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Home arrow eBook Categories arrow Finannce arrow Commercial Real Estate and Construction Lending

Commercial Real Estate and Construction Lending

September 12 2010


Commercial Real Estate and Construction LendingThe authority for national banks to engage in real estate lending is set forth at 12 USC 371 and the Comptroller of the Currency's regulations at 12 CFR 34. Real estate loans include loans secured by single- and multi-family residential property and commercial and industrial buildings of all types.

Permanent loans to finance the purchase of 1- to 4-family residential property will be addressed in a separate Handbook booklet on Residential Real Estate and Home Equity Loans. Commercial real estate loans include loans secured by liens on condominiums, leaseholds, cooperatives, forest tracts, land sales contracts, construction project loans, and in the few states where they are considered real property, oil and other types of mineral rights. National banks may make, arrange, purchase, or sell loans or extensions of credit secured by liens on interests in real estate.

Loans secured by real estate can be divided into two categories based on the source of repayment: credit-based loans and project financing. Credit-based loans are loans secured by real estate that will be repaid from the borrower's business operations or personal assets.

Although the primary collateral for the loan is real estate, the real estate is not the source of repayment. In many instances, these loans are used to finance the acquisition of an owner-occupied business premises that has an economic life similar to the term of the loan. In other cases, they are term loans used for other business purposes, such as working capital. In both cases, however, repayment is expected from the cash flow of the business rather than from the underlying real estate. Examiners should evaluate credit-based real estate loans in essentially the same manner as commercial loans.

The primary focus of this booklet on Real Estate and Construction Lending is the analysis of project financing. Although project financing also relies on cash flow, it is cash flow originating in the underlying real estate collateral. Project financing is repayable primarily from income currently being produced (or anticipated) from existing or future improvements to real estate. The credit capacity of the borrower and any guarantees are secondary sources of repayment.

The borrower in project financing may take any one of several legal forms to hold title to the real estate. Corporations, joint ventures, real estate investment trusts, or partnerships where the general partner is a Subchapter S corporation are the most popular forms. They allow investors to maximize tax benefits and limit personal liability.

Project financing transactions progress in phases based on the value added by the development of a parcel of real estate. Property must first be acquired; then it must be cleared and improved with sewers, utilities, and streets. Only then can a building be constructed. As each of these phases of the development process is accomplished, the overall value of the property is increased. When the project is completed and ready to produce income or be sold, it will be refinanced by a permanent lender.

A bank may finance any one or all of the phases of a real estate project. Most permanent financing, however, is provided by institutional lenders and investors with longer investment horizons than banks, such as insurance companies, pension funds, and real estate investment trusts.

Although banks usually prefer to finance the land development and construction phases of a real estate project, they also provide short-term financing for completed projects. These so-called "mini-perm" loans are used when the developer intends to sell the project soon after normal occupancy levels are achieved. The mini-perm loan allows the developer to avoid the cost and work associated with obtaining a permanent loan commitment prior to completing the project. Miniperm loans, however, have also been common in distressed periods for commercial real estate, such as the early 1990s, when they reflected developers' inability to obtain permanent financing. The "involuntary" mini-perm loans of that period were often part of a bank's work-out strategy for its troubled commercial real estate construction and development loans.

Real Estate Markets
Real estate is a cyclical industry that is affected by both local and national economic conditions, including: growth in population and employment, consumer spending, interest rates, and inflation. While macroeconomic conditions are important factors affecting the overall state of the real estate industry, local supply and demand conditions are by far the more important factors affecting real estate markets.

A bank's commercial real estate and construction lending may be targeted to one or more of the five primary real estate sectors, including: office, retail, industrial, hospitality, and residential (multifamily and 1- to 4-family). Each of these market sectors has its own characteristics. In the office sector, the demand for office spaced is highly dependent on white collar employment. Office space expansion generally lags economic recoveries. In the retail sector, the demand for retail space and the level of retail rents are affected by the levels of employment and consumer confidence and spending.

The industrial sector is most susceptible to the level of consumer spending, inventory levels, defense spending, and the volume of exports. The hospitality sector is affected by the strength of the U.S. dollar, consumer spending, the price of air travel, and business conditions. A weak dollar induces foreign visitors to travel to the United States, while prompting American vacationers to remain in the states. Finally, in the multifamily residential sector, the demand for apartments is heavily influenced by the affordability of ownership housing, local employment conditions, and the vacancy of existing inventory.

Population growth is a key factor for all sectors of the real estate industry because it influences consumer spending and the demand for goods and services. It also influences federal appropriations and state funding for local infrastructure projects and other services directly affecting real estate markets. Changing demographics, such as increases in the level of immigrants or retirees, are also important factors affecting real estate markets.

Risks Associated With Real Estate Lending
The OCC assesses banking risk relative to its impact on capital and earnings. From a supervisory perspective, risk is the potential that events, expected or unanticipated, may have an adverse impact on the bank's capital or earnings. The OCC has defined nine categories of risk for bank supervision purposes. These risks are: Credit, Interest Rate, Liquidity, Price, Foreign Exchange, Transaction, Compliance, Strategic, and Reputation. These categories are not mutually exclusive, any product or service may expose the bank to multiple risks. For analysis and discussion purposes, however, the OCC identifies and assesses the risks separately.

The applicable risks associated with real estate and construction lending are: credit risk, interest rate risk, liquidity risk, transaction risk, and compliance risk. These are discussed more fully in the following paragraphs.

Download Free eBook: Commercial Real Estate and Construction Lending, Comptroller's Handbook

PDF format, 320KB, 98Pages.

Comptroller of the Currency
Administrator of National Banks

Table of Contents
Introduction 1
Background 1
Real Estate Markets 2
Risks Associated With Real Estate Lending 2
Real Estate Loan Policy 5
Appraisal and Evaluation Programs 10
Construction Lending 11
Evaluating the Borrower in a Construction Loan 14
Evaluating the Collateral for Construction Loans 14
Documentation for Construction Loans 14
Disbursement of Construction Loans 16
Monitoring the Progress of Construction Projects 18
Interest Reserves 19
Warning Signs for Problem Real Estate Loans 20
Workouts and Foreclosures 21
Review of Individual Loans and the Analysis of Collateral Value 21
Classification Guidelines for Troubled Commercial Real Estate Loans 23
Examination Procedures 25
Appendix 45
A. Interagency Policy Statement on the Review and
Classification of Commercial Real Estate Loans 45
B. Interagency Guidelines for Real Estate Lending Policies 63
C. Revised Interagency Guidance on Returning Certain
Nonaccrual Loans to Accrual Status 72
D. Interagency Guidance on Reporting of In-substance
Foreclosures 75
E. Interagency Appraisal and Evaluation Guidelines 76
F. Troubled Loan Workouts and Loans to Borrowers
in Troubled Industries 87
Glossary 91
References 95

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Last Updated ( September 12 2010 )
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