FRBSF Economic
Letter
2007-01; January 5, 2007
Concentrations in Commercial Real Estate Lending
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Commercial real estate (CRE), such as office towers,
shopping centers, and apartment buildings, makes up
approximately one-third of the total value of U.S.
real estate. Not surprisingly, CRE-related loans account
for a significant portion of total bank lending—about
22% as of 2005. Given its size and prominent role in
past episodes of large loan losses, CRE lending is
monitored closely by bank supervisors. Recently, the
federal banking regulatory agencies issued guidelines
regarding the management of risks arising from CRE
lending concentrations (Board of Governors 2006).
This Economic Letter examines the rise in CRE lending
concentration at commercial banks and the performance
of CRE loans since the early 1990s. The analysis
shows that while concentration in CRE lending has increased
substantially at many banks, for those banks with
CRE
concentrations, the subsequent performance of their
CRE loan portfolios, as well as their overall loan
portfolios, has not been notably different from other
banks. In terms of capital, CRE-concentrated banks
have slightly lower capital ratios, although they
also have exhibited higher capital growth rates. On
balance,
the evidence suggests that, in what has been a relatively
benign economic environment, banks focusing on CRE
lending have been as effective as other banks in
managing their lending risks. However, more analysis
is needed
to understand the differences in levels of capitalization.
Supervisory guidance on CRE lending concentrations
In December 2006, the federal banking regulatory
agencies issued new guidance on sound risk management
in response
to recent increases in CRE loan concentrations. The
guidance focuses on CRE loans for which cash flows
from the real estate are the primary source of repayment.
CRE loans are defined to include land development
and construction loans as well as loans secured by
multifamily
property or nonfarm nonresidential property where
the primary source of repayment is derived from rental
income or the proceeds of a sale or financing. Importantly,
the guidance does not apply to CRE loans for nonfarm
nonresidential properties where the primary source
of repayment comes from cash flows generated by the
borrower's business operations, since repayment of
these loans is less influenced by the general CRE market.
Although the guidance does not provide a formal definition
of CRE concentration, the agencies intend to use
two numerical criteria to begin identifying banks with
potential CRE concentration risk. The first criterion
is when total loans for construction, development,
and other land exceed 100% of total risk-weighted
capital.
The second criterion is two-pronged: when total CRE
lending—defined as loans secured by multifamily
and nonfarm nonresidential properties, CRE-related
commercial
loans, and loans identified under the first criterion—exceeds
300% of total risk-weighted capital, and when the
CRE loan portfolio has grown by more than 50% over
the
prior 36 months. The agencies also intend to consider
other factors in evaluating CRE concentrations, such
as the geographic dispersion of the loans. Banks
with CRE concentrations are reminded that their risk
management
practices and capital levels should be commensurate
with the level and nature of their lending risks.
Historical analysis of CRE concentration
The historical analysis of CRE concentration is based
on annual bank-level data on total CRE lending (i.e.,
the second criterion) from year-end regulatory reports
filed in 1991 through 2005. The number of banks exceeding
the 300% threshold was 531 in 1991, accounting for
about 5% of banks and 21% of bank CRE lending. In
2005, 2,177 banks exceeded the threshold, encompassing
29%
of banks and 44% of bank CRE lending.
 To examine the activities of individual banks, the
distributions of total CRE concentration ratios across
all reporting banks were calculated. Figure 1 summarizes
these annual distributions using three percentiles.
The median value, which is representative of the
typical bank, has risen steadily from 70% in 1991 to
180% in
2005. Note that the distance between the 25th and
the 75th percentiles, has expanded greatly from 125
percentage
points in 1991 to 264 percentage points in 2005.
This increased dispersion among banks is due mainly
to sharp
increases in CRE lending by banks that already had
relatively large CRE portfolios.
Measuring the effects of CRE concentration
Policy concerns about high CRE lending concentrations
are based in part on historical precedent. For example,
the percentage of aggregate bank CRE lending that is
nonperforming averaged about 6% from 1984 to 1988 and
then rose dramatically to 14% in 1990. These CRE loan
losses adversely affected the performance and capital
levels of many banks, which, combined with changes
in capital regulation, helped to precipitate the bank "credit
crunch" of the early 1990s. This percentage declined
to 6% in 1993 and continued to decline through 2000.
Since then, it has averaged 1.5%. The early 1990s episode
has raised general concerns about the overall riskiness
of CRE lending and the CRE concentrations observed
recently, although changes in economic conditions,
bank risk management and supervisory practices over
the past decade should have lessened these concerns.
To determine the effect of CRE concentration on banks
since 1991, certain measures of bank performance
were examined over a period of five years after bank-level
CRE concentrations were identified. Focusing on banks
with more than five years of available data, the
analysis
here uses the top decile of banks based on the CRE
concentration ratio for each year in the sample period.
For 1991, the sample consists of 944 banks making
up 33% of aggregate CRE lending, while for 2005, 735
banks
making up 18% of CRE lending are included. About
95% of these banks have less than $1 billion in assets.
The mechanism used to perform the analysis is to
compare the rank ordering of the concentrated CRE banks
in
certain performance categories to the rank ordering
of all banks. In particular, I examine whether CRE-concentrated
banks tend to have high CRE nonperforming loan (NPL)
growth rate rankings in the years ahead. The empirical
results show that for all five years after a bank's
CRE concentration is identified, only about 25% of
the CRE-concentrated banks have CRE NPL growth rates
higher than the median bank. These results suggest
that most banks with CRE concentrations have experienced
relatively low CRE NPL growth up to five years after
the CRE concentration was identified. A similar result
was found for their overall NPL growth.
Capital positions provide a way to assess bank performance
that can shed light on the impact of risk-management
practices. The ranking analysis was conducted on
banks' total risk-based capital ratios, the broadest
measure
of capital adequacy. The median capital ratio for
all banks is relatively high at 14.7%, much above the
10%
threshold for well-capitalized banks under federal
requirements. The median ratio for CRE-concentrated
banks is lower at 11.5% for up to five years hence.
In contrast, the ranking analysis shows that risk-based
capital at CRE-concentrated banks grew more rapidly
than at the median bank; roughly 75% of them had
higher capital growth rates than the median bank for
up to
five years ahead. These results suggest that CRE-concentrated
banks have been increasing their capital actively,
albeit from lower levels and probably in part due
to their concentration risks.
Conclusion
This Economic Letter examines the historical behavior
of banks with CRE concentrations. These banks were
shown to have slightly lower CRE NPL growth rates
than a typical bank and to have grown their risk-based
capital
at a faster rate. A possible explanation for these
performance results is that most CRE-concentrated
banks have managed these exposures prudently over the
sample
period. However, the relatively favorable economic
conditions prevalent during much of the period could
overstate the success of their risk-management practices. Jose A. Lopez
Senior Economist
Reference
Board of Governors of the Federal Reserve System,
Joint Press Release, December 6, 2006. "Concentrations
in Commercial Real Estate Lending, Sound Management
Practices."
Opinions expressed in this newsletter do not necessarily
reflect the views of the management of the Federal
Reserve Bank of San Francisco or of the Board of
Governors of the Federal Reserve System. Comments?
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