Part 6: OCC CRE Update—Loan Policy and Underwriting Limits
Introduction: Barking Up the Wrong Tree?
Management author Pearl Zhu has observed, “The Board’s role is to pull management out of the trees to see the forest.” ?Getting lost in the woods and barking up the wrong tree are some of the risks in real estate that banks must mitigate, along with a number of other issues in real estate lending.?Moreover, bankers need to keep abreast of changes in the regulatory world and retrain as necessary, especially when the OCC updates its real estate guidance.?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 Also rescinded is OCC Bulletin 2013-19, "Commercial Real Estate Lending: Comptroller's Handbook Revisions and Rescissions," (https://occ.gov/publications-and-resources/publications/comptrollers-handbook/files/commercial-real-estate-lending/index-commercial-real-estate-lending.html )?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:
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.?A primary driver of this summary series has been to apprise bankers of its contents and to offer readers the opportunity to compare the contents with their own CRE lending policies, and his Part 5 review is of the OCC’s view of management and board oversight:
·???????Overview and role of credit risk review and internal audit (Part 1)
·???????Supervisory LTV limits (Part 2)
·???????Property types and loan types (Part 3)
·???????Risks associated with CRE lending (Part 4)
·???????Management and board oversight (Part 5)
·???????Loan policies, underwriting standards, underwriting practices, and exceptions to policy (Part 6)
·???????Credit administration
·???????Risk-rating CRE loans
·???????Appraisals and evaluations
·???????Environmental risk management
·???????Workout and restructuring
·???????Concentration risk management
·???????Third party risk management
Part 1 of this summary series provided an overview of the update as well as additional detail on roles of credit risk review and internal audit advising readers that the two functions should be independent but that internal audit still has the right to audit credit risk review.?Part 2’s emphasis was on supervisory loan-to-value (LTV) limits.?Both Mark Twain and Will Rogers advised that we should buy land because “they ain’t make any more of the stuff.”?The inevitable rise in land values has always been attractive, but after the real estate bubbles of the 1970’s and 1980’s, they drew their own lines in the dirt, and they have refreshed those lines in this update.?Part 3 continued the task of providing more details on specific sections, and the section under review in Part 3 is “property types and loan types:” Part 4 surveyed eight categories of risk that examiners expect banks to identify, manage, and monitor-- credit, interest rate, liquidity, operational, compliance, strategic, reputation, and price.?Part 5 examined regulatory expectations that the board’s role is to oversee the bank’s activities, provide credible challenge to management, and hold management accountable. This Part 6 highlights the OCC’s expectations for CRE lending policies, and this summary provides several bullet-pointed lists by which a bank can compare its CRE policy with the OCC recommended policy components.
Loan Policies
A bank’s loan policies should establish clear underwriting standards consistent with the types of CRE lending performed and should establish standards for sound loan structure such as tenor, amortization, guarantees, equity, and covenants that are within the risk parameters approved by the board and consistent with regulations. When evaluating the adequacy of CRE loan policies, examiners consider the:
?? nature and scope of the bank’s CRE lending activities
? size, complexity, condition, and risk profile of the portfolio
? quality of management and internal controls
? expertise and size of the lending and loan administration staff
? market condition
The regulations also require the bank to monitor conditions in the real estate market in its lending area to ensure that its real estate lending policies continue to be appropriate for current market conditions. In addition, the regulations specify that a bank’s real estate lending policy should reflect consideration of the “Interagency Ga real estate lending policy, including
? loan portfolio management considerations
? underwriting standards
?? LTV and supervisory loan-to-value (SLTV) limits
? exceptions to general lending policy
?? loan administration
Supervisory Loan-to-Values (SLTV’s)
Setting maximum CRE LTV’s at the supervisory loan-to-value (SLTV) limits is a practical approach because, first, the SLTV’s reflect the LTV’s that precipitated problem CRE loans back in the 1980’s, and second, using these SLTV’s as maximum policy LTV’s makes it easy to track excess SLTV exposures for reporting purposes.?In fact, while banks should establish their own internal CRE LTV limits, the OCC warns that these limits should not exceed the following supervisory limits or else the offending bank opens itself to “increased supervisory scrutiny” and actions that may include restrictions on acquisitions, new branches, etc.:
-Loan category SLTV limit (less than or equal to)
-Raw land ?????????????????????????????????????????????????????????????????????????????????????????????????????????????????65%
-Land development or improved lots ?????????????????????????????????????????????????????????????????75%
-Construction:
?????????????????????????????-Commercial, multifamily, and other nonresidential ?????????????????80%
????????????????????????????-One- to four-family residential ???????????????????????????????????????????????????????????????????85%
-Improved property:
?????????????????????????????-Commercial, multifamily, and other nonresidential?????????????????? 85%
????????????????????????????-Owner-occupied one- to four-family and home equity????????????????????? 90%
?An LTV limit has not been established for permanent mortgage or home equity loans on owner-occupied, one- to four-family residential property, but if any of these loans exceed an LTV ratio of ?90 percent or more at origination, the bank should require appropriate credit enhancement in the form of either mortgage insurance or readily marketable collateral. ?SLTV limits should be applied to the underlying property that collateralizes the loan. For loans that fund multiple phases of the same real estate project, e.g., a loan for both land development and construction of an office building, the appropriate LTV limit is the limit applicable to the final phase of the project funded by the loan; however, loan disbursements should not exceed actual development or construction outlays.
