CRE Risk Review

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Assessing regulators’ warnings about rising CRE lending risks

By Howard Schneider

For months federal banking regulators have been cautioning banks about loosening their credit standards in the face of stiff economic and competitive forces, and early last year they issued a particular warning about growing risks in commercial real estate (CRE) lending. Regulator cited relaxed underwriting standards, less monitoring of market conditions and increased CRE loan concentrations in bank commercial portfolios as factors behind the collective regulatory action.

The Federal Reserve, the FDIC and the Office of the Comptroller of the Currency said their purpose was “to remind financial institutions of existing regulatory guidance on prudent risk-management practices for CRE lending activity through economic cycles.” Certainly they succeeded in gaining the attention of community bankers, since almost all are active CRE lenders.

However, that doesn’t necessarily mean the regulatory statement will or should significantly alter CRE lending activities at community banks. Each bank should assess its own individual lending practices, borrowers and marketplaces, community bankers say.

“Good institutions have strong practices that demonstrate themselves in downturns,” states Rob Edwards, chief credit officer at United Community Bank in Blairsville, Ga.

Staying disciplined

A $9.6 billion-asset community bank, United Community Bank has assigned a team to go through the joint regulatory statement on CRE lending and to review the bank’s CRE lending policies accordingly. Edwards says, “We think we’re doing everything right” by maintaining a disciplined approach.

Regulators have expressed particular concern about banks engaging in construction loans in markets they’re unfamiliar with. CRE lending in some markets is becoming “overheated” due to recent growth in multifamily residential building, Edwards admits. He emphasizes that banks that sufficiently underwrite their commercial borrower’s ability to repay historically enjoy long-term success.

Community bankers can compare the current ratio of single-family starts to apartment construction against historic averages in a market, Edwards points out. Doing so can show whether building activity is becoming unbalanced in an area.

Population growth and demographic changes are other factors that United Community Bank monitors. Edwards says loan concentrations also are reviewed quarterly at the board level. United Community is evaluating the use of stress testing on its loan portfolio, as well. Since 2007 the bank has repositioned its balance sheet, Edwards adds. Its commercial land-loan totals dropped from $1.4 billion to $350 million during that time.

Acquisitions have helped fuel both growth and lending diversification. Two years ago United Community purchased Business Carolina Inc., a Small Business Administration and U.S. Department of Agriculture lending specialty firm.

CRE lending still dominates United Community’s commercial portfolio. But solid underwriting means that just half of 1 percent of the bank’s $2.3 billion in CRE loans is nonperforming. It’s hard for regulators to find fault with the bank’s activities—or results.

Hotel lending niche

Diversification isn’t a big consideration for Sushil Patel, executive vice president and chief lending officer at State Bank of Texas, a $650 million-asset community bank based in Dallas.

State Bank specializes in hotel lending. “That’s what we do best,” Patel says.

Today $440 million of the bank’s $500 million portfolio involves CRE lending. Hotel lending accounts for $350 million of that total.

Patel says establishing “an open dialogue” with regulators in recent years has helped State Bank demonstrate why CRE loan concentrations aren’t a safety and soundness issue for the bank. “Now we have a framework under which we can operate—and they have a comfort level,” he reports.

State Bank’s “strong controls and monitoring” alleviate concerns about the bank’s CRE concentrations, Patel adds. The bank has listened to examiners, absorbed what they were saying—and then devised a plan to deal with those issues. Adding capital, regularly reviewing the concentration of CRE loans in its portfolio and monitoring the overall health of the hospitality industry are steps the bank has taken in recent years.

“Regulators are like parents,” Patel observes. “They want all banks to succeed, and criticism is for our own good.”

Returning to a specialty

However, trying to please regulators caused State Bank to briefly move away from its focus on hotel lending in 2004. Loan participations allowed the bank to diversify into apartment buildings and gas stations, but resulted in losses. Today it is back to concentrating on its hotel niche.

Some lenders are chasing CRE deals in the hotel industry today, Patel notes, and extending credit up to 80 percent of a hotel’s appraised value. But State Bank is aware property values are at cyclical highs and is more cautious. The bank’s underwriting principles include borrowers “having skin in the game” that amounts to at least 25 percent of a property’s purchase price, Patel says.

Almost all of State Bank’s CRE borrowers in the hotel business are doubly committed to the property’s business success, since they’re owner-operators. Debt service coverage ratios also are required to be at least 1.25 times historic net operating income. Finally, the bank focuses on financing hotel projects with 150 or fewer rooms, because it knows that market niche well.

“Regulators are like parents. They want all banks to succeed, and criticism is for our own good.”
—Sushil Patel, State Bank of Texas

Two out of five U.S. hotels within that sector are owned and run by persons of Indian heritage, Patel points out. In fact, State Bank’s board members own and operate more than 200 properties. Patel’s father, Chan Patel, founded State Bank in 1987 and is its chairman, president and CEO. The father and his sons, Sushil and Rajan, also make the bank’s lending decisions.

Having that level of expertise helps State Bank handle distressed loans. Typically the bank limits its losses by renovating and selling troubled assets.

Patel describes State Bank as being “very profitable,” and its results show that. In 2014, SNL Financial named State Bank the nation’s best-performing community bank with between $500 million and $5 billion in assets. The bank’s net interest margin was 6.61 percent that year, and its pretax return on average tangible assets was 12.28 percent.

Due to the severity of the last real-estate-driven recession, when many CRE loans caused banks difficulties, the regulators are “trying to get ahead of the curve this time around,” Patel comments. But State Bank’s experience shows that local lenders who underwrite carefully and are able to explain their approach to regulators still can concentrate on CRE assets.


Howard Schneider is a freelance financial writer in California.

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