Commercial Real Estate exposures: Lending risks and Regulatory focus

– Team Finserv | finserv@vinodkothari.com

Background

Lending backed by value or liquidity of certain types of assets is regarded as sensitive sector exposure and calls for a special focus of the lending institution from a risk management perspective. Regulators view it with attention, for reasons of the vulnerability of these exposures to cyclical price changes, as also the contribution of such lending to asset bubbles and systemic instability. Capital market and commercial real estate lending are two instances. Lending to capital markets (equity shares) may cause an excess flow of liquidity into stocks, thereby creating an asset bubble. When the bubble bursts, lending goes bad, and of course with several other systemic implications. Same is the case with commercial real estate. Flow of easy or cheap money causes investor interest in CRE to build up, thereby causing prices to spiral up, resulting into asset bubble.

It is for this reason that CRE exposures have always been seen by regulators with concern.

Residential real estate is not free from risk of correlated credit risks due to fall in property prices, as was clearly seen during the build-up to the Global Financial Crisis.

In this article, we discuss what makes these real estate exposures significant? How different are these from other credit exposures of financial institutions? What are the regulatory norms surrounding such exposures? What constitutes exposure to CRE, both direct and indirect?

What is real estate exposure?

Before we get into the topic, let us first understand what would classify as a “real estate exposure” under the Basel III Framework^[1] which provides the following requirements:

• The exposure should be secured by a fully completed immovable property.
• The loan should be a claim on the property.
• The claim should have legal enforceability.
• All the information at the time of origination and for monitoring should be properly documented.
• Property value should not be materially dependent on borrower’s performance; there should be prudent valuation of the property.
• Borrower must have the ability to repay.

An exposure meeting the above requirements shall be considered as real estate exposure which shall be further classified into either “residential” or “commercial”, basis the type of real estate.

Residential real estate exposure

Residential real estate exposure is secured by a property in the nature of a dwelling unit and satisfies all applicable provisions enabling the property to be occupied for housing purposes (i.e., residential property). While “residential” exposure does result in creation of real estate exposure in the books of the lender, the repayment of the loan, in most cases, would not be linked to the cash flows generated from the property i.e., the intention would be to reside on the said property and not engage in a commercial activity to generate cash flows.

However, if the purpose is to engage the property in commercial activity, it cannot be classified as “housing finance” as it is not used for a residential unit. This is easier to determine in case of corporates (since there wont be any question of residing in the house) but difficult to determine in case of individuals. Hence for individuals, the RBI has prescribed a limit of two units to be considered in housing finance. If such individual takes finance for a third unit, it will be deemed CRE.

The material dependency on the cashflows generated from the property is an essential feature since it will determine whether the exposure would be classified as CRE.

In the Indian context, para 4.1.16 of the RBI’s Master Directions^[2] for Housing Finance Companies defines the term “housing finance” which includes financing for purchase/ construction/ reconstruction/ renovation/ repairs of “residential dwelling units”. These loans are primarily to individuals, with an exception of loans given to builders for constructing a residential dwelling unit. It may be noted that the term used here is “residential dwelling unit”. Hence, for instance, if the loan to a builder is used for construction of villa, the same may not be classified as housing finance if the villa is not for residential dwelling.

Additionally, the HFC Directions also state that loan for third dwelling unit onwards to an individual will be treated as “commercial” real estate exposure, hence classifying only the first two as “residential”. The rationale here being that the third property, in all probability, would not be used for residential purpose and may be let out thereby making the property as an “income-generating unit” (also discussed under examples of CRE classification below).

Commercial Real Estate Exposure

This particular sub-category under the real estate exposure is the one which is critical for a financial institution to identify. In general, there is a systemic risk associated with real estate exposure since it is sensitive to movement in real estate prices; the same is even more volatite in case of commercial real estate (CRE). In global parlance, CRE is referred to as ‘income-producing real estate’ or IPRE, however, the RBI regulations make use of the word ‘CRE’ while making a reference to IPRE.

CRE, based on global experience, has been observed to be more sensitive than residential real estate. There are several reasons to this:

1. Investment in CRE is obviously an investment activity, unlike an RRE where a person buys a residential property for dwelling purposes. CRE investment is mostly huge, and increasingly comes from institutional investors such as property funds, REITs, etc. These investors are sensitive to sectoral risks and returns. There may be concerted withdrawal of funds from the sector based on adverse news or developments, causing prices to come crashing. For instance, the recent fall in property prices in Sweden due to high inflation rates and the likelihood of further interest rate rises^[3]. Further, A high bank exposure to CRE loans compromises its financial stability. High CRE loan exposures were also major contributors to bank failures in the US, as observed after global financial crisis during which overall CRE prices declined by 30%.
2. The repayment of an RRE loan comes from the income of the individual and not from the cashflows from the property. However, CRE investment is mostly backed by cashflows form the same property. Therefore, if there are risks affecting the CRE – for example, a sustained vacancy or lack of popularity of the place, or fall in rentals, the repayment ability of the borrower gets impaired. Defaults follow. Further, considering that the same property is also attached as a collateral to the loan, the recovery also gets weakens.
3. Valuations of property are connected with prevailing rentals, and rentals themselves are sensitive to prevailing demand for spaces. For example, if retail business faces slump, retail spaces will see a sharp drop in rentals, causing a crash in prices. This does not happen in case of RRE

