Banking organizations’ exposure to commercial real estate (CRE) is substantial. Therefore, banks should get back to basics and ensure that a proactive risk management strategy is in place, which is critical to manage CRE credits.
Total outstanding commercial and multifamily debt is $3.5 trillion, with $1.6 trillion or approximately 45 percent held in U.S. commercial banks. Due to the weakness in securitization markets and limited ability to place CRE debt in these markets, refinance risk in banks is high and increasing. Projections indicate that $300 to $500 billion in CRE debt will mature in 2010. Increasing capitalization rates, coupled with increasing vacancy rates and decreasing net operating income (NOI), have resulted in a valuation problem. Bankers are expressing a growing concern that income-producing properties will lack sufficient NOI to cover break-even debt service coverage (DSC), even on an interest-only basis in some cases.
With these concerns in play, how do banking organizations get back to the basics in managing CRE loans? Here are some best practices to keep in mind.
First, enhance policies and procedures to address today’s emerging issues. In general, credit policies should:
Second, CRE portfolio monitoring is important. Common practices include segmenting CRE loans by property type, maturity and geographic area to obtain a clearer understanding of the risk.
Third, key staff must also become active in the monitoring of the credits. Site visits are a key; they should include taking pictures to determine the condition of properties, vacancies, etc. Lease and financial information needs to be obtained and analyzed to determine the property’s current performance and future prospects. Furthermore, the lender should review documentation for completeness and ensure that property taxes are paid.
Fourth, other best practices include talking with the borrower to determine his or her plans to obtain or retain tenants. How will these plans affect the property’s cash flow? In addition to analyzing market conditions, lenders should determine if any new competition has come into the borrower’s market area and what affect it has on the borrower’s NOI and ability to retain or obtain tenants.
Fifth, most, if not all, of these CRE loans have guarantors. Therefore, a robust guarantor analysis is needed to assess the value, sufficiency and liquidity of a guarantor’s net assets and the magnitude of ongoing cash flow that considers both actual and contingent liabilities. The analysis of a guarantor’s global cash flow should consider inflows, as well as both required and discretionary cash outflows from all activities. This may involve integrating multiple partnership and corporate tax returns, business financial statements, K-1 forms and individual tax filings. Anything short of a comprehensive global cash flow analysis diminishes confidence in the assessment of guarantor strength, even in the face of significant liquid assets, because liquidity may be needed to fund contingent liabilities and global cash shortfalls.
Sixth, senior management and directors should develop enhanced capital analysis and planning processes for measuring the appropriateness of the capital structure, given the risk profile of the organization. Good analysis takes into consideration asset quality and asset concentrations, as well as the composition of those concentrations.
Keep up with what’s new and noteworthy at the St. Louis Fed. Sign up now to have this free monthly e-newsletter emailed to you.
Fed in Print: An index of the economic research conducted by the Fed.