When a loan is fully cross-collateralized by two or more properties or secured by a collateral pool of two or more properties, the appropriate maximum loan amount under SLTV limits is the sum of the value of each property, less senior liens, multiplied by the appropriate LTV limit for each property. To ensure that collateral margins remain within the supervisory limits, lenders should recalculate whenever collateral substitutions are made to the collateral pool.
SLTV Capital Limits
The total amount of all loans in excess of the SLTV limits at origination should not exceed 100 percent of total capital. Further, the total loans for all commercial, agricultural, multifamily or other non-one- to-four-family residential properties should not exceed 30 percent of total capital. As mentioned earlier, a bank will come under increased supervisory scrutiny as the total of such loans approaches these levels. Loans that met SLTV limits at origination for which the collateral subsequently declined in value do not constitute SLTV exceptions and are not included in the calculation of the aggregate
Setting Internal LTV Limits
In establishing internal LTV limits, each lender is expected to carefully consider the bank-specific and market factors listed under “Loan Portfolio Management Considerations,” as well as any other relevant factors, such as the particular subcategory or type of loan. For any subcategory of loans that exhibits greater credit risk than the overall category, a lender should consider establishing an internal LTV limit for that subcategory that is lower than the limit for the overall category. The LTV ratio is only one of several pertinent credit factors to be considered when underwriting a real estate loan. Other credit factors to be considered are highlighted in the “Underwriting Standards” section. Because of these other factors, the establishment of these supervisory limits should not be interpreted to mean that loans at these levels will automatically be considered sound. LTV means the percentage or ratio that is derived at the time of loan origination by dividing an extension of credit by the total value of the property(ies) securing or being improved by the extension of credit plus the amount of any readily marketable collateral and other acceptable collateral that secures the extension. The total amount of all senior liens on or interests in such property(ies) should be included in determining the LTV ratio. When mortgage insurance or collateral is used in the calculation of LTV ratio, and such credit enhancement is later released or replaced, the LTV ratio should be recalculated. The LTV is calculated by dividing the loan amount by the market value28 of the property securing the loan plus the amount of any readily marketable collateral and other accept
Effective CRE lending policies generally reflect the following for each type of loan or property:
? Minimum standards for borrower or project net worth, support provided by guarantees (if applicable), borrower and guarantor cash flow, and debt-service coverage ratio (DSCR)
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? LTV limits by property type
?? Maximum loan tenor
? Minimum debt yield
?? Amortization criteria, including standards for the acceptability of and limits on non-amortizing loans
?For condominium and single-family residential projects that convert to rentals and tend to depreciate at an accelerated rate relative to owned units, amortization periods of less than 30 years generally would be reasonable. The determination of what is reasonable depends on an evaluation of the individual project. Some banks restructure these types of loans as mortgage loans in the developer’s name. Such developer loans should fit into those prudent underwriting parameters outlined in the bank’s loan policies:
? Pricing and profitability objectives
? Minimum standards of documentation consistent with the type of lending performed
Construction Loans
?For construction loans, effective construction risk management with disbursement controls confirming construction draws are commensurate with verified improvements and that the budget remains in balance with sufficient funds available to fund completion.
