Keipper, Doug
(Doug Keipper is national risk manager of commercial real estate for North Hollywood, Calif.-based Banker’s Toolbox. The company provides software to help financial institutions improve risk management with anti-money laundering, fraud detection and commercial real estate portfolio analysis tools. He can be reached at 678-566-3114 or doug.keipper@bankerstoolbox.com.)

Red flags carry a very specific warning to swimmers--high surf and dangerous currents. Rip currents are not usually visible to the naked eye, but swimmers caught up in them can be quickly swept towards sea. However, swimmers who stay calm and know how to react are usually able to safely exit a rip current.

Commercial real estate  portfolios have external pressures and risks that also threaten to swamp lenders with bad debt and under-capitalized holdings. According to the Federal Deposit Insurance Corp.'s Fourth Quarter 2008 Quarterly Banking Profile, CRE prices fell by 15 percent in 2008, dropping prices to their 2005 levels. CRE segments such as office properties are also experiencing distress due to economic slowdowns resulting in the highest vacancy rates in nearly two decades.

Beware CRE Red Flags
There are red flags that warn lenders of potential trouble in a portfolio. Lenders can also forecast potential red flags by using CRE stress testing to predict how additional factors, such as the closing of a major employer or rising interest rates, will affect the portfolio in the future.

Lack of Proper Segmentation of Portfolio
Just as individual investors are taught to diversify their portfolios to mitigate risk, commercial lenders must do the same. A lender should have established limits on both the percentage of the total holdings CRE comprises, as well as guidelines for individual segments. Even properly managed portfolios can be very risky if the concentrations are too high in one segment.

One common mistake is failing to consider properties that are typically classified differently but are subject to similar market forces. For example, holdings dependent on tourism income can span traditional definitions of retail, office or housing. Hotels, restaurants, museums, golf courses and convention centers are subject to similar market forces.

Weak Local Market
Beware of a local CRE market described as weak or distressed. Market reports in weak areas will often refer to the CRE supply as over-saturated or excessive. Bankers should know the condition of the local market and be realistic about the movement in both supply and demand.

Ineffective Reporting
Every lender should have systems in place to provide clear reports outlining the health of the portfolio. Unclear reporting leads to poor decision-making and regulatory headaches. Clear reports should have CRE segmentation data, concentration reports by property type, borrower concentration reports and loan performance--both historical and projected based on stress testing.

High Number of Risky Loans
An institution’s lending policy should outline the very limited occasions when it is acceptable to underwrite a loan that is an exception to standard underwriting guidelines. When an institution permits an exception, the loan officer  should document how the transaction does not conform to the institution’s policy or underwriting standards and why the exception is in the best interest of the bank. Loan committee or board of director approval should be obtained before funding and documented in the minutes. 

Borrower Cash Flow Problems
Analyzing the collateral of a CRE loan by reviewing appraisals and requiring periodic inspections is paramount. However, lenders should also analyze borrowers. Cash flow is always critical and commercial lenders should obtain necessary financial information, at origination as well as throughout the term of the loan, to understand the borrower’s entire cash flow position.

Use Stress Tests to Locate Red Flags
CRE stress tests are different from a simple review and should not be confused with the Federal Reserve’s stress test of the nation’s largest institutions. CRE stress testing looks at the known characteristics of the loan and stresses the various factors to extreme levels.

Financial institutions frequently monitor loans for similarities among several criteria, including industry, cash flow source, collateral type and location. They should use stress testing to challenge the realistic worst-case scenarios for each external pressure. The results identify vulnerabilities and can prompt the implementation of mitigation strategies.

When analyzing your portfolio, stress testing can help you answer the following questions:

--How much can interest rates rise before cash flow problems are evident in variable rate loans?

--What is the break-even vacancy rate for cash flow?

--How will unemployment rates affect the borrower’s income?

--How will lower property values affect the loan-to-value ratio and refinancing requests?

The purpose of a red flag is to point out where the danger lies. Once identified, commercial lenders can take the steps needed to mitigate the risks. These strategies may include underwriting future loans with more rigorous standards, raising minimum capital levels beyond policy requirements or proactively refinancing loans before they are in trouble. Management can use the valuable input that stress testing can provide during the strategic planning process and when making future business decisions.

(The views expressed in this article do not necessarily reflect the views or policies of the Mortgage Bankers Association. MBA Commercial/Multifamily NewsLink welcomes your opinions. Submissions/inquiries should be sent to Michael Murray at mmurray@mortgagebankers.org.)