commercial real estate stress testing - rma...

The RMA Journal November 200624

© 2006 by RMA. Mike Newett and Don Gilliam work for BankVision, Inc., a West Coast internal audit and consulting firm that offers various banking services.

Each has over 30 years’ prior regulatory experience with the FDIC.

The LoanPortfolioManagement

section of theComptroller’s Handbookof Loan PortfolioManagement (April 1998)states that in stress test-ing, a bank altersassumptions about oneor more financial, struc-

tural, or economic variablesto determine the potentialeffect on the performance ofa loan, concentration, orportfolio segment. Stress

testing for credit risk can beconducted on individualgroups of loans, concentra-tions, loans above certaindollar thresholds, or otherportfolio segments.Examples of commercialloan collateral are retail realestate, warehouses, andoffice buildings.

A common use of stresstesting is to subject variousassets and liabilities to hypo-thetical scenarios to deter-mine their exposure tochanges in interest rates.

Stress testing of commercial real estate portfolios

has become an even more important risk man-

agement tool, especially since interest rates have

begun to rise. Also, bank regulatory agencies have

sharpened their focus on the industry, particularly

for those banks with substantial concentrations.

This article examines the use of stress testing to

manage the credit risk process.

by M

ike

New

ett

and

Don

Gill

iam

Commercial Real Estate

CommercialReal Estate Stress Testing

The bank then adjusts thebase rates charged on itsloans in accordance withchanges to the base rateindex as stated in the respec-tive loan contracts.

Another use is to alterfinancial variables and assessthe resulting impact. Forexample, altering officespace rental rates or vacancypercentages affects thebuilding’s cash flow andcapactiy for debt-servicerepayment. By determiningthe rental rate at which aproject could no longer serv-ice its indebtedness, thebank can prevent adverseconsequences of unforeseenmarket changes.

Preparing for Stress TestingData. An adequate data-

base of loan information iskey to successful stress test-ing, and it is critical that thedata be appropriate, up-to-date, and accurate—both dur-ing the initial underwritingand at new loan bookingperiods. Although a time-consuming process, data col-lection is essential; other-wise, loan files may have tobe physically reviewed toextract the data needed tosupport the process.

Basic file informationneeded for stress testingincludes such items as theoriginal appraised value(including capitalization rateand date), projected income,original loan to value, anddebt-service coverage foreach loan to be tested.Updated operating incomeand current interest rate data

ensure even more meaningfulresults. Once compiled, the infor-mation should be validated andthen updated—semiannually orusing a time frame that coincideswith the next scheduled stress-testing date.

It’s up to management todecide which loans or loan groupsneed to be stressed. It’s useful toestablish a dollar threshold so thatimmaterial amounts or loans aboutto be paid off are not included inthe analysis. The test portfoliousually includes loans for office,warehouse/industrial, hotel, andapartments, as well as propertiesheld for investment or propertiesunder construction that will beconverted to mini-perm loans.

As shown in Table 1, requiredinformation includes, at minimum,the following:• Loan number or name.• Loan type. • Date of loan.• Original amount of loan.• Net operating income (most

recent available).• Date of last information on

net operating income.• Source of operating informa-

tion (appraisal/credit memo/actual).

• Appraised value.• Date of appraisal.• Capitalization rate from

appraisal.• Original loan to value. • Interest rate spread.• Basis of rate index. • Current interest rate.• Rate floor (if applicable).• Rate ceiling (if applicable).• Annual principal and interest

payments.• Original debt-service coverage. • Current loan balance.

25

C o m m e r c i a l R e a l E s t a t e

His

tori

cal D

ata

Loan

Num

ber

Loan

Type

Date

of L

oan

Amou

nt

Net O

pera

ting

Inco

me

(NOI

)

Date

of N

OI In

foSo

urce

of N

OI

Info

Appr

aise

d Va

lue

Date

of A

VCa

p Ra

te F

rom

AVOr

igin

al LT

VIn

t. Ra

te S

prea

dRa

te In

dex

Inte

rest

Rat

eAn

nual

P&

IOr

igin

al D

SC9/

30/2

006

Loan

Bal

ance

101

13/

25/2

004

1,80

0,00

020

7,90

03/

31/2

006

Cust

omer

Upda

te2,

575,

000

2/20

/200

47.

75%

70.0

0%1.

00%

Prim

e7.

75%

163,

151

1.25

x1,

705,

047

102

25/

20/2

003

2,40

0,00

028

7,40

012

/31/

2005

Fed.

Tax

Retu

rn3,

300,

000

4/15

/200

39.

50%

72.7

0%1.

00%

Prim

e7.

