While the banking market is extensively viewed as more resistant today than it was heading into the financial crisis of 2007-2009,1 the industrial realty (CRE) landscape has actually changed substantially given that the start of the COVID-19 pandemic. This new landscape, one characterized by a greater rates of interest environment and hybrid work, will influence CRE market conditions. Considered that community and regional banks tend to have higher CRE concentrations than big companies (Figure 1), smaller sized banks should remain abreast of present patterns, emerging risk aspects, and chances to update CRE concentration threat management.2,3

Several recent industry online forums performed by the Federal Reserve System and individual Reserve Banks have actually discussed various aspects of CRE. This article intends to aggregate essential takeaways from these numerous forums, in addition to from our recent supervisory experiences, and to share notable patterns in the CRE market and pertinent risk aspects. Further, this article resolves the value of proactively managing concentration danger in a highly dynamic credit environment and offers a number of finest practices that illustrate how threat managers can think about 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 point of view. Since December 31, 2022, 31 percent of the insured depository institutions reported a concentration in CRE loans.5 The majority of these financial organizations were neighborhood and regional banks, making them a critical financing source for CRE credit.6 This figure is lower than it was during the monetary crisis of 2007-2009, but it has actually been increasing over the previous 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 signs of credit degeneration, as CRE loans 30-89 days overdue increased year over year for CRE-concentrated banks (Figure 2). That said, unpaid metrics are lagging signs of a customer's financial difficulty. Therefore, it is critical for banks to execute and keep proactive threat management practices - talked about in more detail later on in this article - that can signal bank management to degrading efficiency.

Noteworthy Trends

The majority of the buzz in the CRE area coming out of the pandemic has actually been around the office sector, and for great reason. A current study from company professors at Columbia University and New York University found that the worth of U.S. office complex might plunge 39 percent, or $454 billion, in the coming years.7 This may be brought on by recent patterns, such as tenants not renewing their leases as employees go fully remote or occupants restoring their leases for less space. In some severe examples, companies are giving up space that they leased just months earlier - a clear indication of how quickly the marketplace can kip down some locations. The struggle to fill empty office is a national trend. The nationwide vacancy rate is at a record 19.1 percent - Chicago, Houston, and San Francisco are all above 20 percent - and the quantity of workplace leased in the United States in the third quarter of 2022 was almost a third listed below the quarterly average for 2018 and 2019.

Despite record vacancies, banks have benefited so far from office loans supported by lengthy leases that insulate them from sudden wear and tear in their portfolios. Recently, some big banks have actually begun to sell their workplace loans to limit their direct exposure.8 The sizable amount of workplace debt growing in the next one to 3 years might produce maturity and refinance dangers for banks, depending on the monetary stability and health of their borrowers.9

In addition to current actions taken by large companies, patterns in the CRE bond market are another important sign of market belief associated to CRE and, particularly, to the office sector. For circumstances, the stock rates of large publicly traded proprietors and designers are close to or below their pandemic lows, underperforming the broader stock market by a big margin. Some bonds backed by office loans are likewise revealing signs of tension. The Wall Street Journal published a short article highlighting this trend and the pressure on realty worths, noting that this activity in the CRE bond market is the current sign that the increasing rate of interest are impacting the business residential or commercial property sector.10 Real estate funds generally base their assessments on appraisals, which can be sluggish to reflect evolving market conditions. This has kept fund evaluations high, even as the property market has actually degraded, underscoring the obstacles that lots of neighborhood banks face in figuring out the current market value of CRE residential or commercial properties.

In addition, the CRE outlook is being affected by greater reliance on remote work, which is consequently impacting the usage case for big office structures. Many business workplace designers are viewing the shifts in how and where people work - and the accompanying trends in the office sector - as opportunities to consider alternate uses for office residential or commercial properties. Therefore, banks need to think about the prospective ramifications of this remote work trend on the need for workplace and, in turn, the property quality of their workplace loans.

Key Risk Factors to Watch

A confluence of factors has actually resulted in several crucial threats impacting the CRE sector that are worth highlighting.

