.11 This triggers a concern for the loan-to-value (LTV) ratio at origination and can easily put banks over their policy limitations or run the risk of cravings. Another element affecting property values is low and delayed capitalization (cap) rates. Industry participants are having a difficult time figuring out cap rates in the present environment because of poor information, fewer transactions, rapid rate motions, and the unsure interest rate course. If cap rates remain low and rates of interest exceed them, it might lead to a negative leverage situation for debtors. However, investors expect to see increases in cap rates, which will negatively impact assessments, according to the CRE services and investment firm Coldwell Banker Richard Ellis (CBRE).12

Modernizing Concentration Risk Management

Background

In early 2007, after observing the trend of increasing concentrations in CRE for numerous years, the federal banking firms released 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 encouraged banks to enhance their danger management in order to handle and control CRE concentration dangers.

Crucial element to a Robust CRE Risk Management Program

Many banks have actually since taken actions to align their CRE risk management framework with the crucial elements from the assistance:

- Board and management oversight

• Portfolio management
• Management info system (MIS).
• Market analysis.
• Credit underwriting requirements.
• Portfolio tension screening and sensitivity analysis.
• Credit threat review function
  
  Over 15 years later, these foundational elements still form the basis of a robust CRE threat management program. An efficient threat management program progresses with the changing threat profile of an institution. The following subsections expand on five of the seven components kept in mind in SR letter 07-1 and objective to highlight some finest practices worth considering in this dynamic market environment that might improve and enhance a bank's existing framework.
  
  Management Information System
  
  A robust MIS provides a bank's board of directors and management with the tools needed to proactively keep track of and handle CRE concentration danger. While many banks currently have an MIS that stratifies the CRE portfolio by industry, residential or commercial property, and location, management may wish to think about extra methods to section the CRE loan portfolio. For example, management may consider reporting borrowers facing increased refinance threat due to rate of interest changes. This information would help a bank in determining prospective re-finance risk, might help make sure the precision of risk rankings, and would facilitate proactive conversations with potential problem debtors.
  
  Similarly, management might wish to review deals financed during the property valuation peak to recognize residential or commercial properties that might presently be more delicate to near-term valuation pressure or stabilization. Additionally, incorporating information points, such as cap rates, into existing MIS might offer useful information to the bank management and bank loan providers.
  
  Some banks have carried out an enhanced MIS by using centralized lease monitoring systems that track lease expirations. This kind of data (particularly relevant for workplace and retail spaces) supplies details that permits lending institutions to take a proactive approach to keeping an eye on for possible issues for a particular CRE loan.
  
  Market Analysis
  
  As kept in mind formerly, market conditions, and the resulting credit danger, differ across geographies and residential or commercial property types. To the degree that information and information are available to an institution, bank management might consider additional segmenting market analysis data to best determine trends and danger elements. In large markets, such as Washington, D.C., or Atlanta, a more granular breakdown by submarkets (e.g., central downtown or rural) may be relevant.
  
  However, in more rural counties, where available information are restricted, banks might consider engaging with their regional appraisal firms, professionals, or other neighborhood development groups for trend data or anecdotes. Additionally, the Federal Reserve Bank of St. Louis maintains the Federal Reserve Economic Data (FRED), a public database with time series info at the county and nationwide levels.14
  
  The very best market analysis is refrained from doing in a vacuum. If significant trends are determined, they might notify a bank's lending method or be included into tension testing and capital planning.
  
  Credit Underwriting Standards
  
  During durations of market duress, it ends up being progressively crucial for lending institutions to totally understand the financial condition of borrowers. Performing international money flow analyses can make sure that banks know about commitments their debtors might have to other banks to decrease the threat of loss. Lenders needs to also think about whether low cap rates are pumping up residential or commercial property appraisals, and they ought to thoroughly evaluate appraisals to understand presumptions and growth projections. A reliable loan underwriting process thinks about stress/sensitivity analyses to much better catch the prospective modifications in market conditions that could impact the capability of CRE residential or commercial properties to generate adequate money circulation to cover debt service. For instance, in addition to the typical criteria (debt service coverage ratio and LTV ratio), a tension test may include a breakeven analysis for a residential or commercial property's net operating income by increasing business expenses or decreasing leas.
  
  A sound risk management process must identify and monitor exceptions to a bank's financing policies, such as loans with longer interest-only periods on stabilized CRE residential or commercial properties, a higher reliance on guarantor support, nonrecourse loans, or other variances from internal loan policies. In addition, a bank's MIS must provide enough information for a of directors and senior management to examine risks in CRE loan portfolios and recognize the volume and pattern of exceptions to loan policies.
  
  Additionally, as residential or commercial property conversions (think workplace to multifamily) continue to crop up in significant markets, lenders might have proactive discussions with genuine estate investors, owners, and operators about alternative usages of property space. Identifying alternative strategies for a residential or commercial property early might help banks get ahead of the curve and minimize the risk of loss.
  
  Portfolio Stress Testing and Sensitivity Analysis
  
  Since the beginning of the pandemic, lots of banks have actually revamped their tension tests to focus more heavily on the CRE residential or commercial properties most adversely affected, such as hotels, office space, and retail. While this focus may still be relevant in some geographic locations, reliable tension tests need to evolve to think about brand-new kinds of post-pandemic circumstances. As gone over in the CRE-related Ask the Fed webinar mentioned previously, 54 percent of the respondents kept in mind that the leading CRE issue for their bank was maturity/refinance danger, followed by unfavorable leverage (18 percent) and the failure to properly establish CRE worths (14 percent). Adjusting existing stress tests to record the worst of these issues might offer informative details to notify capital preparation. This procedure could also provide loan officers details about customers who are specifically susceptible to interest rate boosts and, therefore, proactively inform workout methods for these customers.
  
  Board and Management Oversight
  
  Similar to any threat stripe, a bank's board of directors is eventually accountable for setting the danger hunger for the institution. For CRE concentration risk management, this indicates establishing policies, procedures, threat limits, and loaning methods. Further, directors and management need a pertinent MIS that supplies adequate info to examine a bank's CRE threat exposure. While all of the items mentioned earlier have the potential to strengthen a bank's concentration threat management framework, the bank's board of directors is responsible for establishing the risk profile of the organization. Further, an efficient board approves policies, such as the tactical plan and capital plan, that align with the danger profile of the organization by thinking about concentration limitations and sublimits, as well as underwriting standards.
  
  Community banks continue to hold substantial concentrations of CRE, while many market signs and emerging patterns point to a mixed performance that depends on residential or commercial property types and location. As market gamers adapt to today's developing environment, bankers require to stay alert to changes in CRE market conditions and the risk profiles of their CRE loan portfolios. Adapting concentration danger management practices in this changing landscape will guarantee that banks are all set to weather any possible storms on the horizon.
  
  * The authors thank Bryson Alexander, research analyst, Federal Reserve Bank of Richmond