Stress Testing for Commercial Real Estate Loans

Stress testing for real estate loans is a risk management tool designed to analyze current and emerging risks and vulnerabilities by assessing the impact of changing economic conditions on a borrower’s performance to determine future loss rates. Stress testing can show the impact on earnings, loan loss reserves and capital levels. Stress testing should be done on a transactional basis as well as portfolio stress testing.

Transaction stress testing estimates potential real estate loan losses by looking at changing economic conditions and how those conditions may affect a borrower’s ability to service debt.  Periodic transaction stress testing can lead to early problem loan detection and help management assess strategic decision making regarding the real estate loan portfolio.

Portfolio stress testing also estimates future losses for the real estate loan portfolio by looking at changing economic conditions and how they relate to the borrowers’ performance, loan concentrations by type and the change in credit quality, as they affect potential earnings and capital.

Regardless of the method used, a bank’s approach to stress testing should fit its loan portfolio strategy, size, loan types, and composition. Risk management practices for community banks do not have to be complex but should, at a minimum, assess portfolio risk and capital vulnerability as they relate to potential adverse outcomes and future loan losses.  If stress tests indicate that capital ratios could fall below levels acceptable to support the overall risk profile, bank management should take steps to prevent this from occurring. The bank can review risk exposure and, in some cases, limit growth, adjust the portfolio mix, or adjust underwriting standards.

Risk assessments are generally based on assumptions about potential adverse external events such as: changes in real estate capitalization rates, interest rate risk, debt service coverage, occupancy rates, loan to value (LTV) ratios, property net operating income (NOI), collateral values at the local and regional levels, sector performance based on type of building, contractual terms, and lease rates.

Regardless of the type of stress testing program a bank may have, no program is effective if it is not fully supported by senior management. Management should consider the following: developing a stress testing policy, assigning responsibility to ensure that it is completed, establishing ongoing reporting requirements, and using the results in strategic planning. The key is to start a program and make adjustments as necessary to see what works and what doesn’t.