Stress tests can guide CRE decision-making

Lenders, property owners, economists, and more have been holding their collective breaths when it comes to potential fallout from Covid-19 on commercial real estate. 

Following the previous real estate crisis, regulators placed additional scrutiny on lending practices. While some may have diligently continued the practice over the years, others relaxed their approach during “good times.” 

With so many unknowns, implementing clear internal parameters for CRE stress testing is warranted. You’ll need to consider this in the context of new loans, annual reviews and/or ongoing risk management.

Reconfigure CRE stress testing

Unlike the previous real estate crash, banks with concentrations in CRE are facing multiple stressors. It isn’t simply a change in valuation due to a burst bubble or over-speculation. For example, there may be a permanent reduction in demand for office spaces as remote work continues to be prevalent. Properties once thought to be fairly stable may now face fluctuations not previously considered.

“Depending on the bank’s market, the effect of Covid-19 may have had a longer-term impact on the borrower’s cash flow via rent reductions, deferrals and vacancies,” said Kyle Curtis, senior consultant at Young & Associates, Inc. “Stress scenarios may need to be more aggressive than pre-Covid, and the results may have more of a projected impact to capital.” Young & Associates, Inc., provides consulting to community financial institutions around CRE.

If your bank is looking to perform stress testing, either on a transactional or portfolio basis, you need to ensure that you have the right tools in place. First, you should determine what you are looking to measure with the testing scenarios, including reviewing regulatory guidance. Next, you’ll need to collect the necessary data to complete the test. Finally, you’ll want to ensure consistency and accuracy so that you can rely on the results to make decisions.

Transactional stress testing

Stress testing for a borrower’s property requires being able to input variables and seeing changes in output based on stressed values. While this could occur in spreadsheets, it would require collecting manual data entry, and building the input forms that would calculate proper outputs.

More efficiently, stress testing can be part of a loan portfolio management tool, where you store information about the borrower’s collateral and loans. In a portfolio management solution, tax return or rent roll data can be integrated into your test, eliminating the need for duplicate data entry.

In a transactional stress test, you should analyze the potential impacts of changes in capitalization rate, vacancy rate or interest rates. Don’t limit your stress tests to one scenario. For example, you may run one stress test with the borrower’s “current” loans against the subject property, another stress that includes a new proposed loan, and compare.

You may include your findings for transactional tests as part of a presentation to your loan committee for approval of a new loan, include them in an annual review, or both.

Portfolio stress testing

With portfolio stress testing, you are looking to identify potential losses, but completing such a test also plays an invaluable role in monitoring your risk. You’ll want to segment your portfolio into different types of commercial real estate, and then apply low-, medium- and high-stress scenarios to variables like changes in property values, net operating income and interest rates.

Collecting the data (collateral data, loan data, etc.) can be the most challenging part of this exercise. You’ll need to source data from its highest quality source, such as your core accounting solution or a loan portfolio management solution. Some scrubbing will likely be required, but if you consistently maintain your source data this can be a less tedious task.

Stress test results: What comes next?

Whether your situation requires CRE stress testing on an individual credit or at the portfolio level, or both, you should include commentary from a credit analyst, loan officer or risk management officer that explains the stressors and provides context to the results. 

The benefit of completing such tests is that the results can guide your bank’s decisions around extending credit, underwriting standards or strategic plans. While we hope that the impact on CRE is minimal, it is better to prepare and begin stress testing now.

 

 

Anna Burgess Yang is a regular contributing editor at BankBeat. She was formerly a product manager at a tech company.