Real Estate Lending—What, Me Worry?

1. Real Estate Lending—What, Me Worry? Dev Strischek, SVP & Senior Credit Policy Officer SunTrust Bank, Atlanta GA Dev.Strischek@suntrust.com 404-230-5242 RMA

2. Agenda • Review regulatory concerns about and market expectations for lending to developers and contractors • Provide some guidance on key real estate underwriting and credit risk management tools • Extra added attraction—appendix of analytical and underwriting tips on developers and contractors 2 RMA

3. Why the Fuss? • Over the past 60 years, US banking industry has migrated from C&I lending to real estate lending: • Transformation from C&I to real estate occurred during mid 1980’s • Today RE loans are 75% of total loans for 4,700 banks <$1B in assets • Real estate securities now account for 60% of banking system securities • During 2007-2012’s Great Recession, the 50% of the banks with the • highest real estate ratios accounted for 82% of bank failures RMA

4. Commercial Bank or Real Estate Bank? RMA

5. Recent CRE Trends • Agencies have observed these recent trends: • Increasing investor demand for CRE • Low current interest rates boost income producing properties’ net operating income (NOI) • historically low cap rates result higher property values • Rising concentration levels • Continued strong demand for CRE credit • Earnings pressures • Positive trends, so far, in asset quality (AQ) metrics, e.g., low delinquencies and low net charge-offs (NCO) • More competition among banks & non-banks resulting in easing of underwriting standards & increases in underwriting exceptions RMA

6. Real Estate Regulatory Reminders • 12/18/15 Interagency Statement on Prudent Management for CRE Lending reminds us bankers • To implement prudent risk management practices and capital levels commensurate with level & nature of our institutions’ concentration risks • Of existing regulations & guidance related to CRE lending (See App A) • That agencies focus on our institutions’ adherence concentration risk and other CRE-related guidance RMA

7. Best Practices in CRE Lending • 1-Establish adequate & appropriate • Loan policies, underwriting standards, credit risk management practices & concentration limits approved by Board or designated committee • Lending strategies, such as plans to increase lending in particular market or property type, limits for credit and other asset concentrations, & processes for assessing whether lending strategies & policies continue to be appropriate in light of changing market conditions • Strategies to ensure capital adequacy & allowance for loan losses (ALLL) are consistent with level and nature of inherent risk in CRE portfolio RMA

8. Best Practices in CRE Lending • 2-Conduct global cash flow (GCF) analyses based on reasonable rental rates, sales projections, & operating expenses to ensure borrower has sufficient repayment capacity to service all loan obligations • See App B for lending to real estate developer • See App C for lending to contractors • 3-Perform market & scenario analyses of CRE loan portfolio to quantity potential impact of changing economic conditions on AQ, earnings & capital • 4-inform Board & management so they can assess whether lending strategy & policies continue to be appropriate as market conditions change • 5-assess ongoing ability of borrower & project to service all debt as loans convert from interest-only to amortizing principal repayment, especially during periods of rising interest rates RMA

9. Best Practices in CRE Lending • 6-Implement processes and procedures to monitor potential volatility in supply & demand for lots, retail & office space, & multi-family units during business cycles • 7-Maintain management information systems (MIS) that provide Board and management with sufficient information to identify, measure, monitor, & manage concentration risk • 8-Implement independent processes for appraisal reviews that evaluate whether sufficient information has been provided to support the market value conclusion based on reasonable market rental rates, absorption periods & expenses RMA

10. Credit Risk Defined • Risk that a borrower may not perform in accordance with contractual terms resulting in potential loss of value in assets; unable or unwilling to • pay in full from • Cash flow • Collateral • Guarantees • pay on time • pay as agreed • Credit risk overlaps other risks, but is usually the single biggest risk a bank incurs, and if a bank can manage its credit risk, the other risks are more easily managed • CRE borrower’s repayment issues: • Cash flow dependent on sale or rent of property • Collateral is dependent on cash flow and cap rate used to derive value • Guarantors typically lack liquid assets 10 RMA

11. How Real Estate Banks Get into Trouble • Poor risk assessment • Too many risky borrowers, e.g., developers & contractors • Excessive exposure to risky types of lending • Too many spec construction loans • Too many multi-family housing projects • Concentrations of aggregate risk • Lend too much to one borrower • Lend too much to one place • Lend too much to one industry • Lend too much in one bank line of business (LOB) RMA

12. Types of Risks RMA

13. T-I-C Risk Strategy Alternatives RMA

14. Commercial Real Estate (CRE) Policy Hot Buttons • Underwriting Guidelines • Policy Exceptions • Portfolio Limits and FDICIA Limits • Suggestions for managing CRE concentrations • Lending Authorities • Valuation • Environmental risk • Real Estate Construction Administration (RECAD) • HV-CRE RMA

