Fifth District Supervision Top Risk: Commercial Real Estate

In the Fifth District, third quarter 2022 loan growth was strong as District banks outpaced the nation in all loan categories — Residential, Consumer, Commercial and Agricultural/Farm — even as rates continued to increase. Rising interest rates have added additional operating costs to commercial properties, moderated rental rate growth, impacted housing demand and increased pressure on property values amid additional macro-economic pressures.

At the same time, credit quality remains strong as nonperforming loans and loan losses continued to decrease to historic lows. Many firms around the District continue to express concern over the impact that the economic climate could have on borrower performance in 2023. While these conditions and/or effective portfolio diversification strategies may refocus lending efforts into other asset classes, ongoing risk management of commercial portfolios is key to navigating the evolving economic landscape. Our exam teams will be focused on these and other practices to actively manage the changing conditions and the impact on loan portfolios.

Detailed below are some the best practices to aid your institution:

• Actively manage lending strategies (such as plans to increase lending in a particular market or property type) limits for credit and other asset concentrations, and processes for assessing whether lending strategies and policies continued to be appropriate despite changing market conditions.
• Provide boards and management with information to assess whether the lending strategy and policies continue to be appropriate considering changes in market condition.
• Determine global cash flow at an appropriate frequency based on reasonable (not speculative) rental rates, sales projections and operating expenses to ensure the borrower had sufficient repayment capacity to service all loan obligations.
• Establish proper processes for reviewing appraisal reports. Identify sufficient information to support an appropriate market value conclusion (based on reasonable market rental rates, absorption periods and expenses).
• Assess the ongoing ability of the borrower and the project to service all debt as loans during periods of rising interest rates and operating expenses.

These practices and other strategies are discussed in SR Letter 15-17: Interagency Statement on Prudent Risk Management for Commercial Real Estate Lending, SR Letter 09-7: Prudent Commercial Real Estate Loan Workouts and SR Letter 07-1: Interagency Guidance on Concentrations in Commercial Real Estate.

Do you have questions related to commercial real estate risk management best practices or examination expectations? Reach out to your Central Point of Contact or connect with us at supervisionoutreach@rich.frb.org.