1. Commercial Real Estate Guidance Barbara Falstad Minneapolis Field Office

2. Topics CRE Loans Red flags in CRE Lending CRE Classification Guidelines Part 365 FDIC Rules and Regulations FIL-104-2006 Interagency Guidance on CRE RD Memo 2007-013 Frequently Asked Questions FIL-22-2008 Managing CRE Concentrations in a Challenging Environment Application of Guidance

3. What Are CRE Loans? Land development and construction loans (including 1 to 4-family residential and commercial construction loans) and other land loans Loans secured by multifamily property and non-farm nonresidential property where the primary source of repayment is derived from rental income (50% or more of the source of repayment comes from third party, nonaffiliated, rental income) or the proceeds of the sale, refinancing, or permanent financing of the property Call Reports changed effective 3/31/07 to designate between owner occupied and non-owner occupied

4. What Are CRE Loans? (cont.) CRE loans also include: – loans to Real Estate Investment Trusts (REITs) – unsecured loans to developers BUT exclude loans secured by non-farm, non-residential properties that are owner- occupied

5. Residential Construction Loans Borrower files should include the following documentation: Loan agreement showing a predetermined limit on the number of unsold units to be financed at any one time to avoid overextending the contractor's capacity. Disbursements based on progress payment plans and inspection reports. Periodic inspections during the course of construction; inspections should be by independent party (not the loan officer). Periodic progress reports (summary of inventory lists maintained for each tract project) on the entire project. Inventory list showing each lot number, type of structure, release price, sales price, and loan balance. Current financial information maintained on the builder and any guarantors (should be required by the loan agreement)

6. Important Factors to Remember Exposure in any type of construction lending is that the full value of the collateral does not exist at the time the loan is granted. Bank must ensure funds are used properly to complete construction or development of the property serving as collateral. If default occurs, the bank must be in a position to either complete the project or to salvage its construction advances. Various mechanic's and supplier’s liens, tax liens, and other judgments will likely arise. There should be a requirement that curtailment or amortization should occur if property does not sell according to loan agreement.

7. CRE Red Flags Real estate markets or projects that are experiencing problems – may result in real estate values decreasing from original appraisals or projections Adverse economic developments and/or an overbuilt market – can cause real estate projects and loans to become troubled Inappropriate use of interest reserve – E.g., beyond construction and normal holding period

8. CRE Red Flags (cont.) Extensions or renewals without collection of interest – can inflate income and hide a problem credit Diversion of funds to other projects – could mask cash flow problems (may require tracing of loan proceeds) Borrower’s financial statement indicates borrowings at multiple financial institutions.

9. CRE Red Flags (cont.) Signs of troubled real estate markets or projects include, but are not limited to: Rent concessions or sales discounts resulting in cash flow below the level projected in the original appraisal. Changes in concept or plan: e.g., a condominium project converting to an apartment project. Construction delays resulting in cost overruns which may require renegotiation of loan terms.

10. CRE Red Flags (cont.) Slow leasing or lack of sustained sales activity and/or increasing cancellations which may result in protracted repayment or default. Lack of any sound feasibility study or analysis. Periodic construction draws which exceed the amount needed to cover construction costs and related overhead expenses. Identified problem credits, past due and non accrual loans. For additional red flags, see FDIC Supervisory Insights article – (Vol. 5, Issue 1 – “A Primer on the Use of Interest Reserves”).

11. Classification Guidelines Found in the Manual under “Troubled Commercial Real Estate Loan Classification Guidelines” Additional classification guidelines have been developed to aid the examiner in classifying troubled commercial real estate loans. The guidelines are to be applied in instances where the obligor is devoid of other reliable means of repayment, with support of the debt provided solely by the project. If other types of collateral or other sources of repayment exist, the project should be evaluated in light of these mitigating factors.

12. Substandard Any such troubled real estate loan or portion thereof should be classified Substandard when well defined weaknesses are present which jeopardize the orderly liquidation of the debt, including:  project's lack of marketability  inadequate cash flow or collateral support  failure to complete construction on time  project’s failure to fulfill economic expectations. Weaknesses are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.

13. Doubtful All the weaknesses inherent in those classified Substandard, plus: The weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable. A Doubtful classification may be appropriate in cases where significant risk exposures are perceived, but Loss cannot be determined because of specific reasonable pending factors which may strengthen the credit in the near term. Examiners should attempt to identify Loss in the credit where possible thereby limiting the excessive use of the Doubtful classification.

14. Loss Advances in excess of calculated current fair value which are considered uncollectible and do not warrant continuance as bankable assets. There is little or no prospect for near- term improvement and no realistic strengthening action of significance pending.

15. Part 365 - Real Estate Lending Standards Appendix A to Part 365 – Guidelines It is important to distinguish between the regulation and the guidelines: The guidelines are not part of the regulation. When an apparent violation of Part 365 is identified, it should be listed in the Report of Examination in the same manner as other apparent violations. When an examiner determines that an institution is not in conformance with the guidelines and the deficiency is a safety and soundness concern, it should be listed in the examination report as a contravention of interagency guidelines, not a violation of the regulation.

