Here's the Dirt on the OCC's Update of Its Commercial Real Estate Guidance

Introduction

Mark Twain admitted:?I’m in favor of progress; it’s change I don’t like.”?Well, whether you judge it to be progress or change, on March 29, 2022, The Office of the Comptroller of the Currency (OCC) issued version 2.0 of its "Commercial Real Estate Lending" booklet of the?Comptroller's Handbook. This booklet discusses risks and risk management practices associated with commercial real estate and provides examiners with a framework for evaluating commercial real estate (CRE) lending activities.

The updated booklet replaces version 1.1 of the booklet of the same title issued in January 2017. Also rescinded is OCC Bulletin 2013-19, "Commercial Real Estate Lending: Comptroller's Handbook Revisions and Rescissions," which had updated version 1.0 of the booklet in August 2013.?This latest "Commercial Real Estate Lending" booklet applies to the OCC's supervision of community banks, and “Banks" refers collectively to national banks, federal savings associations, and federal branches and agencies of foreign banking organizations engaged in commercial real estate lending.

The updated 2.0 version:

• reflects changes to laws and regulations since this booklet was last updated in 2017
• reflects OCC issuances published and rescinded since this booklet was last updated
• includes clarifying edits regarding supervisory guidance, sound risk management practices, and legal language.
• revises certain content for general clarity

The OCC’s booklet, “Commercial Real Estate Lending,” is used by OCC examiners in connection with their examination and supervision of national banks, federal savings associations (FSA), and federal branches and agencies of foreign banking organizations (collectively, banks). Each bank is different and may present specific risks and issues, so, examiners are expected to apply the information in this booklet consistent with each bank’s individual circumstances. When it is necessary to distinguish between them, national banks and FSAs and covered savings associations (CSA) are referred to separately.?

CRE lending comprises acquisition, development, and construction (ADC) lending and the financing of income producing real estate. Income-producing real estate comprises real estate held for lease to third parties and nonresidential real estate occupied by its owner or a related party. This booklet addresses the risks inherent in CRE lending, risks unique to specific CRE lending activities and property types, and prudent risk management. This booklet includes expanded examination procedures for examiners to use when a bank’s CRE lending activities. warrant review beyond the core assessments in the “Community Bank Supervision,” “Federal Branches and Agencies Supervision,” and “Large Bank Supervision” booklets of the Comptroller’s Handbook. This booklet also includes an internal control questionnaire and verification procedures to further support the supervision process.

Contents

?It is helpful to review the contents page of this update to get a sense of the breadth and depth, and major sections include:

·???????Authority and limits

·???????Property types and loan types

·???????Risks associated with CRE lending

·???????Management and board oversight

·???????Loan policies, underwriting standards, underwriting practices, and exceptions to policy

·???????Credit administration

·???????Risk-rating CRE loans

·???????Appraisals and evaluations

·???????Environmental risk management

·???????Workout and restructuring

·???????Concentration risk management

·???????Control systems—credit review, internal audit, and third party risk management

·???????Examination procedures

·???????Appendices

In subsequent parts of this summary, we will look at some of these sections in more detail, but after this list of the contents, the first section we will review is how this OCC update views the roles of credit review and internal audit:

Introduction.......................................................................................................................1 ??

???Overview........................................................................................................................ 1

Authority and limits...................................................................................................... 2

Equity Investments in Real Estate .......................................................................... 3

?Real Estate Lending Standards and Interagency Guidelines for Real Estate Lending …………………............................................................................................................... 4

CRE Industry, Property Types, and Loan Types............................................................ 4

Acquisition, Development, and Construction Loans...................................................... 5

Interest Reserves............................................................................................................. 7

Income-Producing CRE Loans................................................................................................................................... 9

?????????????????????????????High-Volatility CRE Loans ............................................................................................................................................. 9

Risks Associated With CRE Lending........................................................................... 10

Credit Risk ................................................................................................................... 11

Construction Issues........................................................................................................ 11

Market Conditions ............................................................................................... ?????????11

Concentration Risk........................................................................................................ 12

Regulatory Changes....................................................................................................... 12

Interest Rates.................................................................................................................. 12

Environmental Liability................................................................................................. 12

Interest Rate Risk........................................................................................................... 13

Liquidity Risk ................................................................................................... .. 13

Operational Risk ............................................................................................................ 14

Compliance Risk............................................................................................................. 15

Strategic Risk................................................................................... .............................. 15

Reputation Risk............................................................................................................... 16

Price Risk........................................................................................................................ 16

Risk Management ................................................................................................................17

Management and Board Oversight .................................................................................. 17

Strategic Planning ............................................................................................................ 17

