Best practices for stress testing the commercial real estate portfolio

Stress testing programs should consider their tests in a one-year time horizon measured in both a mild and severe scenario. Mild scenarios should test items to where they honestly think they will be in one year. Severe scenarios should try and replicate conditions that represent the worst possible outcome for the portfolio but are still logically possible (do not blindly make up severe scenarios).

Without going into every possible stress testing scenario, here is a stress test example for a construction and retail portfolio. The logic of these examples can be transferred to other concentrations:

Construction

Construction loans are typically lines of credit that are periodically drawn to pay construction costs.  The loans are also frequently variable rate, receiving interest-only payments each month until they are repaid by permanent financing. Stress testing this portfolio could be done using individual scenario analysis of the project or concentration stress testing covering such sectors as:

– Land development

– Residential construction

– Commercial construction

– Residential and commercial condominium development

This conversion to permanent financing is highly dependent on certain milestones being met and these milestones form the basis on items that should be stressed and accounted for during stress testing. These items include:

– Change in expected sales price

– Change in projected use (condominium to rental)

– Reserve funds

– Interest rates

– Cap rates

– Absorption rates

– Project collateral values

– Material and labor costs

These items should be stressed in both mild and severe scenarios to measure the potential impact on project cash flows.  If situations turn and the project is not sustainable banks need to be able to look at alternative sources of repayment to complete the project.

Retail

Retail is typically one of the larger segments within the commercial real estate portfolio for the average community bank. Along with multifamily and condominiums, the retail sector is surging in high growth areas such as the Carolinas, Florida, Texas and Nashville. Whether in construction or permanent mode, care needs to be taken to prove that the project is sustainable with the appropriate tenant mix and lease income. Changes to cash flow, and debt service coverage, and loan to value should be analyzed using changes to the following variables:

– Interest rates

– Cap rates

– Lease concessions

– Vacancy rates

– Collateral values

– Marketing costs

The retail market across the United States is in flux right now due to the impact of internet shopping. The internet has caused retailers, both large and small, to contract and even cease operations. An analysis of the rent rolls of individual project exposure to name or otherwise critical tenants should be undertaken and those projects stressed to measure the impact of any potential reduction or loss of lease income. Similarly, the rent roll should be reviewed for any changes in tenant mix that could likely change the retail class.

If you would like to learn more about portfolio stress testing, check out this whitepaper: Stress Testing: The Who, What, When & Why.