15. Example of Underwriting Guidelines RMA

16. Construction Underwriting • Interest reserve • How much • How long • Inventory management • Specs • Models • Pre-sales • Release prices RMA

17. TPEs Applicable to All Wholesale Loans,CRE-Secured Loans, and Business Banking Loans This example shows14 TPEs applicable to all wholesale loans, 7 additional TPEs applicable to wholesale loans secured by CRE, and 2 TPEs applicable only to WLS Production Center loans RMA

18. Obligor – Obligation TPE’s • Most TPE’s are obligation-specific, e.g., • One obligation may be guaranteed, another may not be • One obligation may meet LTV requirements, another may not • But a few TPE’s are obligor-specific, e.g., financial info, DSC, etc. • For example, we count financial statements once against obligor, not against each obligation • Likewise, we cite DSC against obligor, not against each obligation • Obligation and obligor specific TPE’s RMA

19. Portfolio Limits • Limit on total borrower exposure to • Any individual or entity • Any single project • Any single A&D project • FDICIA limits • Total Real estate secured loans in excess of supervisory LTV/Tier 1 Capital < 100% • Commercial real estate secured loans in excess of supervisory LTV/tier 1 Capital < 30% RMA

20. FDICIA LTV and Ratios • Guidelines • Land loans < 65% • Developed land loans < 75% • Improved property < 85% • Residential property < 90% • LTV in excess of guidelines currently measured by these ratios • CRE < 30% of capital • All RE < 100% of capital • Quarterly reporting requirements • Bank board of directors • Format . . . RMA

21. RMA

22. Suggestions for managing CRE concentration • Underwriting standards by project type • Policy exceptions • MIS systems to stratify portfolio by • Loan information • Loan balance, commitment, and TBE • Term, maturity, and amortization • Interest rate • Policy exceptions • Loan documentation exceptions • Collateral information • Property type • Location • Presold/preleased data • Unit sales prices/lease rates • Vacancy rates • Property age • Fixed and variable costs • Appraised value • tenant concentrations by name and industry • Developer concentrations • Risk rating • Total borrower exposure to any one borrower • LTV data integrity RMA

23. Lending Authorities • Restrict CRE authority to individuals with training and experience • One-up approval for riskier requests • Single-purpose properties • Speculative projects • Other policy exceptions • Approval pushed higher as total borrower exposure increases and risk rating worsens RMA

24. Lending authorities grid

25. Valuation—you know the drill . . . • Independence of valuation process • Selection of appraiser • Ordering • Review and approval • Updating • Type of valuation—new and renewal • Under$250M • $250M to $1MM • Over $1MM • Abundance of caution RMA

26. CRE Valuation Requirements RMA

27. Real Estate Construction Administration (RECAD) • Independence • Minimum size of construction loan to manage • Documentation • Draws • Inspections • Liens • Funding • Valuation (appraisal) management • Environmental risk management • Approved appraisers and environmental auditors • Records • Credit files • Doc files • Draw files • Misfiles RMA

28. Construction Lending is Risky • Definition of HVCRE • “Credit facility that finances or has financed the acquisition, development, or construction (ADC) of real property.” • If ADC, then HV-CRE? • Eligibles vs. Excludables • Risk vs. public policy • Why HV-CRE • “Supervisory experience has demonstrated that certain ADC loan exposures present unique risks for which the agencies believe banking organizations should hold additional capital.” RMA

29. HV-CRE Reporting Guidance RMA

30. Quantifying the Capital Cost of HV-CRE • Comparing identical pricing & characteristics for HVCRE & non-HVCRE loans shows that an acceptable HVCRE ROE requires an additional return is received to support the additional capital. Additional Notes • Hurdle rate & assumed tax rate drive the magnitude of the surcharge • The shaded area identifies hypothetical market range reported by lenders Pricing model should include premium for HV-CRE capital cost • Explicitly accounts for the cost required to cover return on additional capital within the existing metrics used to price and approve credit transactions. • Easy to explain and understand • Bank retains the ability to offer product when appropriate • Easy to adjust as warranted in the future RMA

31. HV-CRE Underwriting Issues • OCC-Fed-FDIC interpretative differences • Residential development—in or out? • Ambiguity of community development exclusion--SBA 504? • 15% minimum equity requirement • Based on “as completed” appraisal value • Pre-sold/pre-leased property appraised higher than spec building & so requires more equity? • Cash up front until end of construction loan • Loan documentation governing equity contribution and release • Cost of administering equity contribution • Land equity counted at cost • Inducement to flipping? • Construction loan facility • Major or minor work? • Line of credit for general working capital purposes • Pricing—typically adds 50-90 bps to cost of funds • Other issues? RMA