75%

217,

535

1.29

x2,

274,

506

103

39/

30/2

003

1,66

4,00

025

9,92

012

/31/

2005

Fed.

Tax

Retu

rn2,

736,

000

6/20

/200

59.

50%

60.0

0%1.

00%

Prim

e7.

75%

155,

893

1.66

x1,

121,

876

104

42/

10/2

004

2,23

0,00

024

9,28

86/

30/2

005

Cust

omer

Upda

te2,

750,

000

1/27

/200

49.

50%

81.0

0%Fi

xed

Fixe

d5.

50%

164,

330

1.35

x2,

134,

661

Tabl

e 1

This information could beadded to the loan trail using theformat just listed if columns areavailable, but each new loan andall its data entries must beentered separately. In the alterna-tive, the information can be com-piled on a separate spreadsheet tofacilitate the calculations for thestress tests using arithmetic for-mulas, which is how it’s done inthis article.

A review of the informationusually discloses which capitaliza-tion rates are inaccurate andwhich loan-to-value percentagesand debt-service-coverage ratiosare questionable. It is easier toaddress this information beforethe start of the stress-testing cal-culations, although some ques-tions may arise as the calculationsare completed. Follow-up on anysuspect initial data must occur inthis phase to ensure the integrityof computed data in subsequentcomputations.

The historical data providesthe foundation for these stress-test segments. The formats forthe various tables are coupledwith a historical data sheet foreach stress test.

Stress Tests 1-3: GeneralComments. Using MicrosoftExcel� formulas, the loan data isexpanded to include the effect ofincreases in interest rates,declines in net operating income(NOI), and changes in capitaliza-tion (cap) rates. • NOI can be defined as net

income of a given projectbefore depreciation and amor-tization, and it is a startingpoint to assess the ability ofthe project to repay its indebt-edness. NOI also may include

adequate reserves for repairs,tenant improvements, etc., thatare characteristic of the partic-ular projects being tested.

• Cap rates are the yieldsinvestors anticipate on com-parable investments, appliedto the NOI of the project.

• NOI divided by the cap ratecalculates a value in theincome approach used in theappraisal process. These definitions are over-

simplifications, but they providesome basic background for pur-poses of this discussion.

Management should decidethe degree to which adjustments/changes are made to base data forstressing purposes, using decisionfactors and levels that are consis-tent with the trends noted in thebank’s market. Outside factorsalso may be considered—forexample, anticipated decisionsrelating to interest rate adjust-ments likely to be made by theFederal Reserve. Once thesechanges and adjustments to NOIand other factors are decided,revised debt-service coverage(DSC) and loan-to-value (LTV)ratios are calculated.

DSC is the annual net operat-ing income divided by therequired annual principal andinterest payments expressed as afactor, with 1.00X being 100%.This rate can also show the lenderthe borrower’s ability to sustainadverse events, such as declinesin income, increases in rates, etc.LTV is the loan balance divided bythe appraised or market value andexpressed as a percentage. Thispercentage verifies the lender’sinvestment or risk in the projectcompared to the borrower.

The Stress-Test Examples 1-3#1: Increases in Interest

Rates. The most basic stress test,as shown in Figure 1, is for inter-est rate increases. Usually, thebase interest rate is increased by arealistic increment. Managementmust decide which increaseswould be appropriate for theirrespective institutions. Increasesof 1%, then 2%, and then 3%were used in this example. Theserate shocks, as they correlate tothe rate increases, could belabeled mild, moderate, and severe,respectively.

Input from individual loanaccount officers or additional credit-related information main-tained in the credit files could becritical to the analysis process. Forinstance, mitigating comments bythe account officer would addressany outside factors not evident inthe numeric calculation of therevised DSC. This might includestrength of guarantors, liquidity ofrelated companies or principals,expiring leases with anticipatedincreases in revised agreements,outside sources of income, andnew tenants occupying the space.Loans that exhibit calculatedweaknesses in the various testingprocess and that do not have sometype of mitigating support will beof greater concern to manage-ment. Testing results may dictatethat these credits receive greaterattention in the lending institu-tion’s overall credit administrationprocess.

An institution’s loan policyusually establishes the minimallyacceptable DSC. If the DSC ratiorequired in the loan policy is1.25X for a specific type of loan,with all other credit variablesremaining unchanged, interest


rate increases would likely nega-tively impact the actual ratio. Asloans fall below this coverageratio, there would still be enoughincome to service the debt if theDSC were at 1.00X or higher.However, when the DSC fallsbelow 1.00X, account officer com-ments or a review of the loan by acredit analyst or loan officerbecomes more critical. The analy-sis may highlight additional repay-ment sources or credit strength ofthe principals or guarantors.These could be documented asmitigating circumstances in a sep-arate document or abbreviated inthe Excel spreadsheet under“account officer comments.”Credit relationships with DSC

below 1.00X and without mitigat-ing information could be consid-ered for the internal “watch” listor other appropriate credit-moni-toring system.

