Managing CRE loan portfolio risk during volatile times

Regulatory agencies have sounded warnings about commercial real estate’s (CRE’s) growing risk exposure at credit unions. Exposure and concentration management are both areas of enhanced focus in current examinations.

On November 14, 2024, the chairman of the National Credit Union Administration (NCUA) issued a guidance letter to credit unions about concentration risk stating:

“I encourage credit union officials to understand the concentration risk in their credit union’s current balance sheet, as well as how strategic plans may affect the level of concentration risk; and to ensure their risk management practices are commensurate with the level of risk.”

This guidance letter referred to the previously published guidance on concentration risk from March 2010 which noted: “Excessive concentration risk can severely impact the financial condition of a credit union. High concentrations in areas experiencing severe economic distress could result in significant losses exceeding a credit union’s net worth. It is the fiduciary responsibility of management and officials of credit unions to identify, manage, monitor, and control the risks facing the credit union, including concentration risk. Examiners need to ascertain whether the board of directors and management understand and actively manage this risk. Credit union management should know what their concentration risk is and be able to demonstrate appropriate risk management and mitigation practices to minimize the risk of significant financial condition decline.”

Mitigating risk

What steps can your organization take to reduce risk? One of the first areas of review should be your existing CRE concentration policy and related monitoring. You may believe your policy is adequate for your institution as you have not experienced issues in your CRE portfolio. But you should ask yourselves this question: “Does the current policy and monitoring reflect the composition and risk therein of our CRE portfolio?”

What may have been sufficient in concentration monitoring in the past may no longer be so. Scrutinizing your CRE segmentation at the most granular level may be in order.

An example is many portfolios in larger metro areas benefit from subdividing the office — non-owner-occupied segment further into “Class A” space and “Class B and lower” space. A review of the composition of your CRE portfolio and the collateral that secures it is a prudent undertaking at this time. Also, be sure that your management information system (MIS) accurately captures your findings.

Re-pricing risk

Another area of concern in CRE lending is the credit risk from re-pricing. Many CRE loans were booked with structures that call for a re-pricing after a certain period of time, often five years. The significant rise in interest rates increases the risk of trouble when loans re-price. One tool that can assist you in examining your portfolio subject to re-pricing is to use the debt yield model. 

Debt yield is a measure of the leverage of the cash flow/net operating income (“NOI”). Debt yield is described in the Comptrollers Handbook — Real Estate Lending:

“Debt yield is the ratio of NOI to debt. It is calculated by dividing the NOI by the loan amount (typically senior debt only) with the quotient expressed as a percent. Debt yield provides a measurement of risk that is independent of the interest rate, amortization period, and capitalization rate. Lower debt yields indicate higher leverage. This measure can be especially useful during periods of low interest and capitalization rates where loan amounts established by using the DSCR and LTV ratio may be prudent only as long as the low rate environment is sustained. Debt yields that reflect normalized or higher-rate levels can be used to establish stressed loan amounts that are less vulnerable to higher-rate environments. Debt yield also permits banks or examiners to utilize a common metric to quickly size a loan or assess its relative risk.”

While the calculation is easy enough to make, what does the resulting percentage tell us? The Comptrollers Handbook states:

“While appropriate debt yields vary according to market conditions and property types, 10% is generally considered a minimum acceptable yield with higher yields recommended for riskier properties.”

The result of the debt yield calculation can quickly help you identify the loans most at risk of a problem in the current rate environment. The lower the debt yield, the more leveraged the property’s actual cash flow and the greater the risk.

How Wipfli can help

Amid rising concerns about how loan risk exposure may be threatening your credit union’s portfolio, Wipfli specialists are prepared to help. Our dedicated team of financial services professionals can work with you to improve your risk monitoring and response. In an uncertain environment, advisors you can trust make a big difference in helping you navigate volatility. Contact us today to get started.