Signaling Caution

Photo by Getty Images / Andy Ryan

Photo by Getty Images / Andy Ryan

Regulators warn once again about rising CRE concentrations and risks

By Howard Schneider

Just about every community bank makes commercial real estate loans. A whopping 95 percent of ICBA members are active commercial real estate (CRE) lenders, according to the latest ICBA Community Bank Lending Survey.

Obviously these local lenders took notice when the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency recently issued a joint statement pointing out increased risks in CRE lending. The warning in December cited both growing concentrations of CRE loans and “an easing of CRE underwriting standards.”

Risk-management practices “that cause concern,” the regulators wrote, include “a greater number of underwriting policy exceptions and insufficient monitoring of market conditions.”

Bank examinations also are uncovering less-restrictive loan covenants, extended maturities, longer interest-only payment periods and limited guarantor requirements.

Community banks that are growing their CRE lending will be a focus of examination activity in 2016, adds the regulatory statement. “Historical evidence demonstrates that financial institutions with weak risk management and high CRE credit concentrations are exposed to a greater risk of loss and failure,” the regulators wrote.

Several factors—ranging from rising interest rates to booming multifamily construction—have produced this official stance. Two recent speeches by U.S. Comptroller of the Currency Thomas Curry emphasized that current trends of relaxed credit underwriting and increased lending concentrations are unsustainable.

“This is the third consecutive year in which we’ve seen underwriting standards slip,” he says.

Earlier Curry had noted that “growth rates in commercial real estate are above 14 percent year-over-year for OCC-supervised community and midsize banks.” He believes that in the area of credit risk, “the warning lights are flashing yellow.” He adds that regulators and bank management need to act to prevent those risks from becoming reality. “We can’t afford to wait until the warning lights turn red.”

Responsible lending

Regulatory oversight is nothing new for Chris Courtney, president and CEO of Oak Valley Community Bank in Oakdale, Calif. Seventy to 75 percent of the $871 million community bank’s portfolio involves CRE loans. “We get a lot of attention” from regulators, he says.

But Oak Valley “holds very firm” to three underwriting principles on these loans. First, loan-to-value ratios don’t exceed 75 percent. Second, debt service coverage ratios also must be at least 1.25 percent. Finally, the bank looks closely at what it calls “sponsorship”—a borrower’s ability to make loan payments from income sources that are separate from the property.

Oak Valley competes by making quick decisions, rather than through better pricing or easier underwriting, Courtney explains. He adds that two local banks that were “frequently making concessions to win business” have failed.

CRE loans totaled 869 percent of Oak Valley’s capital in 2001, resulting in a special examination by regulators. The bank began stress testing its portfolio as a result, and today its CRE loans represent 500 percent of the bank’s capital.

Smart for California

Getting through the last recession has shown regulators that Oak Valley can manage a CRE-heavy portfolio. Courtney observes that the bank avoided the high residential mortgage default rates that have afflicted California’s Central Valley by limiting its exposure to highly volatile CRE loans.

One examiner even told Courtney that he was “brilliant” for specializing in commercial real estate rather than the often-recommended course of diversification through commercial and industrial lending or consumer lending. Just 1.03 percent of Oak Valley’s total loan portfolio—or 0.79 percent of its total assets—was nonperforming at the end of 2014, according to the bank’s most-recent annual report.

“I don’t apologize for CRE,” says Courtney, who points out that the bank is lending against tangible assets. Oak Valley also holds more than 30 different types of commercial real estate, which provides portfolio diversification.

Close to 40 percent of respondents to ICBA’s 2014 Community Bank Lending Survey reported tightening CRE underwriting standards over the previous two years. Less than one in 20 community banks believed underwriting was becoming more relaxed.

However, the regulators have a different view. During a December speech, Curry stated, “We see banks and thrifts reaching for yield and growth, sometimes extending their reach at the expense of sound underwriting.”

Curry also suggested that higher rates mean that income property values—and borrowers’ equity—will increase at a slower pace this year. Yet despite these headwinds, Oak Valley and other lenders are finding ways to show examiners that their CRE underwriting practices remain appropriate in today’s marketplace.


Howard Schneider is a freelance financial writer in California.

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