Many institutions alreadyaddress this issue in their creditauthorizations and memorandums,forecasting the effect of a 1-or 2-percentage-point rate increase onrepayment coverage and, some-times, calculating how far rateshave to increase before the bor-rower reaches breakeven. In thisschedule, it is obvious that loan#101 has some potential debt cov-erage problems. Follow-up withthe respective loan officerrevealed that the DSC was mar-ginal going into the transaction

(assuming a policy requirement of1.25X or more), but the loan guar-antor’s financial position supportsthe credit through a strong networth, liquidity, and so on, thusreducing management concernsabout this specific test result. Ifthere are a significant number ofloans falling below 1.00X DSCwith a 3% rate increase, the policyrequirement of 1.25X may have tobe reconsidered.

#2: Decline in Net OperatingIncome. Another method of stresstesting is the effect on NOI gener-ated by the commercial real estateproperty. Declines in rental rates orincreasing vacancy percentageswould adversely affect NOI. InFigure 2, NOI is shown withdeclines of 5%, 10%, and 15%.NOI would be adjusted for thesechanges and a new DSC calculat-ed. The NOI shocks as they corre-late to the NOI changes could belabeled mild, moderate, and severe,respectively.

A new DSC below 1.00Xwould indicate inadequate cashflow from the property to servicethe debt if the borrower experi-ences significant income declines.Account officers may addressthese issues from file information.Also, this would allow manage-ment to address issues that mightbe resolved by working with theborrower. Borrowers without suffi-cient mitigating circumstanceswould be reviewed and could besubject to additional monitoring ora change in the loan grade.

Assuming a DSC requirementof 1.25X for these loan products,two credits (#101 and #102) fallbelow this requirement but stillhave DSC above 1.00X, providingmarginal coverage (1.08X and


Mild Increase

Loan NumberAmount of

IncreaseNew Interest Rate

New Prin. & Int. Pmts.

New DSC after 1% Increase

101 1% 8.75% $180,201 1.15

102 1% 8.75% $240,280 1.20

103 1% 8.75% $167,112 1.56

104 Fixed Fixed $164,330 1.52

Figure 1

Moderate Increase

Amount of Increase New Interest Rate New Prin. & Int. Pmts.New DSC after

2% Increase

2% 9.75% $197,252 1.05

2% 9.75% $263,025 1.09

2% 9.75% $178,331 1.46

Fixed Fixed $164,330 1.52

Severe Increase

Amount ofIncrease

New Interest RateNew Prin. & Int.

PmtsNew DSC after

3% IncreaseAccount Officer

Comments

3% 10.75% $214,302 0.97 Strong guarantor

3% 10.75% $285,770 1.01

3% 10.75% $189,549 1.37

Fixed Fixed $164,330 1.52

Stress Test #1—Increases in Interest Rates

1.12X, respectively). If there are asignificant number of these cred-its, they could be bundled into aninternal “watch” or similar catego-ry to be monitored more closely ifrental rates start falling.

#3: Changes in CollateralValues. Changes in interest ratesand declining net operatingincome may also translate into achange in the collateral value. Thisschedule, as seen in Figure 3, firstupdates the present NOI to thehistorical cap rate as shown in theappraisal. If cap rates are signifi-cantly different, the rate may haveto be adjusted to the current envi-ronment. Then the cap rates fromthe original appraisals or updates

are adjusted upward by 1%, then2%. New appraised values (AVs)are calculated and compared tothe current balance for a newLTV percentage. Original loandata would provide the startingpoint, including the originalappraised value and cap rate.

New LTVs in excess of100% would not indicate aninability to repay, but they dohighlight potential problems incollateral coverage. Higher LTVsresult in a reduced level of equi-ty in a particular collateral prop-erty, should collateral liquidationbecome necessary. Account offi-cers may be in the best positionto furnish additional informationthat may mitigate concerns overthe potential for declines inproperty values.

Two loans (#102 and #104)are approaching the 100% LTVthreshold in this test, but remainslightly below that level.Referring to the original informa-tion (Table 1, Historical Data),loan #102 had a 72.70% LTV, andloan #104 had an 81% LTV. If the

policy required a 75% LTV, loan#104 may have been an exceptionto policy and has not been amor-tized at an amount sufficient tobring it into compliance with poli-cy. The loan file and/or the accountofficer would be expected toaddress the relatively high LTVand potential mitigating circum-stances, if any. The test results alsoshow that in the case of these twoparticular loans, the collateralpotentially provides little equitysupport to the lending institutionin times of critical property-valuedepreciation.

