Law & Accounting: Bank regulators’ enhanced scrutiny of loans may lead to credit crunch

An article by partner Lisa Shimel and associate Victoria Shupe of Bieging Shapiro & Barber LLP, appeared in the February 3, 2016 issue of the Colorado Real Estate Journal, “Bank regulators’ enhanced scrutiny of loans may lead to credit crunch.”

It is often said that those who choose to ignore history run the risk of seeing history repeat itself. That may be the case in 2016 as a result of a recent guidance given by federal bank regulators in late December of last year.

In a December 2015 joint statement, federal bank regulatory agencies advised financial institutions that bank examiners will be enhancing scrutiny on policies and procedures relating to commercial real estate lending and prudent risk management. Whether the December guidance is a storm warning signaling credit tightening as some believe occurred after a similar guidance was issued in December 2006 is yet to be seen, but forewarned is forearmed.

In December 2006, bank regulators issued guidance to commercial banks that required banks to review their CRE loan portfolios with an eye to their tolerance for risk and their ability to properly underwrite and manage those loans. The results were felt in the real estate industry when banks began to reduce their exposure to CRE loans and tightened credit standards for the loans they kept on their books. Developers saw banks focus more intently on loan-to-value ratios, cash flow absorption rates and other metrics associated with loan performance. Rollovers of existing credits became less assured and longtime relations were under strain.

The December 2015 guidance, Statement of Prudent Risk Management for Commercial Real Estate Lending (, is a reminder to banks of the earlier guidance and a signal of what the banks can expect from their regulators. If the past is prologue, it may serve as notice to real estate developers of a change on the horizon relating to available credit.

The premise of the December 2015 statement is observations by regulators of several “red flags.” Regulators specifically noted a 45 percent increase between 2011 and 2015 in multifamily loans, which comprise 17 percent of all CRE loans held by financial institutions, along with record-setting high prices for multifamily properties and record low capitalization rates. Easing of CRE underwriting standards, including an increased number of underwriting policy exceptions and insufficient monitoring of market conditions, also was discussed. While the regulator’s statement noted indicators of CRE market conditions and portfolio asset quality indicators do not currently indicate weakness in the quality of CRE loan portfolios, the regulators pointed out that financial institutions that have not historically weathered difficult economic times generally had high CRE credit concentrations with weak risk management. As a result, regulators are reminding financial institutions to establish loan policies, lending strategies, credit risk management practices and capital levels that adequately identify, measure, monitor and manage the risk arising from CRE lending activities.

As in 2007 and the years that followed, developers should be prepared to see more restrictive loan covenants, less opportunity for extended maturities, greater guarantor requirements and fewer exceptions to underwriting policies. Underwriting review of global cash flow analyses may be tightened up. Banks are likely to more carefully monitor and analyze potential for market volatility in the supply and demand for lots, retail and office space, and multifamily units and to place increased scrutiny on the reasonableness of valuation factors used to value commercial real estate, including rental rates, absorption periods and expenses. In conjunction with assessing the market, lenders will be assessing the ability of the project and the developer to service all debt ongoing as loans convert from interest-only to amortizing loans or during rises in interest rates. The regulators have warned that they will focus on banks with planned or recent substantial growth in the CRE arena, and those that operate in markets or loan segments with increasing growth or risk fundamentals. Developers should be aware of the increased regulatory scrutiny on such institutions and should not be surprised to see tightened credit standards and evaluations.

As the market continues to speed along, it is predictable that bank regulators will continue to vigilantly scrutinize and attempt to rein in commercial real estate lending to avoid a repeat of the 2007 credit crisis and the bank failures that occurred thereafter. Developers should be prepared to change strategies if credit tightens and have planned alternatives to projects or financing. Not only is the December 2015 statement a reminder to financial institutions, but also it should be a reminder to developers as well. History has taught the real estate and financial markets harsh lessons, and it is important that those involved in commercial real estate not only monitor the market but also continuously evaluate risk in investments and borrowing. Continued risk monitoring that includes risk in borrowing and ability to repay loans can assist in aligning goals with the credit markets. 