32. Summary & Closing • Banks more reliant now on RE lending • Heavier reliance on RE lending worries regulators because of losses in previous recessions • Now’s the time for preventive maintenance—is your bank tuned up for RE lending? • Here’s a take-away checklist . . . RMA

33. Real Estate Checklist for Bank Management & Directors RMA

34. References • “Commercial Real Estate Lending,” Comptroller’s Handbook, OCC, August 2013. • Keith Friend, Harry Glenos, and Joseph B. Nichols, An Analysis of the Impact of the Commercial Real Estate Concentration Guidance, April 2013, http://www.occ.gov/news-issuances/news-releases/2013/nr-occ-2013-59a.pdf • “Interagency Statement on Prudent Risk Management for Commercial Real Estate Lending,” OCC Bulletin 2015-51, December 18, 2015. • Alex J. Pollock, “’Commercial’ Bank is Misnomer. ‘Real Estate’ Bank Is More Apt,” American Banker, August 8, 2016. • Derek Pollard, Richard Appel, and Dev Strischek, “Loans to Construct and Finance Medical Office Buildings: Enter at Your Own Risk, The RMA Journal, April 2009, pp. 32-5. • Dev Strischek, “Character and Fraud: Protection and Prevention,” The RMA Journal, Nov 2011, pp. 32-5. • Dev Strischek, “Coming to Terms with Financial Covenants,” The RMA Journal, June 2007, pp. 69-73. • Dev Strischek, “Credit Culture” for American Bankers Association 8-part series published in Commercial Insights: • Credit Culture: Don’t Make Loans without It (CI: 09/08) • Credit Culture: Four Types of Culture (CI: 10/08) • Credit Culture: Determinants of Credit Culture (CI: 11/08) • Credit Culture: How to Change a Bank’s Credit Culture (CI: 12/08) • Credit Culture: Credit Discipline Tools (CI: 01/09) • Credit Culture : Moving from an Old Culture to a New Culture (CI : 02/09) • Credit Culture: How to Identify and Manage Your Bank’s Risk Profile (CI: 03/09) • Credit Culture: Risk Management Strategies to Achieve the Risk Profile and Culture You Want (CI: 04/09) • Dev Strischek, “Lessons Relearned” for American Bankers Association 4-part series published in Commercial Insights (CI) • Culture Clash: Balancing Reward and Risk (CI: 7/10) • Missing “C (character)” in Today’s Credit Analysis (CI:8/10) • Analyzing a Borrower’s Repayment Ability (CI: 9/10) • Share and Share Alike in the Risk of Participations (CI: 10/10) • Dev Strischek, “Financial Statement Guidance: A Credit to the Bank’s Lending Policies,” RMA Journal, April 2013, pp. 20-27. • Dev Strischek, “Five C’s of Credit,” The RMA Journal, May 2009, pp. 34-7. • Dev Strischek, “Ins and Outs of Lending Inside the Box, The RMA Journal, Feb 2010, pp. 38-46. • Dev Strischek, “Lending Inside the Box, The Journal of Lending & Credit Risk Management, Feb 2000, pp. 42-46. • Dev Strischek, “Policy Exceptions Matter as a Rule,” RMA Journal, Jul-Aug 2012, pp. 46-51. • Dev Strischek, “Regulatory Guidance on Commercial Real Estate: Mind the Gap for Great Guidance on Good Lending,” The RMA Journal, April 2006, pp. 62-73. • Dev Strischek, “The Ups and Downs of Cash Flow Projections for Contractors: Making a Case for Downside and Most Likely Scenatrios,” Part 1 published in The RMA Journal Sept 2015, pp. 12-19, Part 2 in Oct 2015, pp. 12-15. • Dev Strischek, “Writing a Credit Policy: Much to Do about Something, The RMA Journal, Feb 2008, pp. 60-5. • Dev Strischek, “Written Policy for Lending to Contractors, Journal of Lending & Credit Risk Management, June 1999, pp. 32-43. • Carla Whitlock and Dev Strischek, “Guarantor Policy: Satisfaction Guaranteed,” The RMA Journal, March 2011, pp. 38-43. • Study on the Impact of Failure of Insured Depository Institutions, FDIC Office of the Inspector General, January 2013. RMA

