Banking Supervisors Monitor Risks in CRE Lending

April 19, 2024

By Joe Davidson, Senior Vice President
Supervision and Regulation
Federal Reserve Bank of Atlanta

Dear colleagues,

I'm excited to kick off our 2024 Supervision and Regulation series by taking this opportunity to share with you my perspectives around the risks that Atlanta Fed bank supervisors see as most concerning within the Sixth Federal Reserve District. We have a unique set of institutions within our supervisory portfolio here at the Atlanta Fed. For US banks, commercial real estate (CRE) loans make up about a quarter of total loans outstanding. But for the universe of community banks-those with assets of less than $10 billion-CRE accounts for nearly half of all loans. I'm sure it's not surprising to hear that examiners continue to monitor banks' preparedness for managing credit risks, bringing an intense focus on the concentration in CRE loans and the challenge of obtaining accurate appraisal values.

For the industry overall, concentration ratios have risen about 15 percentage points for US banks overall, and those within the Sixth District, since the beginning of 2021 and are well over the 300 percent concentration benchmark, an indicator of the banking industry's reliance on-and therefore the potential risk associated with-CRE lending. If this is a potential storm cloud, the silver lining in it is that most CRE borrowers are current on payments. The proportion of CRE loans that are nonperforming remains low on an average basis and has continued to decline since 2020. At the end of the fourth quarter of 2023, just 1.18 percent of CRE loans were nonperforming at US banks (0.51 percent at Sixth District banks). In the aftermath of the 2008 financial crisis, in contrast, nonperforming CRE loan ratios had topped 5 percent. Should overall growth of CRE exposure cross 50 percent or more in the prior 36 months, supervisors will typically exercise enhanced risk management practices. The process to mitigate risk can be seen here in the interagency guidance by the federal bank regulators on concentration risk in CRE lending.

We encourage financial institutions to work proactively and prudently with borrowers who are experiencing periods of financial stress. Such actions may entail loan accommodations that are generally short term or temporary in nature and occur before a loan reaches a workout scenario. I encourage you to refresh yourselves with SR 23-5, which was issued on June 30, 2023, and provides guidance to banks about prudent policies for CRE loan accommodation and workouts. This policy statement provides a broad set of principles relevant to all commercial loan accommodations and workouts. Additionally, it includes a section on a discussion of recent accounting changes on estimating current expected credit losses (CECL) as well as examples on how to classify and account for loans modified or affected by loan accommodations2 or loan workout activity.

These actions can mitigate long-term, adverse effects on borrowers by allowing them to address the issues affecting repayment ability and are often in the best interest of financial institutions and their borrowers. Further, a financial institution should employ prudent risk management practices and appropriate internal controls over such accommodations.

In the current environment, price discovery poses a challenge for banks in our district. The market seems to lack confidence with the current appraisal values in CRE, including multifamily properties. Determining current market values is difficult as a result of fewer new sales and distressed sales weighing down comparison property prices. Insurance premiums have also risen by as much as 54 percent in some states. As a result of heightened demand in certain select markets, the appraised values of commercial properties are on the higher end of the spectrum, thereby driving cap rates to levels close to the rate one can earn on a short-term Treasury bill, as the following chart shows.

CRE cap rates have edged upward and might rise further as a result of the increase in long-term interest rates. Property owners are also encountering pressure on net operating incomes fueled by several other factors, including rising insurance costs. To successfully navigate the current market conditions, industry professionals need to pay close attention to assumptions made in appraisals. In the loan portfolios of District banks that we supervise, our examiners hope to see reasonable appraisal assumptions as well as realistic insurance costs for property valuations.

Here at the Atlanta Fed, the unique set of institutions within our supervisory portfolio provides us with an opportunity to see risks bankers face across a wide spectrum. Although we expect near-term stress in the CRE market to persist, it is also important to note that the capital positions of most US banks are much stronger today than they were during past episodes of similar stresses. Bank supervisors will be focused on CRE concentration risk, among other key risks, as we continue to see the impact of rising rates and a slowdown in domestic and global growth on our banking system.

Sincerely,

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