Commercial Real Estate is once again in the crosshairs of bank regulators who are trying to ensure that a bubble scenario does not develop in this very hot market.
To that end, the Fed, FDIC and OCC put out a joint letter at the end of 2015 reminding lenders of what they consider to be ‘Prudent Risk Management for Commercial Real Estate’.
Based on that guidance and our commercial real estate lending experience we can summarize some of the regulatory hot buttons as follows:
1. Why oh Why are you I/O?
Interest Only Loans – the regulators feel strongly that all loans should have some amortization such that there is at least a partial pay down of principal. The only good reason for I/O in their view is a situation where a property is not yet stabilized so does not have the cash flow to support an amortizing payment. I/O on stabilized properties is otherwise anathema.
2. Are your Plans and Limits on speaking terms?
Concentration Limits and Capital Planning – all banks have certain commercial real estate lending concentration limits set and most have a Capital Plan but very few link the two together. Here the regulators are basically saying – it’s great that you’ve set a limit but show me how your capital position supports that limit and show me that you’ve thought about your limit as a percentage of capital rather than in a vacuum.
3. You Can’t Stress Enough…
Stress Testing Variety – the regulators would like to see that you have:
- Stressed the loan when you originated it to ensure it can refinance on exit
- Stressed the portfolio as a whole and by concentrations
- Measured the ratings change, loan loss implications and capital impact of each stress scenario
- Stressed for worst case scenarios
4. We Take Exception to Your Exceptions
Policy Exceptions and Mitigations – here the regulators are basically saying – if you have a policy then why are there so many exception approvals? Either say it is policy and defend it appropriately or don’t do the deal and if you do it on occasion as an exception, make sure you can point to how you mitigated the risk.
To remain prudent, financial institutions should regularly assess themselves against regulatory requirements for commercial real estate lending, identify gaps and seek options for remediation.