Mild Shock, Moderate Shock, and Severe Shock Stress Tests

The three stress-test examplesin this article are interrelated inthe analysis of the commercial realestate portfolio. We now need totake this analysis a step further andcombine the results, because thesechanges usually work together andhave an influence on the DSC of agiven project and its value.

We start with the basic filedata, including the appraisedvalue, NOI, DSC, LTV, and caprate taken from the originalappraisal maintained on file. Thebasic data has already been identi-fied in Table 1 and calculated inFigures 1, 2, and 3. The historicaldata is then expanded to provide

29

C o m m e r c i a l R e a l E s t a t e S t r e s s Te s t i n g

Figure 2

Stress Test #2—Decline in

Net Operating Income

Mild Shock

Loan Number NOI Less 5% New DSC with 5% Less NOI

101 $197,505 1.21

102 $273,030 1.26

103 $246,924 1.58

104 236,824 1.44

Moderate Shock

NOI Less 10% New DSC with 10% Less NOI

$187,110 1.15

$258,660 1.19

$233,928 1.50

$224,359 1.37

Severe Shock

NOI Less 15% New DSC with 15% Less NOI

$176,715 1.08

$244,290 1.12

$220,932 1.42

$211,895 1.29

Figure 3

Stress Test #3—Changes in

Collateral Values

Mild Stress

Loan Number NOI Applied toHistorical CAP Rate New LTV

101 $2,682,581 63.56%

102 $3,025,263 75.18%

103 $2,736,00 41.00%

104 $2,624,084 81.35%

Moderate Stress

Cap RatePlus 1%

NOI Applied toCAP Rate Plus 1% New LTV

8.75% $2,376,000 71.76%

10.50% $2,737,143 83.10%

10.50% $2,475,429 45.32%

10.50% $2,374,171 89.91%

Severe Stress

Cap Rate Plus 2%

NOI Applied toCAP Rate Plus 2% New LTV

9.75% $2,132,308 79.96%

11.50% $2,499,130 91.01%

11.50% $2,260,174 49.64%

11.50% $2,167,722 98.48%

the data inputs for the MildShock, Moderate Shock, andSevere Shock stress tests that wenow are ready to discuss.

Mild shock summary. Themild shock shown in Table 2 sum-marizes the effects of a 1%increase in interest rates and a 5%drop in NOI, and it applies thoseeffects to the cap rate found inthe appraisal. The result is arevised DSC ratio and LTV per-centage.

A DSC below 1.00X and aLTV above 100% will many timesrelate to the same loan, and theseadditional comments may bebrought forward from Stress Tests1-3, if appropriate.

With a calculated decline invalue combined with potentialDSC below 1.00X, the outsidemitigating circumstances may needto be stronger and/or the loan mayrequire additional review.

The result of the mild shockon the four loan examples showsthat the credits can withstand thethree mild effects and retain ade-quate DSC to meet paymentrequirements and adequate LTVpercentages to provide collateralprotection. However, note thatloans #101 and #102 fall under the1.25X DSC policy requirementestablished by the lending institu-tion but still remain above 1.00Xcoverage. Loan-to-value percent-ages demonstrate sufficient value,with #104 moving to over 85%.

This is not surprising, given the81% historical LTV.

Moderate shock summary.The moderate shock shown inTable 3 summarizes the effects of a2% increase in interest rates and a10% decline in NOI, and then cal-culates the results with the histori-cal cap rate and that rate increasedby 1%. The resulting DSC andLTV ratios reflect these changes.

A DSC below 1.00X and anLTV above 100% will many timesrelate to the same loan, and theseadditional comments may bebrought forward from Stress Tests1-3. With a calculated decline invalue combined with potentialDSC below 1.00X, the outsidemitigating circumstances may

31

Moderate Shock

Moderate Interest Rate IncreaseIncrease of 2% in Interest Rates

Moderate NOI AdjustmentDecrease of 10% NOI Plus 2% Interest Increase

Moderate Change in Collateral ValueDecrease of 10% NOI Applied to CAP Rate Plus 1%

LoanNumber

Amount of Increase

New Int.Rate

New Prin &Int.

Payment

New DSCwith 1% Int.

