Managing CRE concentration risk through change

Giulio Camerini, Ben Cayson
Managing CRE concentration risk through change

While the economic environment might change, needing a plan for managing commercial real estate concentration risk does not.

Commercial real estate (CRE) concentration risk has been a constant supervisory priority in recent years. The Federal Deposit Insurance Corp. (FDIC) released an advisory on managing commercial real estate concentrations in December 2023 that replaced a similar advisory from March 2008. Regulatory agencies have historically issued guidance surrounding commercial real estate concentrations dating back to the 2006 “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.”

Much has changed in CRE lending markets since the 2007 to 2009 recession period – and especially between 2018 and today. Factors including the COVID-19 pandemic, shifts in workplace environments, a run-up in CRE values, changes to housing affordability, rising costs, and rising interest rates have affected the commercial real estate market. Based on past events, lenders should not expect conditions to bounce back as they previously have. However, the unique nature of post-pandemic economic behavior and oversaturation in some markets, such as office properties, lends uncertainty to forecasts.

Keep pace with loan review and credit risk

CRE concentration risk has a history of intense focus

Since the savings and loan crisis of the 1980s, financial institution regulators have recognized that lending organizations possessing high CRE credit concentrations and weak risk management practices carry an increased risk of loss.

Depending on their markets and competition, lending organizations can develop CRE concentrations that expose them to significantly greater risk during economic downturns.

In June 2020, as the effects of the COVID-19 pandemic expanded, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Fed), the National Credit Union Administration (NCUA), and the FDIC issued “Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Institutions.” The agencies also released “Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts” in July 2023, which encouraged lenders to offer borrowers reasonable terms during times of financial stress.

The link between the COVID-19 pandemic and the ongoing effects to the CRE market cannot go unnoticed as many sectors within CRE have not recovered to pre-pandemic levels. Since that period, regulatory agencies have reemphasized the need for financial services organizations to work prudently with borrowers on CRE workouts and those experiencing financial difficulties. Organizations are also asked to proactively identify any CRE weaknesses within portfolios so any cascading effects due to concentrations can be assessed.

Federal financial institution regulators have long issued general guidance to help financial institutions avoid developing overly aggressive and unmitigated CRE concentrations. Such releases include:

A 2015 publication, “Interagency Statement on Prudent Risk Management for Commercial Real Estate Lending,” responded to CRE asset and lending markets experiencing substantial growth. The guidance noted that “increased competitive pressures are contributing significantly to historically low capitalization rates and rising property values.” Regulators added that many organizations’ CRE concentration levels had been rising as a result.

CRE concentrations increased faster at the community bank level, which led regulators to further sharpen their focus on CRE concentrations.

The OCC has consistently highlighted the need for robust oversight within organizations’ CRE portfolios. In their Fall 2017 “Semiannual Risk Perspective,” the OCC noted that the “credit environment continues to be influenced by strong competition, tighter spreads, and slowing loan growth. These factors are driving incremental easing in underwriting practices and increasing concentrations in select loan portfolios – leading to heightened risk if the economy weakens or markets tighten quickly.” More recently, in their Fall 2023 “Semiannual Risk Perspective,” the OCC highlighted that “credit risk is increasing due to higher interest rates, increasing risk in commercial real estate lending, prolonged inflation, declining corporate profitability, and potential for slower economic growth. Key performance indicators are beginning to show signs of borrower stress across asset classes.”

Regulatory focus on CRE loan concentrations remains strong, and lenders should maintain a strong management process that can address potential challenges in interest rates, market fluctuations, and staff experience.

Comprehensive steps can help mitigate CRE concentration risk

Comprehensive steps can help mitigate CRE concentration risk

The most effective methods for addressing CRE concentration risk involve an integrated, holistic approach rather than a piecemeal effort that focuses only on the most urgent or critical concerns.

A holistic approach generally encompasses four principal steps:

  • Validating CRE data. While CRE data is more widely accessible than in the past, lenders should examine their loan portfolio databases and verify that information is correctly classified. Errors in coding and data entry can present a distorted picture of CRE concentrations, and merger activity across different systems generally creates challenges in data aggregation. Processes and procedures for creating, entering, validating, and quality-checking data and coding should be well documented.
  • Analyzing concentration risk. Senior management can carry out risk analyses on validated loan portfolio databases to expose both portfolio and loan sensitivities. Careful loan stratification helps management look at loan concentrations in a new light.
  • Mitigating CRE risk. After analyzing CRE concentrations, senior management can establish policies and processes to monitor CRE loan performance closely and change the mix of the portfolio when appropriate. Senior management oversight of credit portfolio management is critical, as is having an effective management information system in place.
  • Reporting to management and the board. The final step in the concentration risk management process is regularly reporting to the senior management and the board. Reporting should include updates on mitigation efforts for any identified concentrations. Financial services organizations with higher levels of CRE loan activity might consider investing in dashboard reporting systems.

Loan review plays an important role in CRE risk management

Developing and implementing a more dynamic loan review function helps provide management and the board additional information they would not get elsewhere.

In addition to monitoring for conventional red flags and signs of risk, an assertive and proactive loan review function also uses technology and additional sampling to identify portfolio themes and trends. The aggregation of data from the loan review process identifies unique or forming pockets of risk in a portfolio that might not be observed via other activities. As applications for artificial intelligence and machine learning grow, this role likely will continue to evolve.

The loan review function also points out whether management reporting lacks granularity or sufficient detail and identifies other forms of risk associated with appraisal quality and underwriting practices.

Stress testing offers further insights into CRE loan concentrations

Stress testing offers further insights into CRE loan concentrations

Stress-testing processes, whether implemented through regulatory requirements or a lender’s own initiatives, provide even more insights into CRE concentration risk. Additionally, customer segmentation and sensitivity analysis highlight the potential effects certain economic variables could have on the portfolio.

Tweaking a few key inputs reveals the sensitivity of models to various economic scenarios. But beyond this basic function, stress testing also helps facilitate discussions with executive management, board members, and regulators to develop a better understanding of the loan portfolio. It also helps identify better-performing borrowers and segments when seeking potential growth opportunities.

Portfolio- and loan-level stress testing looks different across lending organizations, but the important thing is to start somewhere and to have a road map to address how quickly stress events can evolve.

Crowe can help you determine best practices for future consistency

Having a CRE concentration risk management plan is one thing. Putting it into effective practice can be another.

With uncertainty in markets and potential gaps in staffing and experience, outside support can offer deep knowledge of the industry and assist in developing solutions. Crowe consultants can help you build a strategy that works now and can adapt to the future, introducing technology and processes that enable more timely and intuitive decision-making. Areas to consider include assisting with loan review, helping enhance your existing loan review function, consulting assistance with data quality, or consulting on CRE concentration and stress testing.

Crowe consultants can help you stay ahead of the curve in many areas. Your teams can achieve a better view into your CRE risk profile now and gain a more accurate picture of what concentrations might look like in the future.

Gain a fuller view into your CRE risk

Discuss challenges and solutions with our CRE credit specialists

We can help your financial services organization implement tools and strategies that can help you maintain compliance while pursuing opportunities. We can also take a deep dive into the portfolio with our dynamic loan review process to provide you deeper insights. 
Guilio Camerini
Giulio Camerini
Principal, Consulting
Ben Cayson
Financial Services Consulting