Guidance on Commercial Real Estate (CRE) Exposure is provided by the RBI circular dated September 9, 2009 in line with the Basel II Framework. It defines the term “income-producing real estate” as follows:

“Income-producing real estate (IPRE) refers to a method of providing funding to real estate (such as, office buildings to let, retail space, multifamily residential buildings, industrial or warehouse space, and hotels) where the prospects for repayment and recovery on the exposure depend primarily on the cash flows generated by the asset. The primary source of these cash flows would generally be lease or rental payments or the sale of the asset. The borrower may be, but is not required to be, an SPE (Special Purpose Entity), an operating company focused on real estate construction or holdings, or an operating company with sources of revenue other than real estate. The distinguishing characteristic of IPRE versus other corporate exposures that are collateralised by real estate is the strong positive correlation between the prospects for repayment of the exposure and the prospects for recovery in the event of default, with both depending primarily on the cash flows generated by a property“

As highlighted in the definition, an exposure will be classified as CRE/IPRE exposure, if the primarily source of repayment is linked to a real estate (for example, office buildings to let, warehouse space, etc. Additionally, in case of a default, the real estate will be the primary security for recovery of the loan. That is to say, the exposure is materially dependent on cash flows generated by the property rather than the capacity of the borrower to repay the loan.

While the materiality condition would be seen mostly in cases of businesses and corporates, a loan to an individual for non-business purpose may also get classified as CRE if the repayment will be linked to cashflows from the property (for example, repayment of loan from the rent received on the property).

Cases which would fall under CRE classification:

• Loan to builders for construction of any property intended to be sold or leased – As discussed, the classification of loan as CRE is primarily dependent on the source of collection or recovery. Accordingly, these will be classified as CRE since the repayment would arise from the sale of the property or rent received from the constructed property. Additionally, the recovery in case of default will also be through sale of the said property .
• Loans for multiple houses of individuals – As per the RBI regulations applicable on HFCs, loans for third dwelling unit onwards to an individual are treated as CRE exposure. A borrower having multiple properties i.e. more than two units, is deemed to be using such property for purposes other than residential and hence, treated as income-producing real estate. Accordingly, any loan against the third dwelling unit onwards of the borrower will be considered as CRE.
• Top-up loans – Top-up loan is an additional loan (and not a principal loan) provided on an existing loan against the same mortgaged property. The loan proceeds may be either employed in the construction/ development of the same property, for personal use, or for meeting the LTV. In case the primary loan was against a third (or above) dwelling unit and was treated as a CRE, the top-up loan will also be considered as a CRE, if the funds are to be employed towards such dwelling unit or to maintain LTV.
• Loans for integrated township project – Such funding exposures will be classified as CRE since the primary source of repayment would be sale proceeds of the buildings under the project.
• Exposure in real estate companies or funds investing primarily in real estate companies – Such exposures do not have a direct linkage in creation or acquisition of CRE, however, the primary cash flows would still be generating from CRE. Therefore, indirect exposures in the form of corporate loans to real estate companies, investment made in the equity and debt instruments of real estate companies, extension of guarantees on behalf of companies engaged in commercial real estate activities, exposure to MFs/AIFs/investment vehicles investing primarily in the real estate companies may also be considered as CRE.

Cases which would not fall under CRE classification:

• Loan for business purposes – It may happen that the loan may lead to creation or acquisition of a real estate property where the intention of the borrower is not to to employ such property for business and not for principally generating income from such property. Accordingly, the loan is not creating an exposure on the property.
  • Hotel/hospital business – In the case of a hotel, the cash flows would be mainly sensitive to the factors influencing the flow of tourism, not directly to the fluctuations in the real estate prices. In the case of a hospital, the cash flows in normal course would be sensitive to the quality of doctors and other diagnostic services provided by the hospital. While the source of repayment might also depend to some extent upon the real estate prices to the extent the fluctuation in prices influence the room rents, but it will be a minor factor in determining the overall cash flows.
  • Industrial units – Similarly, for industrial units, the repayment is done from sale of material produced on the property, hence loans for such cases would also not fall under CRE.
• Working capital / credit facilities to construction companies – The cashflows of contractors and construction companies are dependent on the fulfilment of their contractual obligations and receipt of contractual payments (i.e. progress in completion of construction) and are not linked to the real estate property. In case of loans exposures that are secured by real estate property but the repayment primarily depends on other factors such as operating profit from business operations, quality of goods and services, etc., the exposure would not be considered as CRE.
• Advances to HFCs – Exposure to HFCs that are primarily into lending to individuals for residential housing and fulfill eligible criteria for NHB refinance will not be classified as CRE.

