Our Viewpoints

Our Viewpoint

Commercial Real Estate Analysis: Strategies for Commercial Real Estate Lending Today

August 14, 2012

Commercial real estate (CRE) lending is essential to the ongoing success of most community banks. But, in too many recent cases, high concentrations in commercial real estate have also been the catalyst for bank failure. The culprits? Exposure coupled with a downturn in CRE markets.

Back in 2006, regulatory agencies jointly issued guidance on CRE exposure, recommending thresholds of 100 percent of capital for construction lending and 300 percent of capital for total commercial real estate lending. In a recent speech by Comptroller of the Currency Thomas J. Curry, he detailed just how risky not adhering to these guidelines can be.

According to Curry, if you look at the 2,000 banks in March 2007 that had C&D loans that exceeded their capital, 13 percent of them failed by September of 2011. Of those institutions that had CRE concentrations that exceeded the 2006 guidance, 23 percent failed. Conversely, for those institutions that stayed within the guidance, only one-half of one percent failed during the same period.

But, that is just one facet of the challenge.

Today, many existing real estate loans initiated in 2007 and into the first part of 2008 are coming due. The problem is, many of these properties are now appraised at a significantly lower value than they were in 2007, so they are not good candidates for refinancing.

To combat the problem, most institutions are rolling over these loans with a two-year extension in hopes that, with this extra time, collateral values will rise and they will eventually be able to finance the loans out. However, this strategy means these institutions have to hold more money in reserve, so they have fewer funds to lend.

But, it is not all bad news. Institutional real estate in the “A” grade markets is booming, with this sector at or near total recovery. However, commercial real estate in non-gateway cities is recovering more slowly, impacted by hiring slowdowns and tightening purse strings in reaction to the European debt crisis and the unsteady pace of the U.S. recovery.

The question becomes: what does all of this mean to the future of community bank CRE lending?

CRE Lending Strategies for a New World

Commercial real estate remains one of the most profitable market segments for community banks. However, new strategies for assessing the risk of these loans are essential to good lending practices going forward.

In the past, many institutions looked at commercial loans with tunnel vision. “This is a good person, he (or she) has always paid us back before.” Oftentimes, too little attention was paid to the entire deal, including the real value of the loan (as opposed to just the collateral value) and the loan’s projected selling price, the borrower’s credit rating (today, not at the time the last loan was granted) and that borrower’s outside assets. Instead of looking solely at the individual loan, community banks must also add a step to the process – analyzing how the new loan fits in with the entire CRE portfolio.

Although good credit decisions for each loan are critical, they are no longer enough to guarantee good decisions. Institutions have to find a way to add a reality check on how much that loan is really worth, and if their underwriting practices are valid in the current market.

The best way to perform this “check” is to periodically try to sell some loans in the whole loan market, then adjust your underwriting practices, based on market feedback. For example, if the loan buyers say that your interest rate and loan to value are acceptable, but your credit analysis reduces that loan’s value, you can adjust your lending practices accordingly.

If you underwrite with the secondary market in mind, you will manage your risk differently. You will also be more successful during those times when you want to sell to raise capital, or if you need to sell some loans to manage your exposure and risk.

It is also important to stress test your existing portfolio often. Identify those loans with variable interest rates and test out different scenarios. What would a two percent increase do? If the collateral property’s income dropped 10 percent, could the borrower maintain the loan?

Identify those loans with potential risk, and sell those before they take a downward turn.

Finally, it is critical to invest in the kind of technology that allows you to manage your credit risk, adjust your underwriting practices and stress test your portfolio without a lot of manual effort. The right, scalable, system can also enable you to prepare your go-to-market paperwork easily – with one person spending an afternoon running standard reports on payment history, underwriting information and appraisal value, as opposed to 10 staff members manually pulling the information together from paper files. Just as important, it can easily help you assess risk through stress testing and “what if” scenarios,” all critical to good portfolio management.

In today’s world, community banks should approach commercial lending with eyes wide open. Underwriting for the secondary market, adjusting underwriting practices based on market feedback, and stress testing the entire loan portfolio to identify potential risk are all smart strategies in an uncertain world.


James Hartzog
Senior Commercial Lending Expert and Product Manager
James Hartzog