Federal banking regulatory agencies acknowledge that financial institutions serve a vital role in their communities by supplying credit for business and real estate development. Recently, however, federal agencies also observed that commercial real estate concentrations have been rising over the past several years.

With concern for potential exposures and risks, a joint regulatory guidance on Concentrations in Commercial Real Estate (CRE) and Sound Risk Management Practices was issued in December 2006.

This guidance is a reminder to institutions that their risk management practices and capital levels should be commensurate with the level and nature of their CRE concentration risk. Although there are no hard limits on the amount of CRE lending institutions may conduct, common sense should always prevail.

As such, institutions that have significant CRE concentrations are expected to establish good risk management practices. In addition to regulatory expectations for sound loan underwriting policies and loan portfolio management, organizations should also have sound loan processes and procedures in place.

Standard procedures for every step along the way

Land development and construction loans are typically funded with staged advances to coincide with project events as they occur. As a result, CRE lending arrangements require experienced loan operations personnel along with specific risk management procedures.

For instance, institutions should have adequate processes and procedures in place to ensure sufficient funds are available to support projects to their completion. In addition, the right procedures can make certain that disbursements are properly made to the right parties involved in performing project work and to those providing project materials. This includes the practice of making certain that no mechanics liens are filed against properties.

Institutions must also exercise a number of prudent controls. Examples include the need for an inspection process and documentation on construction progress. Organizations should verify that project inspections conducted at the time of draw requests clearly demonstrate progress consistent with the payouts requested.

Equally important is the need for strong checks and balances between the lender and the disbursement control personnel.

A foundation of diligence

Although the manageable level of CRE concentration risk will vary by institution, organizations may need to take a closer look at their risk management systems. Institutions that are active in land development and construction loans should strongly consider a thorough loan processing review by a third-party expert. Doing so could prove valuable before the next regulatory examination.