Tackling the commercial real estate downturn

Editor's Note: Jay Blandford, CEO of Austin, Texas-based community financial institution advisor Abrigo, shared his written views on the state of commercial real estate and the potential impact of the downturn on community banks. This conversation has been lightly edited. . Q: Despite community banks having fewer CRE holdings in major metropolitan areas than larger banks, does the downturn in the CRE market still impact smaller banks' holdings in smaller and diversified CRE spaces? If so, how can they navigate those challenges?.A: "It absolutely could affect some community banks. CRE has been a cornerstone of community bank portfolios because of their critical role in funding community development. The Fed has reported that, of the 60 percent of CRE loans held by banks, more than two-thirds are held by lenders with less than $100 billion in assets. The type of real estate can vary a lot by institution. Community banks are more likely to be funding smaller dentist office spaces and strip malls in their areas, for example, than they are skyscrapers in more urban regions.."CRE also plays to community banks' strengths. They typically know and lend for local properties, and often have close relationships with their borrowers. They are also experienced with complex cash flow forecasting and management. Even so, all banks need to take a proactive approach to managing CRE risk, especially now. Portfolio and loan-level stress tests assess the vulnerabilities in a specific portfolio and help lenders see the potential impact on an institution's capital. Without stress testing, it's harder for bankers to spot loans at risk and play a more active role in the lending relationship or in managing the portfolio..Q: Do you expect the CRE market in non-urban areas will remain strong in the coming months? You mentioned Abrigo does a look-ahead to help banks see loans that could be at risk. What is the look-ahead currently saying? Which community bank loan portfolios do you expect will be at risk in the near future? .A: "In recent years, many non-urban areas have experienced growth and increased demand for commercial properties because of their lower costs, the rise of remote work, and population shifts. These trends have led to a relatively strong CRE market in non-urban areas. However, economic uncertainty and high interest rates could tighten demand for commercial properties as well as lenders' appetite for CRE loans. They could also increase the risk that isolated CRE loans in a portfolio deteriorate. ."The community bank loan portfolios we see more at risk are those that have grown CRE lending dramatically in recent years without the same kind of attention to managing risk. That could be a bank understaffed for loan review or one still doing everything on paper, which makes it harder to track annual financials, review risk ratings, or even see where loans may be out of compliance or where concentration risk needs attention. In our role working with over 400 CFIs in the area of stress testing, we can see how many of these institutions have mature risk management programs, including stress testing analysis, to see the potential impact on the institution's capital if CRE deteriorates. Similarly, many FI examiners and advisors — including Abrigo — are helping these banks "peek around the corner" to see loans that might be at risk so bankers can play a more active role in the lending relationship." .Q: Fed Chair Jerome Powell recently said firms and banks with higher CRE considerations need "to have enough capital, enough liquidity and a plan to take the losses that are probably going to take place." Do you agree banks with higher CRE considerations will need to take those steps to prepare for the losses? Does that include community banks, in your opinion?.A: "I agree banks with higher CRE concentrations need to take precautions, including making sure their capital and liquidity are sufficient. Another important way institutions can manage CRE risk is to make sure they are accurately estimating their allowance for credit losses. We don't know where community banks' losses relative to CRE loans will shake out. But we surveyed close to 50 top executives at community financial institutions during one of our recent events to get their take. Half said they don't expect they'll need to increase loss provisions for the CRE loans on their books. Another 40 percent expect to maintain provisions for CRE. Remember, community banks have close ties to their local economies, giving them valuable insights into the health of the CRE market in their area. They're unique in that regard. ."Still, we know community banks should be mindful of potential risks and take appropriate steps to manage them. We know examiners are going to be looking closely at how banks do that. Overall, the main thing for banks, including community banks, is to prudently manage their CRE exposure and be prepared to address potential losses in a proactive and prudent manner.".Q: You mention many community financial institutions have mature risk management programs, with many already undertaking stress testing analysis to review the potential impact on capital if CRE deteriorates. What does a complete risk management program include? Do any banks not have such programs? If so, what steps should they undertake to have one? .A: "Many institutions have developed an enterprise risk management strategy inclusive of a number of risk monitoring activities. These activities are documented in their capital planning process, which includes liquidity and capital stress testing. For more commercial oriented portfolios, loan reviews and loan level stress testing provide additional analysis for the portfolio. Stress testing is key to CRE risk mitigation. Regulators have determined that institutions with 100% of total capital in loans tied to construction and development or total CRE loans of 300 percent or more risk-based capital should conduct an annual stress test. Even if an institution doesn't meet those thresholds for required stress testing, regulators increasingly expect lenders to manage CRE loan portfolios closely — especially those that have grown rapidly.."Most financial institutions use CRE stress testing, loan reviews, and the current expected credit loss (CECL) process for estimating the allowance to identify and quantify risks associated with CRE segments. If a bank was missing one of those pieces, they would be missing a lot of insight into the portfolio that could impact their bottom line. Aligning critical inputs and assumptions (such as prepayments and early withdrawals, average loan-life expectations, and forecasts) across these three processes as well as asset/liability management gives them the most holistic view to manage risk and inform capital planning, risk appetite, and strategy.. Q: Do you expect the recent downturn of New York Community Bank will have a broader impact on the banking industry? If so, how so? If not, why not? .A: "It's possible NYCB's struggles could affect investor and customer confidence in regional banks. We expect regulators will probably look closely at the factors that led to the bank's issues and are likely to scrutinize other banks with comparable portfolios. But on a more positive note, the NYCB downturn should prompt banks to reevaluate their lending practices and get on top of problem CRE loans. They don't necessarily need to become more conservative in their CRE lending in a way that affects borrowers and property developers — that will depend on their particular circumstances. But they should review their risk management practices, especially if they have higher CRE exposure, and make appropriate adjustments."