Stress testing of commercial real estate portfolios has become an important credit risk management tool, especially since interest rates have started rising. As you are aware, bank regulators assess the degree to which banks and financial institutions monitor and manage credit risk. The recent proposed guidance on “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” dated January 10, 2006, included stress testing as part of this process for banks meeting regulatory concentration thresholds.

The OCC in its Comptroller’s Handbook of Loan Portfolio Management states that in stress testing, a bank alters assumptions about one or more financial, structural, or economic variables to determine the potential effect on the performance of a loan, concentration, or portfolio segment.

For the stress testing process, management must insure that sufficient data is collected and recorded during the initial underwriting period. Commercial property can take the form of retail real estate, warehouses, office buildings, etc. Loan trial information would already be available such as current loan balance, interest rate and index, and scheduled payments. File information would include the original appraisal value and date, capitalization rate, original loan to value, rate ceilings and debt service coverage. Updated operating income (if available) and current interest rates are then entered into the analysis. Once the information is compiled, it can be updated semi-annually or when significant market changes occur.

This information could be compiled into the loan data system through software enhancements or specific programs as they become available, and downloaded to a stress testing summary. Alternatively, it can be assembled on a separate Excel spread sheet to facilitate the calculations for stress tests using arithmetic formulas.

Using Excel or software formulas, the data is expanded to include the effect of increasing Interest Rates, declines in net operating income (NOI), and changes in capitalization (Cap) rates. NOI can be defined as net income of the project before depreciation and amortization and after adequate reserves for repairs, etc. that are characteristic of the particular project. Cap Rates are the yields investors anticipate on comparable investments, applied to the NOI of the project. NOI divided by the Cap Rate calculates a value in the income approach used in the appraisal process. This is an oversimplification but provides some background for this discussion.

Stress Testing of Individual Commercial Loans

Three basic Stress Tests can be computed from this information. Interest rates can be increased by 1 percent increments; NOI decreased by 5 percent or 10 percent increments; and Cap Rates adjusted by 1 percent increases. With changes to interest rates and NOI, revised debt service coverage (DSC) and loan-to-value (LTV) ratios are calculated. DSC is the net operating income divided by the required annual principal and interest payments expressed as a factor with 1.00x being 100 percent. LTV ratio is the loan balance divided by the appraised or market value and expressed as a percentage.

A new DSC below 1.00 would indicate inadequate cash flow to service the debt if the borrower experiences significant interest rate increases or declines in rental income. Account officers could address this issue from file information or other sources. Borrowers without sufficient mitigating circumstances such as guaranties, outside income, etc., could be subjected to additional monitoring or a change in the loan grade.

For the third stress test, Cap Rates from the original appraisals are adjusted upward by 1 percent increments and new appraised values (AVs) are calculated, then compared to the current balance for a new LTV. These revised LTV’s in excess of 100 percent would not indicate an inability to repay, but highlight potential problems in collateral coverage if there are significant market changes.

Please note that there is potential for lowering of the loan grade in cases of inadequate DSC and no offsetting circumstances, especially if the borrower becomes past due, has financial problems in other projects, etc. These changes would also have to be considered in the analysis of the bank’s allowance for loan and lease losses and concentration limits. Management may choose to revise existing loan policies based on the volume of loans that have inadequate DSC or LTV coverage as disclosed by these stress tests. The proposed guidance also discusses these areas.

Summarizing the Results

The above three basic stress tests are considered interrelated in analysis of the commercial real estate portfolio. Management’s strategy for addressing these results should be in an analysis that is reviewed by the board of directors. By conducting these stress tests, management is more informed of the potential exposure in the commercial portfolio and can address weaknesses disclosed by the analysis.