Managing CRE Portfolio Risk in a Downturn

The CRE Market Is Under Pressure

Tighter credit conditions, worsening income pressure, and elevated refinancing needs are creating headwinds in the CRE market, exacerbated by higher rates of withdrawals and costlier deposits at the regional and community banks that hold the lion's share of outstanding CRE loans. It’s not all bad news; while certain segments like office space seem particularly bleak, the outlook for other areas of CRE are not necessarily so gloomy, and some lenders may even find in this cycle an opportunity to get closer to customers and act as true partners in a time of hardship. That said, for many CRE-focused lenders, even a slightly elevated loss rate could be catastrophic; a granular understanding of existing portfolios and intentional management of risk strategies will be required for banks to navigate what will likely be a volatile year for CRE.

Over the past few weeks, the SEC released a number of letter exchanges with regional and community banks in which they expressed concern about the quality of reporting and level of insight those banks had into the health and concentration of their CRE portfolios. Key asks from the Commission centered on more granular reporting, with the aim of making it easier for investors to understand the exposure banks have by loan type, geography, occupancy and other crucial factors. Clear in the responses was that though the banks will work to comply, they in many cases lacked the data processing ability to report with the granularity that the SEC was requesting.

The bank regulatory agencies maintain a standard set of requirements and best practices for effective management of CRE portfolios. In the summer of 2023, the FDIC added to this guidance, including practical suggestions that centered on more robust portfolio monitoring and effective usage of stress testing. While much of this guidance is probably well known to CRE teams within banks, the fact remains that existing systems and processes are often not up to the task of delivering the type of ongoing monitoring and risk mitigation that will be necessary should CRE woes continue unabated.

In reading this guidance, we see several takeaways that we believe banks should be actively contemplating:

1.    Portfolio Management:

Effective portfolio management in CRE lending involves a comprehensive Management Information System (MIS) that measures, monitors, and controls CRE concentration risk. This system should provide detailed information on various aspects of the CRE portfolio, including loan segmentation, concentration limits, and performance. The cyclical nature of CRE markets necessitates dynamic management of concentration limits and exposure levels, particularly in response to changing market conditions. The importance of managing these risks is underscored in market downturns, where the costs of poor portfolio management can be exorbitant.

Key Takeaways:

• Implement a robust MIS to track and analyze CRE portfolio characteristics and risks, ensuring it captures detailed data for effective reporting and decision-making.
• Regularly adjust CRE concentration limits and lending strategies in response to market changes, using concrete numerical indicators to assess market risks.
• Prepare for the potential impact of market downturns, including increased resource allocation for loan collection and the possibility of foreclosure, while also considering the opportunity costs of holding non-earning assets.

2.    Portfolio Stress Testing:

‍Portfolio stress testing and sensitivity analysis are crucial tools for banks with CRE concentrations to evaluate and manage the potential impact of market downturns. These tools include transactional sensitivity analysis, stressed loss rate testing, scenario analysis, and ratings migration analysis. Each method offers insights into the bank's exposure and vulnerabilities in various market conditions, guiding strategic decisions to mitigate risks and prepare for potential downturns.

Key Takeaways:

• Conduct regular portfolio stress tests and sensitivity analyses, including evaluating assumptions such as absorption rates, sales prices, and loan variables.
• Use stressed loss rate testing to forecast the impact of market downturns on capital and earnings, adjusting historical loss rates based on current portfolio characteristics.
• Implement scenario analysis and ratings migration analysis to assess the impact of specific events or economic changes on the CRE portfolio, thereby informing adjustments to lending strategies and risk management practices.

3.    Market Monitoring & Analysis:

Diligent monitoring and analysis of individual CRE markets are vital for regional banks' success in CRE lending. This involves using various tools and data sources for market information, understanding the specific demands and conditions of different market segments, and integrating this analysis into a strategic lending approach. The process requires active communication and collaboration between risk management and lending staff to align with the bank's overall strategy.

Key Takeaways:

• Implement robust market monitoring tools, utilizing both external data sources for large markets and in-house knowledge for smaller markets.
• Establish a CRE risk management function to set concentration risk limits and oversee compliance, ensuring alignment with lending activities.
• Develop and communicate a clear lending strategy based on market analysis, utilizing tools like heat maps to guide lending decisions and manage risk exposure.

Partnering to Pave a Path Forward

Quality underwriting and effective risk management will always be critical for smaller banks, but in today's CRE environment, banks need to go further to ensure they have their arms around their portfolios and have the clarity and agility to manage potential losses well in advance of them becoming an existential problem for the institution. We recognize that this is, for many institutions, easier said than done. A complex patchwork of data providers, internal systems, legacy workflows, and organizational structures makes adopting a modern approach to CRE lending not only daunting but potentially impracticable in the near term without the right partners.

As CRE lenders look to shore up their capabilities in portfolio monitoring, scenario modeling and ongoing risk management, we feel strongly that Blooma should be front and center in those considerations. Canapi invested in Blooma in 2021, leading their Series A with the belief that their intelligent document parsing and intuitive data management engine would drive significant value for Alliance banks with heavy CRE concentrations. In addition to eliminating manual data entry and streamlining the originations process, Blooma’s Portfolio Intelligence suite delivers dynamic dashboards, stress testing, business intelligence, and prescriptive insights that give banks peace of mind and gives regulators confidence in their banks’ balance sheets.

Several Canapi Alliance banks are already working with Blooma and have seen up to an 85% decrease in origination times and up to four times reductions in overall costs to service their portfolios. Importantly, Blooma can be consumed via desktop or API, and integrates with existing data providers, loan management systems, and Excel workflows, so there is no lengthy implementation process or delayed time to value.

Our mission at Canapi has always been to help our bank partners identify and leverage the technologies that will help them succeed against a rapidly changing macro backdrop. For many banks, there is nothing more important today than getting a firm grasp on their CRE portfolios, and we would welcome the opportunity to help you do that with Blooma. If you would like to learn more or speak to the team, please do not hesitate to reach out.