IncreaseNOI Less 10% New DSC

NOI Less10%

Applied toHistoricalCap Rate

Cap RatePlus 1%

New NOIwith CAPRate Plus

1%

NewLTV

AccountOfficer

Comments

101 2.00% 9.75% 197,252 1.05 187,110 0.95 2,414,323 8.75% 2,138,400 79.74%Strong

guarantor

102 2.00% 9.75% 263,025 1.09 258,660 0.98 2,722,737 10.50% 2,463,429 92.33%Guarantor has

liquidity

103 2.00% 9.75% 178,331 1.46 233,928 1.31 2,462,400 10.50% 2,227,886 50.36%

104 Fixed Fixed 164,330 1.52 224,359 1.37 2,361,674 10.50% 2,136,752 99.90%

Table 3


Mild Shock

Mild Interest Rate IncreaseIncrease of 1% in Interest Rates

Mild NOI AdjustmentDecrease of 5% NOI Plus 1% Interest Increase

Mild Change in Collateral ValueDecrease of 5% NOI Applied to Historical CAP Rate

LoanNumber

Amount of Increase New Int. Rate New Prin & Int.

PaymentNew DSC with

1% Int. Increase NOI Less 5% New DSC New NOI withHistorical CAP Rate New LTV

101 1.00% 8.75% 180,201 1.15 197,505 1.10 2,548,452 66.91%

102 1.00% 8.75% 240,280 1.20 273,030 1.14 2,874,000 79.14%

103 1.00% 8.75% 167,112 1.56 246,924 1.48 2,599,200 43.16%

104 Fixed Fixed 164,330 1.52 236,824 1.44 2,492,884 85.63%

Table 2

need to be stronger or the impact-ed loans may require additionalreviews.

With a 2% interest rateincrease and NOI declining by10%, DSC ratios on #101 and#102 fall below 1.00X. While bothhave strong guarantors with suffi-cient liquidity, the LTV on #102moves to above 90%. Loan #104 isnear 100% LTV but still has suffi-cient DSC at 1.37x, aided by itsfixed interest rate.

Severe shock summary. Thesevere shock shown in Table 4summarizes the effects of a 3%increase in interest rates and a15% decline in NOI, and then cal-culates the results applied to thehistorical cap rate plus 2%. Theresulting DSC and LTV ratiosreflect these changes.

The calculation for adjustedAV less current loan balance rep-resents the amount of potentialexposure in the commercial realestate portfolio with the effects ofthe severe stress tests. This col-umn can be accumulated and 1)compared to the bank’s capitalaccounts, 2) included in the calcu-

lation of the allowance for loanand lease losses (ALLL), and 3)used in the review of creditadministration policies, includingconcentration limits as subse-quently discussed.

With a 3% interest rateincrease and 15% decline in NOI,the DSCs for loans #101 and #102fall to 0.82X and 0.85X, respec-tively. While strong guarantors aremitigating factors, their overallfinancial situation and liquiditymay have to be addressed in thefile or in subsequent transactions.With the decline in NOI andincrease in the cap rate, loans#102 and #104 have potentialexposure totaling $442,341. Whilenot a material item in itself, if thepotential exposure in the entireportfolio is material, managementmay want to reconsider DSCratios and LTV percentages cur-rently specified in the loan policy.The total effect on the commer-cial income-producing propertyportfolio could also be shownunder the narrative factors in theALLL as possibly requiring anadditional 0.25% to 0.50% incre-mental margin to address the

potential exposure.Analysis of potential decline

in appraised value. Anothermethod of reviewing commercialreal estate values for stress testingwould be to take the appraisedvalue of the project and observethe effects of declines in value, asshown in Table 5. Declines of10%, 15%, 25%, and 35%, forexample, could be applied to theoriginal appraised values of prop-erties serving as collateral forloans being tested. AdjustedLTVs could then be calculated.We would also supply the Excelsheet with the historical data andthe data inputs to test for declinesin appraised value.

Most loan policies require aregulatory lending margin (15-25%)in the property for the originalgranting of the loan, so few expo-sures in the adjusted values appearuntil the decline in property valuereaches 25-35%. Exceptions mightinclude non-real-estate additionalcollateral or workout loans. Therecould be other circumstances: Forexample, some credits could havelong lease-up periods or unfinishedtenant improvements that might


Severe Shock

Severe Interest Rate AdjustmentIncrease of 3%

Severe NOI AdjustmentDecrease of 15% NOI Plus 3.00% Rate Increase

Severe Change in Collateral ValueDecrease of 15% NOI Applied to CAP Rate Plus 2%

LoanNumber

Amountof

Increase

New Int.Rate

New Prin &Int. Payment

New DSCwith 3% Int.