Commercial Real Estate – Residential Housing

This is a sub-category within the CRE exposure and was introduced vide the RBI circular dated June 21, 2013^[4]. CRE-RH would consist of the following loans:

1. Loans to builders/developers for residential housing projects
2. Loans for integrated housing projects with a minor portion of commercial space such as shopping complex, school, etc. . Here, RBI has prescribed that for such loans to be classified as CRE-RH, the commercial area in the residential housing project should not exceed 10% of the total Floor Space Index of the project.

As discussed earlier, CRE exposures are subject to an emphasised focus due to their sensitivity from inherent price volatilities^[5]. The rationale behind such a bifurcation of CRE exposure as CRE-RH is that a residential housing project exhibits lesser risk and volatility as compared to the CRE sector as a whole. Hence, this sub-category will have lower risk weight and provisioning requirements (separately discussed below) as compared to other CRE exposures.

Now that we have seen what would and would not classify as CRE, let us see the impact of CRE classification and what it means for financial institutions.

Risk weights on RRE and CRE

One of the major impacts of an exposure being classified as CRE is that it will have a higher risk weight, thereby increasing the capital requirement as compared to RRE exposures. For instance, the table below shows the risk weights applicable on RRE and CRE exposures.

As can be seen in the table above, CRE exposures attract 100% risk weights with a lower risk weight of 75% for CRE-RH. Meanwhile, the maximum risk weight for RRE is 50%.

Sectoral limit

Exposure to CRE is treated as a sensitive sector exposure for NBFCs and HFCs. Keeping in view that a considerable reliance on CRE, or for that matter, any sector deemed to be sensitive, may significantly impact a financial institution’s performance and stability in case of such sector’s downfall, the regular requires them to limit their exposures towards such sensitive sectors. Accordingly, the Boards of financial institutions are required to set internal sectoral limits for sectors to which their business is sensitive to, which would necessarily include CRE. The limits are to be based on vulnerability assessments of various sectors and their likely impact on business. NBFCs are also required to fix sub-limits within the CRE exposure for financing land acquisition. While HFCs are prohibited from investing more than 20% of its capital fund in land or building except for its own use. Additionally, any investment above 10% shall be made only in residential units.

In case of banks, the RBI circular dated April 18, 2017 has allowed participation of banks in REITs upto 20% of its networth subject to the following condition:

• Having a board-approved policy in place on exposures to REITs which lays down an internal limit on such investments within the overall exposure limits in respect of the real estate sector.
• Investment should not exceed 10% of the unit capital of the REIT.

Provisioning and disclosures

The provisioning requirements in case of standard assets will differ in case the exposure is classified as CRE. The requirement for HFCs is on par with the commercial banks^[7] as provided in the table below:

Individual housing loan	0.25%
CRE-RH	0.75%
CRE	1%
Loans at teaser/special rate (i.e., housing loans at comparatively lower rates of interest in the first few years after which rates are reset at higher rates)	2% (0.40% after 1 year from the date on which the rates are reset at higher rates)

Additionally, exposures of banks, NBFCs and HFCs exposure to real estate sector (both direct & indirect), in RRE as well as CRE and investment in MBS is required to be disclosed specifically in notes to accounts.

High volatility CRE (HV-CRE) lending

HVCRE, has been introduced under the Basel III norms and while the Indian regulations do not provide for such classification, the concept still becomes crucial to understand.

HVCRE, as a concept, started gaining attention after the Financial Crisis 2007-08 when the regulators felt that certain CRE exposures were perceived to be riskier than other commercial real estate exposures. The phenomenon of HVCRE is majorly for the purpose of risk weights and capital requirements as HVCRE loans involve commercial real estate projects that regulators perceive to be high risk and require a more larger capital buffer.

The Basel norms define HVCRE lending as financing of commercial real estate that exhibits higher loss rate volatility (ie higher asset correlation) compared to other types of secured lending. HVCRE includes:

1. CRE secured by properties of types that are categorised as sharing higher volatilities in portfolio default rates;
2. Loans financing any of the land acquisition, development and construction (ADC) phases for properties of those types in such areas; and
3. Loans properties where the source of repayment at origination of the exposure is either the future uncertain sale of the property or cash flows whose source of repayment is substantially uncertain (e.g., the property has not yet been leased to the occupancy rate prevailing in that geographic market for that type of commercial real estate), unless the borrower has substantial equity at risk.

Impact due to HVCRE classification

The Basel Norms prescribe a higher capital requirement where a loan is classified as HVCRE. Since such loans are considered riskier, they carry a higher risk weight of 150% as compared to 100% risk weight in case of usual CRE exposures. A higher capital requirement as well as the riskiness of the exposure leads to higher pricing by financial institutions for HVCRE loans. However, in India, all CRE exposures carry an equal risk weight

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^[1] CRE 20.71 – https://www.bis.org/basel_framework/chapter/CRE/20.htm?inforce=20230101&published=20221208#paragraph_CRE_20_20230101_20_71

^[2] Para 12.1 – https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=12030

^[3] The Swedish mortgage market (Q4, 2022) – https://nordiccreditrating.com/insight/swedish-mortgage-market

^[4] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=8047&Mode=0

^[5] Extract from Monetary Policy Statement 2013-14 (para 82)

^[6] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=12165

^[7] As per Master Circular – Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances – https://www.rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=12281