Governance Structure........................... ................................................................... 18

Management and Board Reports....................................................................................... 18

Loan Policies..................................................................................................................... 19

Loan Portfolio Management Considerations..................................................................... 20

Underwriting Standards..................................................................................................... 21

Acquisition, Development, and Construction Policies...................................................... 22

Investor-Owned Residential Real Estate Lending Standards ........................................... 25

Supervisory Loan-to-Value Limits.................................................................................... 26

Excluded Transactions....................................................................................................... 27

Loans Exceeding Supervisory Loan-to-Value Ratio Limits.............................................. 28

Exceptions to General Lending Policy ............................................................................. 28

Underwriting Practices...................................................................................................... 29

Analysis of Borrower’s and Guarantor’s Financial Condition ......................................... 29

Underwriting Acquisition, Development, and Construction Loans.................................. 30

Construction Concerns...................................................................................................... 31

Evaluating the Developer Borrower ................................................................................ 32

Determining Project Feasibility ....................................................................................... 32

Collateral Valuation for Acquisition, Development, and Construction Loans ……….... 36

Underwriting Income-Producing CRE Loans.................................................................. 39

Loan Structure....................................................................................................................... 39

Covenants.............................................................................................................................. 41

Income-Generating Capacity of CRE................................................................................ 42

Debt-Service Coverage Ratio ........................................................................................... 43

Debt Yield.......................................................................................................................... 43

Value Analysis................................................................................................................... 43

Loan-to-Value Ratio ......................................................................................................... 44

Credit Administration ....................................................................................................... 44

Acquisition, Development, and Construction Credit Administration............................... 45

Monitoring Progress of Construction Projects.................................................................. 45

Disbursement Processes.................................................................................................... 48

Income-Producing Property Credit Administration.......................................................... 49

Investor-Owned Residential Real Estate .......................................................................... 50

File Documentation........................................................................................................... 51

Risk-Rating CRE Loans.................................................................................................... 53

Analyzing Repayment Capacity of the Borrower............................................................. 53

Evaluating Guarantees...................................................................................................... 54

Assessing Collateral Values.............................................................................................. 54

Other Considerations ....................................................................................................... 55

Risk-Rating Investor-Owned Residential Real Estate Loans .......................................... 57

Classification of CRE Loans............................................................................................ 57

Special Mention .................................................................................................................. 58

Substandard......................................................................................................................... 58

Doubtful ............................................................................................................................. 59

Loss.................................................................................................................................... 60

Appraisals and Evaluations............................................................................................ 60

Appraisal and Evaluation Program................................................................................ 63

Appraisal and Evaluation Reviews................................................................................ 64

Environmental Risk Management................................................................................. 65

Loan Workouts and Restructures....................................................................................... 68

Accrual Status................................................................................................................ 69

Troubled Debt Restructurings........................................................................................ 71

Allowance for Credit Losses............................................................................................. 71

Foreclosure........................................................................................................................ 71

Concentration Risk Management...................................................................................... 71

Key Elements for CRE Concentration Risk Management............................................ 73

Control Systems................................................................................................................ 73

Credit Risk Review....................................................................................................... 74

Internal Audit................................................................................................................ 74

Third-Party Risk Management..................................................................................... 75

Examination Procedures...................................................................................................76

Scope .......................................................................................................................................... 76

Quantity of Risk........................................................................................................... 79

Quality of Risk Management....................................................................................... 85

? Policies....................................................................................................................... 85

? Processes.................................................................................................................... 87

Personnel...................................................................................................................... 89

Control Systems........................................................................................................... 90

Conclusions ................................................................................................................. 92

Internal Control Questionnaire ................................................................................... 95

Verification Procedures.............................................................................................. 109

Appendixes......................................................................................................................111

Appendix A: Quantity of Credit Risk Indicators........................................................ 111

Appendix B: Quality of Credit Risk Management Indicators.....................................113

Appendix C: Supervisory Loan-to-Value Limits ...................................................... 116

Appendix D: Underwriting Considerations by Property Type................................... 119

Appendix E: Appraisal Review Worksheet................................................................ 132

Appendix F: Evaluation Review Worksheet .............................................................. 136

Appendix G: Glossary ............................................................................................... 137

Appendix H: Abbreviations........................................................................................ 143

References.......................................................................................................................144

Now that we have some sense of the update’s contents, let’s see what the OCC expects of credit review and of internal audit.