? Standards for evaluating borrower and guarantor creditworthiness and global financial condition, including
? assets (type, amount, and liquidity)
? global cash flow
? direct and contingent liabilities
? any tertiary repayment sources that may be available to a bank in the event of recourse
– minimum requirements for the borrower’s initial hard equity, e.g., cash or unencumbered investment in the underlying property
? Expectations for evaluating project feasibility and sensitivity to changes in economic conditions, including the sensitivity of projections to changes in market variables, such as interest rates, ???vacancy rates, and operating expenses
? Expectations for reviewing construction and site plans and construction budgets
? Deterioration or damage to improvements that may materially affect property value
? Standards for the acceptability of and limits on the use of interest reserves
?? Requirements and limits on interest-only loans for stabilized commercial real estate
? Preleasing requirements for income-producing property
? Presale and minimum release requirements for tract development financing
? Limits on partial and nonrecourse loans
? Requirements for takeout commitments
? Requirements for affirmative and negative loan covenants
? Requirements for borrower equity such as specifying the amounts required, the acceptable types and sources of equity, and the timing of the equity contribution
? Environmental risk management standards
Acquisition, Development, and Construction Policies
For development and construction projects, and completed commercial properties, the policy should establish, commensurate with the size and type of the project or property:
? requirements for feasibility studies and sensitivity and risk analyses, e.g., sensitivity of income projections to changes in economic variables such as interest rates, vacancy rates, or operating expenses
? minimum requirements for initial investment and maintenance of hard equity by the borrower, e.g., cash or unencumbered investment in the underlying property
? minimum standards for net worth, cash flow, and debt service coverage of the borrower or underlying property
? standards for the acceptability of and limits on non-amortizing loans
? standards for the acceptability of and limits on the use of interest reserves
? pre-leasing and pre-sale requirements for income-producing property
? pre-sale and minimum unit release requirements for non-income-producing property loans
? limits on partial recourse or nonrecourse loans and requirements for guarantor support
? requirements for takeout commitments
? minimum covenants for loan agreements.
The bank’s lending policy typically defines acceptable tenors for various types of construction loans. The appropriate tenor is generally based on the time needed for construction and stabilization or sale and would not be shorter than that required for completion. The bank may wish to provide construction financing that covers the expected construction period with the facility converting to bridge financing for the expected stabilization period. The lending policy may include extension options, but the length of the extension options should be consistent with the expected construction time plus the projected absorption period.
Appropriate covenants for construction or development loans may include
? a limit on the permissible number of speculative units and models for the subject property
? a limit on the number or dollar amount of unsold units including speculative units and models a builder may have for all projects at any one time, and for projects financed by the bank
? a limit on raw land inventory or the number of attached projects in progress at any one time
? limits on additional debts, guarantees, and liens
? the borrower’s or guarantor’s minimum liquidity, net worth, debt-to-worth ratios, etc.
? maximum distributions, or restrictions on distributions to partners or owners, before loan repayment
CRE Underwriting
Underwriting commercial real estate loans involves borrower/guarantor financial analysis, project feasibility, loan structuring, and collateral valuation. Fundamental to the process is the analysis of the borrower’s overall financial condition and resources, the financial responsibility of any guarantor, the nature and value of any underlying collateral, and the borrower’s capacity and willingness to repay as agreed. The bank should obtain appropriate financial information on the borrower(s) and guarantor(s), as applicable, including income, liquidity, cash flow, contingent liabilities, and other relevant information to support sound underwriting. Loan documents typically include covenants requiring the periodic submission of financial information that allows the bank to adequately monitor the borrower’s and guarantor’s overall financial soundness and capacity to support the credit. Underwriting includes determining whether the borrower demonstrates the capacity to meet a realistic repayment plan from available cash flow and liquidity. Cash flow from the underlying property or other indicators of borrower capacity is evaluated to determine whether, and to what extent, the borrower can adequately service interest and principal on a prospective loan request.
Exceptions to Policy
Examiners also should review lending policy exception reports to assess the frequency and nature of policy exceptions and to determine whether exceptions to the bank’s loan policy are adequately documented, approved, reported, and appropriate in light of relevant credit considerations. An excessive or significantly increasing number of exceptions to the CRE lending policy could indicate that the bank has relaxed its underwriting practices, needs to revise its loan policy, or that its policies are inconsistent with the board’s risk tolerance. The frequency and types of policy exceptions should be stratified to identify exceptions by loan officer, too.
Summary and Closing:?Know Your Risks
Clint Eastwood’s Dirty Harry warned, “A man’s got to know his limitations, so this Part 6 is aimed at targeting a bank’s CRE loan policy limits, especially the STLV’s.?A pragmatic approach would be to set CRE LTV maximums at the STLV levels so that LTV policy exceptions also capture the information needed for calculating and reporting the bank’s excess loans compliance with the 30% and 100% capital ratios.?Watch the trends in policy exceptions to determine if?lenders and approvers are adhering to policy, and if not, why—training need, market competition??Finally, if there are any other loan review issues or topics related to the OCC’s revised guidance that you would like to explore in more detail, please contact Dicom’s SVP of Sales and Marketing, Jim Xander, at [email protected] or at 407-246-8060.?As Dirty Harry suggested, “Go ahead, make my day,” and tune up your CRE loan policy.