35. Glossary • A&D Acquisition & Development • ALLL Allowance for Loan & Lease Losses • ABL Asset Based Lending • AR Accounts Receivable • CA/CL current assets to current liabilities ratio, aka current ratio • CAMELS Bank rating system assessing Capital, Asset quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk • CAPEX Capital expenditures • CCO Chief Credit Officer • CoREDI non REDI borrower who decides to engage in REDI activity, e.g., doctors who borrow to buy office building • CRE Commercial Real Estate • CRO Chief Risk Officer • CRM Credit Risk Management • Doc Documents, documentation • DSC Debt Service Coverage ratio • D/W Debt to Worth ratio • EL Estimate of Loss • GPM Gross profit margin = GP/Sales • Inv Inventory • FDICIA FDIC Investment Act • LGD Loss Given Default • LOB Line of Business, e.g., commercial lending, CRE lending, private banking, consumer lending, mortgage banking, etc. • L-T Long-Term • LTC Loan to Cost ratio • LTV Loan to Value ratio • Max Maximum, < • Min Minimum, > • NOI Net Operating Income • NW Net Worth • NWC Net Working Capital • OAEM Other Assets Especially Mentioned, aka Special Mention (SM) • O-O Owner-occupied • % percentage, e.g., LTV = 80% • PD Probability of Default • PRAC Product Risk Assessment Committee • RAROC Risk-Adjusted Return on Capital • RE Real Estate • REDI Real Estate Developer-Investor , full- time professionals in CRE • ROA Return on Assets • SM Special Mention, aka OAEM • S-T Short-Term • TBE Total Borrower Exposure • W-I-P Work in progress • X ratio, e.g., DSC = 1.2X RMA

36. Appendices • App A: Interagency Regs & Guidance for CRE Lending • App B-1: Lending to RE Developers • App B-2: RE Developers Red Flags • App C-1: Lending to Contractors--Industry Issues and Trends • App C-2: Lending to Contractors—Banking Considerations • App C-3: Lending to Contractors--Profile of Higher Risk Contractor • App C-4: Lending to Contractors—Info Needed to Underwrite, and Approve a Credit Request • App C-5: Lending to Contractors—Underwriting Considerations • App C-6: Lending to Contractors—Underwriting Considerations (continued) • App C-7: Lending to Contractors--Typical Bank Covenants and Conditions RMA

37. Appendix A: Interagency Regs & Guidance for CRE Lending RMA

38. Appendix B-1: Lending to RE Developers • Borrower’s repayment capacity • Nature & degree of protection provided by global cash flow from business operations or collateral to cover ALL existing and proposed obligations • Borrower’s character, overall financial condition, resources, & payment record • Market conditions that may influence repayment prospects & cash flow potential of business operations and/or underlying collateral • Collateral • Current & projected vacancy & absorption rates • Lease renewal trends & anticipated rents • Effective rental rates or sales prices after concessions • Time frame for achieving stabilized occupancy or sellout • Property’s NOI vs budget with reasonable operating & maintenance costs • Discount rates & direct capitalization rates • Guarantees • Guarantee is written and legally enforceable • Guarantor has financial capacity to be able and willing to support credit through ongoing payments, curtailments or re-margining Source: “Analyzing Repayment Capacity of the Borrower,” Commercial Real Estate Lending, OCC, August 2013, pp. 72-3. RMA

39. Appendix B-2: RE Developers Red Flags • Delinquent real estate taxes • Declining sales prices or rental rates • Cancellations of sales contracts or reservations • Liberal sales or unusually generous concessions including rent, tenant improvement allowances, moving allowances, a& lease payments • Slower absorption than budgeted • Delinquent lease payments from major tenants • Higher vacancy & turnover rates • Changes to initial concept or development plan, e.g., condo converted to apartment building • Construction budget overruns • Borrower requests for significant reallocation of funds to other budget line items • Late or delinquent payments • Draw requests ahead of schedule for work yet to be completed • Construction delays or other unanticipated events that could lead to cost overruns • Liens due to worker or supplier payment disputes • Borrower requests for additional financing due to unanticipated costs or expenses • Deterioration in performance of borrower’s other properties or businesses • Interest reserves that have been repacked Source: “Other Considerations, Commercial Real Estate Lending, OCC, August 2013, p.72 RMA

40. Appendix C-1: Lending to Contractors--Industry Issues and Trends • Facts of life: • construction activity much more volatile than business cycle swings • interest rates and accelerator principle aggravate construction volatility • competition drives margins down while cycle contributes to revenue swings • thin GPM -->high break-even points • W-I-P inventory and fixed assets-->illiquidity • high leverage and low solvency-->poor capitalization • post 9/11insurance costs-->harder to transfer risk • vulnerability to failure • Recession Issues • Entry of relatively inexperienced contractors into market • Decreasing use of established regional and national contractors • Increasing common ownership of project developer and general contractor • Resistance to bonding requirements • Resistance to equity and liquidity requirements • Volatility of construction materials prices RMA