IncreaseNOI Less 15% New DSC

NOI Less15% Appliedto Historical

Cap Rate

Cap RatePlus 2%

New NOIwith CAPRate Plus

2%

New LTVAdjusted AVLess Current

Loan Balance

101 3.00% 10.75% 214,302 0.97 176,715 0.82 2,280,194 9.75% 1,812,462 94.07%

102 3.00% 10.75% 285,770 1.01 244,290 0.85 2,571,474 11.50% 2,124,261 107.07% (150,245)

103 3.00% 10.75% 189,549 1.37 220,932 1.17 2,325,600 11.50% 1,921,148 58.40%

104 Fixed Fixed 164,330 1.52 211,895 1.29 2,230,472 11.50% 1,842,565 115.85% (292,096)

Potential Exposure (442,341)

Table 4

provide some mitigation. Thisexposure can be summarized andrelated to capital accounts and theALLL. In reality, a potentialdecline is not a default, and com-mercial properties are like otherassets held by investors/owners thatfluctuate over time through valueincreases and declines. The sum-mary of the potential declines rep-resents another view of the portfo-lio and analysis of the institution’sexposure.

The effects of declines in AVare not material in the first twodecline scenarios. A decline of10% or 15% has no effect due tothe policy requirements on theLTVs of the loans at origination.The effects start materializing atthe 25% decline on loan #104 dueto its historical (original) LTV,which was 81%. Other loansremain below 100% LTV,although #102 exceeds 90%. At a35% decline, loans #101 and #102also exceed 100% LTV, but thepotential exposure is limited.Another factor in this analysis maybe whether a credit is relativelynew and has not had much amor-tization. Loan #104 has morepotential exposure, due to its his-torical LTV. Management may

want to reconsider the LTV policyrequirements or redefine theparameters of an acceptableexception to policy, depending onthe volume of loans with LTVsexceeding 100%.

If the real estate market dete-riorated to this “severe stress”level, the exposure in these loansmight have to be recognized byaugmentation of capital accountsand/or additional allocations to theALLL. If foreclosures or reap-praisal of nonaccrual loans andother problematic loans produceda significant decline in appraisedvalues, those losses would likelyhave to be charged to earnings orcapital accounts.

Analyzing the Effect of Declines in Real Estate Development Lots or Construction Loans

Land, lots, and constructionloans: Analysis of potentialdecline in value. A schedule canbe constructed of funded con-struction loan commitments divid-ed into various categories, includ-ing residential lots, single-familyresidential homes, land, and retailbuildings. Table 6 provides anexample.

The amounts can be tested

for declines in value and theeffects on the institution’s capitalaccounts. For example, using a75% LTV guideline from the loanpolicy, the construction loans areassumed to be conforming to thisLTV policy. The construction loansegment could be subjected topotential declines in value begin-ning with 35%. We can assumethat it would take more than a25% decline in the market valueof the collateral before therewould be an effect, which wouldbe only the difference between25% and 35%, i.e., 10%. Thispotential decline in the construc-tion loan portfolio can be appliedto the institution’s capital accountsto measure the impact on a largeconstruction portfolio if the mar-ket value adjusts downward. • A 35% decline would have a

potential decline based on thestated policy LTVs of thecommitted amounts.

• A 40% decline would have apotential decline and a result-ing lower capital ratio afterdeducting potential exposure.

• A 50% decline would revealadditional potential exposurededucted from capitalaccounts.

33

AV Decline

LoanNumber

10%Decline inProperty

Value

10%Decline:Adjusted

LTV

AV Adjusted10% Less PrincipalBalance


Value

15%Decline inAdjusted

LTV

AV Adjusted15% LessPrincipalBalance


Value

25%Decline inAdjusted

LTV



Value

35% Declinein Adjusted

LTV


101 2,317,500 73.57% 2,188,750 77.90% 1,931,250 88.29% 1,673,750 101.87% (31,297)

102 2,970,000 76.58% 2,805,000 81.09% 2,475,000 91.90% 22,145,000 106.04% (129,506)

103 2,462,400 45.56% 2,325,600 48.24% 2,052,000 54.67% 1,778,400 63.08%

104 2,475,000 86.25% 2,337,500 91.32% 2,062,500 103.50% (72,161) 1,787,500 119.42% (347,161)

Potential Exposure (72,161) (507,964)

Table 5


A decline in value would beamplified by the volume of suchcommitted amounts in each cate-gory. The results of this analysiswould have to be considered infuture management decisions,understanding that it is unlikelythat all categories of constructionloans in all locations woulddecline in tandem.

While these adjustments seemsevere, this accentuates the needto understand risk and the levelthat board of directors will tolerate.If the bank is concentrated inundeveloped lots or another cate-gory, management may feel thatthis concentration should bereduced or offset by other unrelat-ed asset investments to betterdiversify the portfolio.

Correlation of real estateportfolio sectors. While specula-tive construction would obviouslyhold the most risk in a marketdownturn, all sectors of the realestate market would likely experi-ence some adjustment. For thisreason, stress testing is used on allmarket segments.

