Early Risk Identifiers and Adverse Trends with CRE Loans


There is no doubt that Commercial Real Estate is getting hit hard in this recession.  High unemployment rate, reduced long-term consumer confidence, and declining GDP are just a few adverse trends that effect CRE.   The purpose of this article is to help identify portfolio risks as well as risks with a specific loans.  With the goal of assisting you in preparing for better or worst conditions to come.

We’ll be discussing the data to capture, how to view this data, and end with a sampling of Risk Factors that can be applied to individual loans.

The Data

A risk can be as easy to recognize as a “past due” payment, or be as subtle as a price to earnings ratio change.  In this vast black and white to murky grey spectrum, the most subtle, can be the must useful, in helping to plan for the worst-case scenario and eventually to the best conditions.  With that said, CRE concentration data that is good, accurate, and verifiable is crucial in identifying risk and using this information to better protect and manage your portfolio.

Data Elements

There are five basic loan data elements; they are Disposition, Characteristics, Values, Time and Environment.  All five are related and interdependent to each other and as such, need to be viewed as a five-dimensional matrix (see Figure 1).

The following is a list of the parts within each element:

  1. Disposition
    1. Risk Ratings
    2. Past Dues / Delinquencies
    3. Charge-Offs
    4. Non-Accruals
    5. Loan-to-Value
    6. Debt Service Coverage Ratio
  2. Characteristics
    1. Market (Geographic)
      1. Localized
      2. Regional
    2. Product:
      1. Construction, land development, and other land loans
      2. Loans secured by multifamily (5 or more) residential properties
      3. Loans secured by non-farm nonresidential properties
    3. Borrower Type:
      1. Individual(s)
      2. Partnership
      3. Corporation
      4. REIT
    4. Property Characteristics:
      1. Property type
      2. Property location
      3. Property size
      4. Property age
      5. Percent Occupancy
      6. Tenants (Who, Square Footage, Industry and Rates)
    5. Contractual/Facility Characteristics:
      1. Lien position
      2. Recourse / Non-Recourse
      3. Purpose
      4. Geography
      5. Collateral
      6. Industry
      7. Vintage
      8. Deal Size
  3. Values
    1. Currency Volumes
    2. Number of Loans
    3. Percentages of Portfolio Mix
  4. Time
    1. Loan Date
    2. Maturity Date
    3. Periods (Monthly, Quarterly, Annually)
  5. Environment
    1. Economy
      1. Unemployment
      2. GDP
      3. Consumer Confidence
    2. Political
      1. Taxes
      2. Government Spending
    3. Natural
      1. Weather
      2. Geological

Management Information Systems

To view, manipulate, and manage this data your MIS needs to allow for easy-of-use report writing and data retrieval mechanism.  As simple as it sounds, information systems may have difficulty in delivering the accurate information, reporting capability, or capturing the appropriate data needed for analysis.  Because of this, the validity of the CRE data is often overlooked or the data is buried away.

We strongly recommend a relational database reporting system in which all these data elements can be systematically validated, and “scrubbed” clean before any risk analysis of your portfolio begins.

Identifying Risk

Armed with clean and accurate data in a flexible database reporting environment, analyzing your portfolio and/or performing individual loan sensitivity tests can now be started.

Build reports that identify concentrations and diversification within these data elements.  This is done by stratifying your portfolio into segments with common risk characteristics or sensitive to similar factors.

Simple Example

The numbers of CRE loan delinquencies are rising.  You may want to stratify (group) by geographic markets, industries, and products.  By looking at each group you may be able to determine a trend or “hot” spot that you will want to either further investigate or prepare for what the trend is indicating.  Figure 2 below shows three overly simplified reports of a 19-loan portfolio (of which 7 are delinquent).

If we just looked at the first report by Product we could assume that it is our Construction loans that are causing the problem. But, looking at the Markets we might think that it is Orange County.  However, looking at it by Industry we see that Office space is what is really causing the vast majority of the Delinquent loans (at 83% of all Office loans are delinquent).

Now if you can take this example one step further and plot this data over time you might see a whole new picture.  Even better, plot these results over time compared with appropriate economic indicators in the same period; and now you will be able to project out what your portfolio may look like in the future with estimated environmental changes.

Risk Factors

A Risk Factor is a condition or logical circumstance that would indicate an individual loan as being at risk (rather than your portfolio).  In the simple example above the Risk Factor were loans in which the borrowers were delinquent in their payments.  There are a multitude of possible risk factors that could be used to flag loans and then use this information to stratify those loans to see trends or concentrations of problems.  An integrated information system should be flexible enough to provide for establishing such risk factors and easily tracking them.

As a starting point for you to create your own group of risk factors, here is a list of a few to begin with (obviously changing values to meet your own criteria):

  1. Delinquent: Last payment by borrower > than 45 days
  2. Lateness: Average days between date due and date paid > than 10 days
  3. Vacancy: Property Vacancy Rate > than 15%
  4. Builder: The Builder on the Project = The Borrower
  5. LTV: Loan / Appraised Value > 80%
  6. Single Tenant: Tenant occupied Square Footage = Complex Square Footage
  7. Legal Action: Lien (or law suite) filed on property = yes
  8. Interest Reserve: Months Left of Interest Reserve < Months left to Maturity
  9. DSCR: Debt Service Coverage Ratio < 1.10
  10. Construction Draw: Last Hard Cost Draw > 32 days ago