Why total CRE at US banks might sometimes include owner-occupied properties

While owner-occupied commercial real estate loans are viewed as less risky than nonowner-occupied commercial real estate, that does not mean bank regulators will not scrutinize the credits.

Owner-occupied loans are often treated as safer credits because they are essentially business loans more directly tied to the health of the borrowers' operations; nonowner-occupied loans are more reliant on rental income. The dependency on rental income is partly why nonowner-occupied properties are viewed as more risky, said Klaros Capital managing director Kevin Stein, a former managing director in Barclays' financial institutions group and a former associate director at the Federal Deposit Insurance Corp.

The performance of owner-occupied loans depends more on "the cash flow of the business, which isn't tied to the rent rolls of the real estate," Stein said in an interview.

Banks include their commercial real estate (CRE) concentrations in regulatory quarterly call reports, which define owner-occupied nonfarm nonresidential properties as those having less than 50% of the loan repayment from rental income. The distinction is part of guidance regulators issued in 2006 after commercial CRE concentrations had risen for several years and directed banks to exclude owner-occupied from total CRE.

However, since it is guidance — not regulation or law — it could be applied differently to different banks. The term guidance gives regulators latitude to tell individual banks they are worried about a specific risk. Given the recent concerns around credit quality in a higher interest rate environment, there is greater potential for all loans — including owner-occupied CRE — to face increased scrutiny.

Some banks have seen regulators change their viewpoints on the classification of owner-occupied loans.

One-off situation or new trend?

A Missouri-based banker, speaking on condition of anonymity, said his bank has been managing its CRE concentration based on the 2006 regulatory guidance since 2007. Then something happened during its Federal Reserve exam in mid- to late 2023.

"During our exam, we were told to manage that ratio appropriately, that the Fed was considering total commercial real estate loans when looking at the ratio to capital," the banker said in an interview.

Total CRE concentrations can raise regulatory red flags when they surpass 300% of capital. The Missouri bank was below 300% but moved past that level after a Fed examiner said to include owner-occupied and a recreational property. His bank was also told to include owner-occupied going forward, whereas in the past, just nonowner-occupied was included in the CRE-to-capital ratio.

"We tried to argue that the scope of the guidance was geared toward nonowner-occupied commercial real estate, and it kind of fell on deaf ears," he said.

The banker said his bank's properties are in "more suburban areas with more mom-and-pop type of tenants" and have "strong occupancy rates and cash flows."

Regulators are "broad brushing" CRE concentrations and not giving credit for "strong asset quality" and "stronger commercial real estate portfolios that maybe don't indicate problems with occupancy or cash flow," he added.

Times are a-changing

Bank advisers say a situation such as this is likely an outlier: Generally, owner-occupied continues to be excluded from total CRE, though regulators still look at it. However, regulators do get concerned about concentration risk, said Jill Cetina, a former vice president of supervision at the Dallas Fed who is now at Texas A&M University's Mays Business School.

"The rationale for any concentration metric is to avoid the risk of having a high quantity of very correlated exposures relative to capital," Cetina said in an email. "High concentrations are, of course, associated with elevated failure."

Owner-occupied or not, certain CRE loans can become riskier during different economic cycles.

"An owner-occupied loan to a CRE developer is going to be highly correlated with a CRE cycle," Cetina wrote. "An owner-occupied CRE loan to a dental practice — not so much."

With the current CRE headwinds, banks, investors and regulators need to be thoughtful about which exposures are at risk, irrespective of how they are labeled, Cetina said. "This is about having a risk management mentality as opposed to a merely compliance mentality and clinging to a single metric," Cetina said.