Maturity/refinance risk: Many fixed-rate office loans will be growing in the next number of years. Borrowers that were locked into low rates of interest might face payment obstacles when their loans reprice at much higher rates - in some cases, double the original rate. Also, future re-finance activity might need an additional equity contribution, potentially developing more financial pressure for debtors. Some banks have actually started providing bridge financing to tide over specific customers till rates reverse course.
Increasing danger to net operating income (NOI): Market participants are pointing out increasing expenses for items such as energies, residential or commercial property taxes, upkeep, insurance, and labor as a concern due to the fact that of heightened inflation levels. Inflation might cause a structure's operating expense to increase faster than rental income, putting pressure on NOI.
Declining property value: CRE residential or commercial properties have actually recently experienced considerable rate modifications relative to pre-pandemic times. An Ask the Fed session on CRE kept in mind that appraisals (industrial/office) are down from peak prices by as much as 30 percent in some sectors.11 This triggers an issue for the loan-to-value (LTV) ratio at origination and can easily put banks over their policy limitations or run the risk of appetite. Another element affecting possession values is low and lagging capitalization (cap) rates. Industry participants are having a tough time determining cap rates in the existing environment because of bad information, less transactions, quick rate movements, and the unsure rate of interest course. If cap rates stay low and rate of interest surpass them, it could lead to an unfavorable leverage situation for customers. However, investors anticipate to see increases in cap rates, which will negatively affect evaluations, 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 a number of years, the federal banking firms released SR letter 07-1, "Interagency Guidance on Concentrations in Commercial Real Estate." 13 While the assistance did not set limits on bank CRE concentration levels, it motivated banks to boost their risk management in order to handle and manage CRE concentration risks.

Crucial element to a Robust CRE Risk Management Program

Many banks have given that taken steps to align their CRE threat management framework with the crucial elements from the assistance:

- Board and management oversight
- Portfolio management
- Management info system (MIS).
- Market analysis.
- Credit underwriting standards.
- Portfolio stress testing and sensitivity analysis.
- Credit threat evaluation function

Over 15 years later on, these fundamental components still form the basis of a robust CRE danger management program. A reliable danger management program progresses with the changing risk profile of an institution. The following subsections broaden on five of the seven elements kept in mind in SR letter 07-1 and aim to highlight some best practices worth considering in this vibrant market environment that may modernize and reinforce a bank's existing framework.

Management Information System

A robust MIS supplies a bank's board of directors and management with the tools needed to proactively keep an eye on and handle CRE concentration danger. While numerous banks already have an MIS that stratifies the CRE portfolio by market, residential or commercial property, and area, management may wish to think about additional methods to segment the CRE loan portfolio. For example, management might think about reporting customers facing increased re-finance danger due to rates of interest fluctuations. This information would aid a bank in identifying potential re-finance risk, might help ensure the precision of risk rankings, and would facilitate proactive discussions with possible issue customers.

Similarly, management might wish to evaluate deals funded during the property appraisal peak to determine residential or commercial properties that might currently be more sensitive to near-term appraisal pressure or stabilization. Additionally, including information points, such as cap rates, into existing MIS could offer beneficial info to the bank management and bank lenders.

Some banks have actually carried out an improved MIS by using centralized lease tracking systems that track lease expirations. This kind of information (particularly relevant for office and retail areas) offers info that allows lending institutions to take a proactive approach to keeping an eye on for possible problems for a particular CRE loan.

Market Analysis

As noted previously, market conditions, and the resulting credit danger, vary across geographies and residential or commercial property types. To the degree that data and info are offered to an institution, bank management may consider more segmenting market analysis data to finest recognize trends and threat elements. In big markets, such as Washington, D.C., or Atlanta, a more granular breakdown by submarkets (e.g., main downtown or rural) may matter.

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

The very best market analysis is refrained from doing in a vacuum. If meaningful patterns are recognized, they may notify a bank's loaning strategy or be included into tension screening and capital planning.

Credit Underwriting Standards

During periods of market pressure, it becomes increasingly essential for lenders to totally comprehend the monetary condition of debtors. Performing worldwide capital analyses can guarantee that banks learn about dedications their debtors may need to other banks to lessen the threat of loss. Lenders should also think about whether low cap rates are pumping up residential or commercial property appraisals, and they ought to thoroughly examine appraisals to understand presumptions and development projections. An efficient loan underwriting process thinks about stress/sensitivity analyses to much better capture the possible modifications in market conditions that might affect the capability of CRE residential or commercial properties to produce sufficient money flow to cover financial obligation service. For example, in addition to the normal criteria (financial obligation service coverage ratio and LTV ratio), a stress test might include a breakeven analysis for a residential or commercial property's net operating income by increasing operating expenditures or reducing rents.

