Navigating the Allowance for Commercial Real Estate Losses After CECL Adoption
Earlier this month, the Federal Reserve System held an “Ask the Fed” session regarding the elevated risk associated with commercial real estate (CRE) lending. As such, it seems timely that we provide some insights into what we’ve witnessed as pertains to CRE and the impact of the new accounting methodology for credit losses.
Per the Financial Accounting Standards Board’s (FASB) Accounting Standards Update (ASU) 2016-13, all banking institutions were required to adopt the current expected credit loss (CECL) model by 2023 for calculating allowances for credit losses (ACL). With CECL, the ACL blends historical credit loss experience with an estimate of the expected credit losses on financial assets with similar risk characteristics.
Banks with total assets over $1 billion are required to complete Call Report Schedule RI-C, which provides for the disaggregation of ACL. As such, ACL data pertaining specifically to commercial real estate is published for these institutions here. The disaggregated reporting allows for greater insight into whether CRE ACL is responsive to changes in CRE lending conditions and facilitates peer comparison of allowance coverage.
CRE ACL coverage levels1, measured as CRE ACL as a percent of total CRE loans, today stand at a national average of 1.2 percent, which is comparable to estimates of pre-Great Recession CRE allowance coverage levels. It’s worth noting that in the Fifth Federal Reserve District CRE loans2 make up 41.9 percent of total loans, which is higher than the nationwide average of 36.5 percent. However, the ACL allocated to CRE as a percent of total CRE is 1.1 percent for the Fifth District, which is below the national average of 1.2 percent.
CRE market and property fundamentals have shifted in recent years. Market conditions are markedly different than when loans were underwritten two to four years ago — interest rates are higher, rents have declined, investor and lender appetite has cooled, and limited transactions in many markets have led to difficulties with price discovery. These factors all lead to challenges with refinancing. While CRE lending has slowed in recent quarters, market uncertainty, tighter lending standards and weaker demand, as well as concerns about liquidity positions and the after-effects of the pandemic have all impacted CRE performance and led many banks to reassess their risk appetite and concentration levels in the sector. Banks with concentrations in office and multifamily CRE lending may need to increase their allowance to account for an elevated risk in these sectors.
Banks should regularly monitor potential credit deterioration and market conditions to reassess collateral valuations — even in the absence of market transactions — and ensure that ACL reasonably reflects the potential for lifetime losses. Bankers should ensure that a full credit cycle’s worth of loss rates is employed. Moreover, accurate and timely risk ratings for CRE loans are a crucial component to managing allowances. Loans transitioning to nonaccrual status should be reviewed carefully as well as individually for additional expected losses. These decisions are crucial for accurately estimating potential credit losses and ensuring the financial stability of the institution.
In addition to loan allowances, bankers should also provision for off-balance sheet CRE commitments listed in Call Report Schedule RC-L. Namely, banks must ensure that their CECL model incorporates allowance calculations for these unfunded commitments (lines of credit) that are not unconditionally cancellable, and report this unfunded commitment allowance to Call Report Schedule RC-G. As with loan allowance modeling, any qualitative factoring used in the calculation of unfunded commitment allowances — including management’s rationale for factoring — should be well-supported.
The allowance for credit losses can be complex and challenging — therefore, it’s important to use effective risk identification practices for monitoring, measuring and reporting. Learn more about resources available to your institution on the CECL method at the Federal Reserve’s CECL Resource Center. You can also reach out to your Supervision contact team at the Richmond Fed for any questions you have regarding recent trends and analysis of credit losses.
1CRE ACL is for banks over $1 billion in assets that file Schedule RI-C.
2These are loans for institutions over $1 billion in assets that file Schedule RI-C.