16. Regulations vs. Guidelines Example: 100% aggregate limit of loans in excess of supervisory LTV limits… If bank doesn’t have documented limits – could be a violation If bank has documented limits, but exceptions exceed 100% of capital – could be a contravention.

17. 2006 Guidance RD Memo 2006-038 (12/15/06) FIL 104-2006 (12/12/06) Interagency Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices Purpose This guidance was developed to remind institutions that strong risk management practices and appropriate levels of capital are essential elements of a sound CRE lending program, particularly when an institution has a concentration in commercial real estate (CRE) loans.

18. Scope The Guidance focuses on those CRE loans for which the cash flow from the real estate is the primary source of repayment rather than loans to a borrower for which real estate collateral is taken as a secondary source of repayment or through an abundance of caution.

19. CRE Concentration Assessments The Guidance does not establish a CRE concentration limit that applies to all institutions. The Guidance encourages institutions to identify and monitor credit concentrations, establish internal concentration limits, and report all concentrations to management and the board of directors on a periodic basis.

20. Risk Management Institutions should address the following key elements in establishing a risk management framework that effectively identifies, monitors, and controls CRE concentration risk: Board and management oversight Portfolio management Management information systems Market analysis Credit underwriting standards Portfolio stress testing and sensitivity analysis Credit risk review function FIL 104-2006 discusses each one of these elements in detail.

21. Supervisory Oversight As part of their ongoing supervisory monitoring processes, the Agencies will use certain criteria to identify institutions that are potentially exposed to significant CRE concentration risk. An institution that has experienced rapid growth in CRE lending, has notable exposure to a specific type of CRE, or is approaching or exceeds the following supervisory criteria may be identified for further supervisory analysis of the level and nature of its CRE concentration risk.

22. Supervisory Oversight Conditions for further supervisory analysis: Total reported loans for construction, land development, and other land represent 100 percent or more of the institution’s total capital; or Total commercial real estate loans represent 300 percent or more of the institution’s total capital, and the outstanding balance of the institution’s commercial real estate loan portfolio has increased by 50 percent or more during the prior 36 months.

23. Assessment of Capital Adequacy The Agencies’ existing capital adequacy guidelines note that an institution should hold capital commensurate with the level and nature of the risks to which it is exposed. Accordingly, institutions with CRE concentrations are reminded that their capital levels should be commensurate with the risk profile of their CRE portfolios.

24. Memo on FAQs RD Memo 2007-013 (5/10/07) Frequently Asked Questions on Commercial Real Estate Guidance Purpose To distribute the answers to frequently asked questions on the joint guidance, Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.

25. Scope/Definition CRE loans are loans where the source of repayment is primarily generated by cash flow from the real property, such as rental income or proceeds from the sale or refinance of a property. Generally includes loans on an office building, shopping center, retail space, warehouse facility, multifamily property, hotel or motel.

26. Scope/Definition Owner-occupied loans and so-called “abundance of caution” loans would not be included within the scope of the guidance. 3/31/07 Call Report revisions - Memo Items RC-C 10a 3/31/08 Call Report revisions – RC-C 1.e.(1) & 1.e.(2) – Owner occupied includes hospitals, golf courses, recreational facilities, car washes, and churches unless the property is owned by an investor who leases the property to the operator who, in turn, is not related to or affiliated w/ the investor. – Non-owner occupied includes hotels, motels, dormitories, nursing homes, assisted living facilities, mini-storage warehouse facilities, and other similar properties.

27. Assessment of Capital Adequacy The guidance is not intended to imply that institutions with CRE concentrations should be automatically expected to increase their existing capital levels. Rather, the guidance serves as a reminder that the agencies’ capital adequacy guidelines require institutions to hold capital commensurate with the nature and risks to which it is exposed.

28. Assessment of Capital Adequacy Concentration risk should be reflected in the ALLL to the point where the impact on credit losses is probable and can be reasonably estimated. Otherwise, uncertainty due to concentration risk should be reflected in appropriate capital levels.

29. Additional Guidance: FIL-22-2008 FIL -22-2008: Managing Commercial Real Estate Concentrations in a Challenging Environment (3/17/2008) Re-emphasizes key points in the original 2006 CRE guidance: – Increase or Maintain Strong Capital Levels – Ensure that the ALLL is Appropriately Strong – Manage C&D and CRE Loan Portfolios Closely – Maintain Updated Financial & Analytical Info – Bolster the Loan Workout Infrastructure

30. Application to Examinations Review the most recent quarterly CRE lending report and any other CRE monitoring reports during onsite examination activities. Comment in the open section of the report (under an Asset Quality heading) describing the dollar amount, type, and risks of the bank’s CRE portfolio. If concerns are identified, these concerns should be adequately described together with any recommendations and corresponding management responses. When such concerns are described, a comment should also be made in the Confidential – Supervisory Section indicating the penetration ratio for the CRE concentration.