41. App C-2: Lending to Contractors—Banking Considerations • Contractor lending is specialized skill--lending authority usually restricted to lenders experienced in construction • Contractor lending is higher risk portfolio—banks may set maximum limit in $$ or as % of total loan portfolio • Contractor lending is permanent, not seasonal– so borrowing base formula (% billings ) employed to administer borrowings • Lend to contractors based on downside cash flow, and take collateral and guarantees as secondary repayment sources • Lend to contractors in bank’s target market who are engaged in projects within bank’s target market RMA

42. App C-3: Lending to Contractors--Profile of Higher Risk Contractor • Warning Flags for Bankers: • Inability to get bonding, bonding capacity has been cut, or insurance agent unable to renew bonding company with current surety • contract status report shows major jobs behind schedule • jobs are outside of traditional geographic market • product is not contractor’s traditional offering • AR/AP ratio < 1.00 • credit agency reports show poor payment record, judgments, liens, bankruptcy, etc. for firm and/or principals • delinquent taxes--payroll, income, sales, RE, etc. • expired contractor license or unlicensed contractor • Inability or unwillingness to provide current financial statements, including contract status report, receivables ageing, trade payables ageing • Inability or unwillingness to provide current financial statements, including contract status report, receivables ageing, trade payables ageing RMA

43. App C-4: Lending to Contractors—Info Needed to Underwrite, and Approve a Credit Request • Thoughtful explanation of reason for borrowing, amount desired, length of time to repay • Business plan—company’s overall strategy • Current financial info—BS, P&L, contract status report, receivable ageing, payables ageing • Financial projections showing ability to repay loan • Bonding and insurance • Personal guarantees of owners/principals • Personal financial statements of owners/principals • Tax returns on company and guarantors • Collateral from borrowers and guarantors • Credit agency reports on company and guarantors • Other? RMA

44. App C-5: Lending to Contractors—Underwriting Considerations • Entry of relatively inexperienced contractors into market and decline in use of established regional and national contractors • Sponsorship—customer’s ability to build, lease or manage this type of property in this market, “been there, done that . . .,” • Qualified third parties—property managers, project managers, leasing agents, external accountants, internal accounting and bookkeeping, real estate attorneys, civil engineers, architects, insurance agents, etc. • Global cash flow—resources of borrower and guarantors vs their collective debts • Increasing common ownership of project developer and general contractor and resistance to bonding requirements • Most sureties won’t bond projects where developer and contractor are under common ownership, so . . . • Require bonding of subcontractors at some minimum level, say 10% to 20% of budgeted hard costs • Additional upfront equity to offset completion risk for unbonded work • Stand-by letter of credit in lieu of general contractor bond • Spell out default points—project completion deadline in construction loan agreement • Rigid compliance with construction loan administration—3rd party review of contract and budget for feasibility and reasonable retention, equity injected upfront before any draws, 3rd party inspections, low tolerance for overadvances, monitoring of contingency fund depletion too early in project, lender approval of any changes to plans, specs, and construction budget RMA

45. App C-6: Lending to Contractors—Underwriting Considerations (continued) • Volatility of construction loan materials • Market intelligence from building supplies wholesalers and retailers in local market • Monitor commodities prices for steel, lumber, gypsum, concrete, oil, etc. • Credit checks on your borrower with its suppliers • Third-party data providers—RMA, IbisWorld, various real estate sources • Review and stress-test construction contracts and budgets—breakeven analysis • Resistance to equity & liquidity reqts • Reduce LTV and loan term, increase amortization • Require subsequent lump-sum cash equity injections • Springing lien on cash collateral under bank control RMA

46. App C-7: Lending to Contractors--Typical Bank Covenants and Conditions • No additional lenders without prior bank consent • subordination of any related party debt • no decrease or loss of bonding capacity • bonding company rated A or A+ by Best’s • copies of all documentation submitted to surety • monthly financial statements including BS, P&L, Cash Flow, AR aging, AP aging, and contract status report • cross-defaults and cross-collateralization • bank as loss payee on key person life or disability insurance equal to bank’s exposure • no change in ownership or control without prior bank approval • borrowing base certification and covenant compliance certification • Financial covenants • Minimum current ratio • Maximum debt/worth ratio • Minimum net working capital with step-up provision to capture some % of earnings • Minimum net worth with step-up provision to capture some % of earnings RMA