A sound danger management process ought to identify and keep track of exceptions to a bank's financing policies, such as loans with longer interest-only durations on supported CRE residential or commercial properties, a greater dependence on guarantor assistance, nonrecourse loans, or other variances from internal loan policies. In addition, a bank's MIS should offer enough details for a bank's board of directors and senior management to assess threats in CRE loan portfolios and determine the volume and trend of exceptions to loan policies.

Additionally, as residential or commercial property conversions (think workplace to multifamily) continue to appear in significant markets, lenders might have proactive conversations with real estate financiers, owners, and operators about alternative usages of realty area. Identifying alternative strategies for a residential or commercial property early might help banks get ahead of the curve and decrease the threat of loss.

Portfolio Stress Testing and Sensitivity Analysis

Since the start of the pandemic, many banks have revamped their stress tests to focus more greatly on the CRE residential or commercial properties most negatively affected, such as hotels, workplace, and retail. While this focus might still matter in some geographic areas, effective tension tests need to progress to think about new types of post-pandemic scenarios. As gone over in the CRE-related Ask the Fed webinar pointed out earlier, 54 percent of the participants kept in mind that the top CRE issue for their bank was maturity/refinance risk, followed by unfavorable take advantage of (18 percent) and the inability to precisely develop CRE values (14 percent). Adjusting existing tension tests to capture the worst of these issues could provide informative information to notify capital planning. This process might likewise use loan officers details about borrowers who are particularly vulnerable to rates of interest boosts and, thus, proactively inform exercise strategies for these debtors.

Board and Management Oversight

Just like any risk stripe, a bank's board of directors is eventually responsible for setting the risk cravings for the organization. For CRE concentration risk management, this indicates establishing policies, procedures, danger limitations, and loaning methods. Further, directors and management need an appropriate MIS that offers enough information to assess a bank's CRE risk direct exposure. While all of the products discussed earlier have the possible to strengthen a bank's concentration threat management structure, the bank's board of directors is accountable for developing the threat profile of the organization. Further, an efficient board approves policies, such as the tactical strategy and capital strategy, that align with the risk profile of the institution by considering concentration limits and sublimits, in addition to underwriting requirements.

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

* The authors thank Bryson Alexander, research expert, Federal Reserve Bank of Richmond; Brian Bailey, industrial realty topic expert and senior policy consultant, Federal Reserve Bank of Atlanta; and Kevin Brown, advanced inspector, Federal Reserve Bank of Richmond, for their contributions to this short article.

1 The November 2022 Financial Stability Report launched by the Board of Governors highlighted numerous crucial actions taken by the Federal Reserve following the 2007-2009 financial crisis that have promoted the strength of banks. This report is 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, offered at www.chicagofed.org/publications/chicago-fed-letter/2021/463.
3 The November 2022 Supervision and Regulation Report released by the Board of Governors defines concentrations as follows: "A bank is considered focused if its building and construction and land development loans to tier 1 capital plus reserves is greater than or equivalent to one hundred percent or if its overall CRE loans (including owner-occupied loans) to tier 1 capital plus reserves is greater than or equal to 300 percent." Note that this method 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," due to the fact that it includes owner-occupied loans and does rule out the 50 percent development rate during the previous 36 months. SR letter 07-1 is offered at www.federalreserve.gov/boarddocs/srletters/2007/SR0701.htm, and the November 2022 Supervision and Regulation Report is offered at www.federalreserve.gov/publications/files/202211-supervision-and-regulation-report.pdf.
4 See SR letter 07-1, available at www.federalreserve.gov/boarddocs/srletters/2007/SR0701.htm.

5 Using Call Report data, we discovered that, as of December 31, 2022, 31 percent of all banks had construction and land development loans to tier 1 capital plus reserves greater than or equivalent to 100 percent and/or overall CRE loans (consisting of owner-occupied loans) to tier 1 capital plus reserves greater 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 consists of owner-occupied loans and does rule out the half development rate during the prior 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, readily 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 presented by Brian Bailey on November 16, 2022, highlighted the significant volume of office loans at fixed and floating rates set to grow in the coming years. In 2023 alone, nearly $30.2 billion in drifting rate and $32.3 billion in fixed rate office loans will grow. This Ask the Fed session is offered 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 existed by Brian Bailey and is available 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.