Most closely allied would bespeculative lot development loans

for residential real estate with thespeculative building of single-family residences (SFRs). A slow-down in speculative SFRs willimpact undeveloped or partiallydeveloped SFR lot inventory.

Another area would be specu-lative commercial real estate lotdevelopment. Any downturn inthe office, retail, warehouse, andrelated markets would affect thepartially developed or finished lotinventory for speculative commer-cial properties.

Management could calculateconcentrations of speculative andpre-sold SFRs and speculativeSFR lot inventory for a more real-istic assessment of this risk.

Stress Testing Income on Total LoansAnalysis of decline in inter-

est income/increase in loan lossprovisions: total loans. As seenin Table 7, several scenarios canbe compiled for the possibility ofa decline in interest income fromthe downturn in all loan sectors,along with a comparable percent-age increase in the provision forloan losses in the income state-ment. For example, the financial

information at the end of a quartercan be adjusted for a 10% declinein interest income coupled with a10% increase in the loan loss pro-vision. This would incorporate adecline in the overall portfolio,not just the CRE portion. Totalloan income could be reduced by15%, along with an increase inloan loss provisions of 15%.Additionally, a 25% reduction oftotal loan income would be cou-pled with an increase in loan lossprovisions.

A substantial increase in prob-lem assets would increase otherexpenses that follow these events(e.g., legal expenses, collectionscosts, etc.). However, this is gen-erally manageable without a largeincrease in other expenses in theshort term. The detrimentaleffects on net income will be evi-dent from the analysis of thisexample, which highlights theeffects of a substantial economicdecline in all loan areas.

The 10% decline in NII andother effects leave this examplewith positive income, althoughsubstantially decreased. A 15%decrease in NII and increase in


Land, Lots, and Construction Analysis of Potential Decline in Value (in 000s)

Description 9/30/2006Committed

LTVGuideline

35%Decline

40%Decline

50%Decline

Residential Lots $40,000 75% $4,000 $6,000 $10,000

SFRs 30,000 75% 3,000 4,500 7,500

Undeveloped Land 40,000 75% 4,000 6,000 10,000

Retail Construction 30,000 75% 3,000 4,500 7,500

Office Construction 10,000 75% 1,000 1,500 2,500

Totals $150,000 $15,000 $22,500 $37,500

Tier 1 Capital $35,000 $20,000 $12,500 ($2,500)

Adjusted Capital Ratio 8.75% 5.20% 3.31% Negative

Additional Capital Required for Restoration of 8% Tier 1 Capital $10,800 $17,700 $31,500

Table 6

35

LLP result in a small loss, increas-ing with the 25% decline in NIIand 25% increase in LLP withother minor adjustments.

Other Regulatory ConsiderationsReferences have been made

throughout this article to situationswhere several of the stress testshave resulted in the potentialneed to revisit certain credits froma credit risk perspective. This mayinvolve cases where extensiveincreased risks revealed by stress-es raise concerns about the overallcredit quality of such loans.Management then must ensurethat the bank has made adequateprovisions in the ALLL for suchpotential credit weaknesses.

Internal loan grading andALLL. Prudent banking entailsthe development and implemen-tation of a formal program foridentifying problem loans and/orthose exhibiting the potential tobecome problems. Banking regu-latory agencies expect financialinstitutions to establish their ownrespective internal risk manage-ment program that will incorpo-rate, at minimum, a risk-ratingprocess. In support of this pro-gram, banks normally adopt a for-

mal internal loan grading/ratingsystem to identify the degree ofproblems evident in the loan port-folio. As various influences comeinto play—in this case, externalevents created by adverse devel-opments resulting from a varietyof causes (interest rate increases,declines in property values,etc.)—banks must reassess thedegree of protection accorded bythe borrowers’ and guarantors’ability to repay and protectionprovided by equity in collateralproperties.

The results of the variousstress tests presented in this arti-cle can be incorporated into therisk management program as anadditional tool for identifyingpotential problems that maydevelop in the portfolio. Stresstests may show exceptions arisingfrom situations where projectedchanges will result in depressedLTVs (representing lower or lackof equity position) and lowerDSCs (indicating possible issueswith regard to the borrower’s abili-ty to repay). In these instances,credit officials must determinewhat the appropriate response willbe to these noted exceptions. Thestress-testing process itself pro-

vides one initial measure to betaken—that is, to follow up withthe appropriate credit officers todetermine if any mitigations areevident (strong guarantors, addi-tional non-real-estate collateral,etc). If not, then the next stepwould be to decide if a givenexception needs to be assigned areduced credit grade (as definedwithin that given bank’s internalcredit risk identification program)or otherwise listed for“watch/track closely” status. Inthe latter scenario, further consid-eration would be accorded thesecredits during the ALLL reviewperiod, as subsequentlyaddressed, which should occur onat least a quarterly basis.