Roles of Credit Risk Review and Internal Audit

Credit Risk Review.?Periodic independent reviews should be conducted to verify the accuracy of ratings and the operational effectiveness of the bank’s risk-rating processes. Objective reviews of credit risk levels and risk-management processes are essential to effective portfolio management and provide senior management and the board with an objective, independent, and timely assessment of the overall quality of the CRE portfolio. Credit risk review is a key internal control and an element of the safety and soundness standards described in the “Interagency Guidelines Establishing Standards for Safety and Soundness” found in appendix A of 12 CFR 30. For more information, refer to the “Loan Portfolio Management” booklet of the Comptroller’s Handbook (national banks); OTS Examination Handbook section 201, “Overview: Lending Operations and Portfolio Risk Management” (FSAs); and OCC Bulletin 2020-50 (national banks and FSAs).

The heightened credit risks from loan concentrations make a credit risk review function even more critical in determining whether originations are consistent with the bank’s loan policy and accurately reflect the board’s stated risk appetite and strategic plan. The foundation of the bank’s credit risk review function is an effective, accurate, and timely risk rating system. Risk ratings should be objective, and appropriate for the types of CRE loans originated by the bank. If credit risk review processes have previously been determined to be effective for the bank and the findings are current, the examiners may use these processes during the examination process.

Internal Audit.??Internal audit objectively and independently reviews and evaluates CRE lending activities, including accounting systems, management reporting, and operations. Internal audit gives the board important information about the efficiency and effectiveness of credit risk management activities, specifically whether existing internal controls are sufficient and working as intended. Internal audit does this by

? evaluating the reliability, adequacy, and effectiveness of accounting, operating, and administrative controls.

? determining whether internal controls result in timely and accurate recording of transactions and safeguarding of assets.

? determining whether the bank complies with laws and regulations and whether personnel adhere to established bank policies, procedures, and processes.

? determining whether management is taking appropriate and timely steps to address current and prior control deficiencies and audit report recommendations.

? ensuring that audit activities are performed by a qualified person.

CRE lending audits typically focus on underwriting, disbursement, credit administration, workout activities, and ALLL or ACL processes. Most audit reviews include credit and loan documentation file samples to review specific transactions for adherence once policies and operating procedures are considered adequate. Many internal audit reviews also include the proper processing of cash disbursements, loan payoffs, and loan charge-offs. Internal audit also typically reviews and reconciles critical management reports, including testing the accuracy and timeliness of reports provided to the board and senior management.

As explained in the 2020 “Interagency Guidance on Credit Risk Review Systems,” the credit risk review function is expected to be independent of a bank’s internal audit function. Coordination of credit risk review with the internal audit function can facilitate the reporting of material risk and control issues to the audit committee, increase the overall effectiveness of these monitoring functions, better use available resources, and enhance the bank’s ability to comprehensively manage risk. Although there are advantages to coordination, an effective internal audit function maintains the ability to independently audit the credit risk review function.

Summary and Closing

In 1942, Winston Churchill reminded Britons:?Now this is not the end.?It is not even the beginning of the end.?But it is, perhaps, the end of the beginning.?CRE lending has rebounded from the Covid recession, and banks are dusting off their CRE policies and practices.?The OCC has done the same with this 2.0 update of its CRE lending, and this first part of this summary of the update notes that:

·???????The revisions are essentially updating the guidance since its last revisions in 2013 and 2017

·???????The table of contents provides an overview of the breadth and depth of the CRE Lending booklet

·???????The OCC expects credit review to be on the watch for concentrations and keep an eye on the risk rating system, and if credit review is doing its job satisfactorily, examiners may rely on credit review processes in conducting their own exams

·???????Internal audit focuses on ?processes such as disbursement, credit administration, workout activities and ALLL processes, and while credit review and audit may coordinate, OCC expects internal audit to be able to independently audit the credit review function.

Future parts of this summary will delve into other parts of this revised guidance:

·???????Authority and limits

·???????Property types and loan types

·???????Risks associated with CRE lending

·???????Management and board oversight

·???????Loan policies, underwriting standards, underwriting practices, and exceptions to policy

·???????Credit administration

·???????Risk-rating CRE loans

·???????Appraisals and evaluations

·???????Environmental risk management

·???????Workout and restructuring

·???????Concentration risk management

·???????Third party risk management

You will also find this summary of the OCC CRE Update and subsequent commentary on some its sections on Dicom Software's website at www.dicomsoftware.com because of its software support of bank loan review functions and the ubiquitous presence of real estate in bank portfolios. If you are curious about its other informational resources, don't be shy--contact Dicom’s SVP of Sales and Marketing, Jim Xander, at [email protected] or at 407-246-8060.?Remember Will Rogers’ advice to the shy: “Why not go out on a limb??That’s where the fruit is.”?What a peachy idea—contact us!