Mitigating CRE Concentration Risk in 2024

According to a Federal Reserve Bank of St. Louis report, market sentiment about the CRE office sector declined sharply over the last two years, with the Bloomberg REIT office property index falling 52% from early 2022 through the third quarter of 2023 before stabilizing in the fourth quarter. With the continuing weakness in the office rental market, CRE risk is top of mind for financial institutions.

Citing CBRE data, the report said that office vacancy rates reached 19% for the U.S. market as of the first quarter of 2024, surpassing previous highs reached during the Great Recession and the COVID-19 recession. It should be noted that published vacancy rates likely underestimate the overall level of vacant office space, as space that is leased but not fully used or that is subleased runs the risk of turning into vacancies once those leases come up for renewal.

Regulators have paid close attention to the need for risk mitigation, particularly in the area of concentration risk, ever since the savings and loan crisis of the 1980s. Depending on the area of concentration, this risk can be even higher during times of economic downturns. The most effective way to address CRE concentration risk involves an integrated, holistic approach rather than a piecemeal effort that focuses only on the most urgent or critical concerns.

Validated Data is the Cornerstone of Strong Risk Management

One of the first red flags when it comes to credit risk is using manual processes and disparate spreadsheets to manage portfolios. Errors in coding and data entry can warp the view of a bank’s CRE concentrations. Meanwhile, merger activity across different systems creates even more challenges in data aggregation, making it difficult to gain a comprehensive view of portfolio performance, especially across lines of business. Processes and procedures for creating, entering, validating, and quality-checking data and coding should be well documented and standardized. 

One advantage that today’s lenders have in validating data is that CRE data is more widely accessible than ever before, so consider whether there are data points or metrics missing that could strengthen risk management. With additional data resources, senior managers can conduct more robust risk analyses on validated loan portfolio databases to expose sensitivities and view loan concentration in a new light.

Effective Analysis Uncovers Hidden Risks

Uncovering and mitigating risk in an especially complex CRE market not only requires accurate, validated data, banks also need tools that help connect the dots between the data points. In other words, do you have the tools and processes in place to pinpoint and get ahead of hidden risks in the portfolio? 

Some concentration risks are less obvious upfront. For example, a bank that serves several commercial clients in the RV manufacturing space may also lend to various suppliers. This could encompass real estate loans, inventory loans and lines of credit. At first, this may look like a diverse portfolio, but it’s actually highly correlated and presents major risk if demand for RVs shrinks. 

To mitigate such risks, financial leaders need a comprehensive view of CRE properties themselves, as well as the relationships associated with those properties. Senior management can then establish policies and processes to monitor CRE loan performance closely and change the mix of the portfolio when appropriate. This involves proactive loan reviews, stress testing and ongoing reporting. 

What’s Measured (or Reported) Gets Managed

Risk reporting should include updates on mitigation efforts for any identified concentrations, as well as ways to track and manage policy exceptions. Dashboard reporting systems can make it easier to spot overconcentration and other issues before they become major problems in the portfolio, particularly for financial institutions with high levels of CRE loan activity. While automation eases some of the routine tasks in running reports and evaluating risk, senior management oversight of everything is still critical.

CRE market weakness isn’t expected to abate any time soon. As the St. Louis Fed notes: “Stress in the commercial real estate market is likely to remain a key risk factor to watch in the near term as loans mature, building appraisals and sales resume, and price discovery occurs, which will determine the extent of losses for the market.”

Senior bank leaders should re-evaluate their approach to managing credit risk, with particular attention to CRE concentration risk. The current CRE space is proving to be complex and tough to navigate, especially as interest rates are expected to remain high for longer. However, the banks that take steps to enhance their risk mitigation strategies will be well-equipped to support their commercial borrowers through 2024 and beyond.

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