Additionally, there must be aprocess to provide needed provi-sion expense contributions to thebank’s ALLL account to coveranticipated loan losses and to pro-vide a general reserve to supportrisk identified in the remainingloan portfolio. Financial institu-tion directors must certify theadequacy of the ALLL when fil-ing their reports of income/condi-tion with their respective agen-cies. In situations where adversetrends are noted (such as

Decline in Net Interest Income and Increase in Loan Loss Provisions in (000s)

Mild Decline Moderate Decline Severe Decline

AccountYTD Through

9/30/2006

10% Decline NII

10% Increase LLP

15% Decline NII

15% Increase LLP

25% Decline NII

25% Increase LLP

Total Interest Income $20,000 $18,000 $17,000 $15,000

Total Interest Expense (10,000) (10,000) (10,000) (10,000)

Loan Loss Provision (1,000) (1,100) (1,150) (1,250)

Noninterest income 2,000 2,000 2,000 2,000

Noninterest expense (6,000) (6,000) (6,000) (6,000)

Provision Income Tax (3,000) (2,700) (2,550) (2,250)

Net Income $2,000 $200 ($700) ($2,250)

Table 7


depressed real estate markets,which ultimately adversely affecta bank’s level of equity protectionor a borrower’s ability to generatesufficient cash flow for use inrepaying obligations) and thereare no mitigating circumstancesidentified, potential exists forrepayment problems. As men-tioned, there is potential for alower loan grade or an adverseclassification of the loan in casesof inadequate DSC and no miti-gating circumstances, especially ifthe borrower becomes past due orhas financial problems in otherprojects. These changes wouldalso have to be considered in theanalysis of the bank’s quarterlyreview of the ALLL. Additionally,the presence of large concentra-tions in any given loan category,especially in commercial realestate portfolios, must be factoredinto the analytical process.

Effect on earnings. In caseswhere increased reserve allocationsmust be provided to the ALLL,operating earnings will be impactedbecause loan loss provisions repre-sent an expense item; ultimately,equity capital will be affected as aresult of the loss of retained earn-ings used to fund the increasedreserve. As loan problems—or thelikelihood of loan problems—increase, the bank may need to addadditional equity support (by aug-menting capital). Each bank regu-latory agency has developed itsown set of regulatory standardswith regard to capital adequacy.Bank management should coordi-nate with its respective agencyshould the need for capital aug-mentation ever appear necessary.

Loan concentrations. Loanconcentrations result in cases

where a significantly large volumeof economically related assets (inthis case, real estate loans) in com-mon have been advanced or com-mitted. In general, loans in thesame specific economic cate-gories/types representing in excessof 100% of total equity capitalwould constitute a concentration.Credit administration practices andprocedures are of primary impor-tance when assessing stress testingand are addressed in various regu-latory publications. The JointRegulatory Agency Proposed Guidanceon Commercial Real Estate Lending,dated January 10, 2006, mentions anumber of considerations:• Underwriting procedures

should be formalized and spe-cific, with policy exceptionstracked.

• Loan concentrations shouldbe realistic and periodicallyevaluated in view of marketconditions.

• Studies of market conditionsshould be presented periodi-cally to the loan committee orboard of directors. Thesestudies should address mar-kets where the loan concen-trations or loan products pre-dominate.

• Loan officers should haveadequate experience in theirareas of responsibility.

• More complex appraisalsshould be adequatelyreviewed, and the reviewshould be documented.

• Values cited in appraisalsshould be monitored andperiodically reported to theloan committee, especially ifthey reflect material changesin pricing.

• Managements should beaware of their representation

in the market. Is the bankfinancing the majority of com-mercial real estate for a partic-ular segment, such as ware-houses or office buildings?The bank’s internal concen-tration is monitored by con-centration limits, and it ishelpful to note the level ofrisk in the external market.

• The analysis of the ALLLshould adequately address con-centrations and other factors,including the condition of realestate markets in which theinstitution lends.

SummaryBy using the tests and con-

sidering the issues presented inthis article, management shouldhave an overall idea about anypotential exposure in the portfo-lio and may want to address poli-cies regarding future credit deci-sions. In addition, the need forfurther review or monitoring ofcertain relationships will be evi-dent from the stress-testingprocess. The impact of the alloca-tion on the ALLL may need tobe considered and additionalamounts allocated. ❐

Contact Mike Newett or Don Gilliamby visiting www.bankvisioninc.com.



commercial real estate stress testing - rma...

Documents