Acquisition, Development, and Construction Lending

The U.S. has benefited from strong economic growth and generally favorable real estate markets since the early 1990s. As a result, financial institutions in many metropolitan areas are active in residential and commercial real estate acquisition, development, and construction (ADC) lending. ADC lending has had a positive impact on financial institutions and the overall economy. However, information obtained by the FDIC through the examination process and from other sources indicates that several areas of the country are experiencing very high levels of construction activity and an extremely competitive lending environment. The combination of these factors often leads to thin profit margins on ADC loans and looser underwriting standards. This letter is intended to make institutions aware of this situation and to remind them of existing regulatory guidance for real estate lending activities. 

Recent studies undertaken by the FDIC's Division of Insurance find early indicators of potential imbalances in a number of real estate markets. These studies, which are supported by the opinions and research of credible industry experts, caution that the rapid pace of development within various markets may lead to an oversupply of developed property during the next several years. Many of the most rapidly expanding metropolitan areas are located in the Southeast and Southwest portions of the country. While the studies do not predict an imminent downturn in these markets, they do raise concerns about the substantial growth in real estate development and the related increase in financial institution ADC loan concentrations within some markets. Additional information about these studies can be found on the FDIC's World Wide Web site at /bank/analytical/bank/fil998.html. 

The majority of financial institutions have operated their ADC lending programs prudently for most of this decade. However, ADC lending is a highly specialized field with inherent risks that must be managed and controlled to ensure that this activity remains profitable. Management's ability to identify, measure, monitor, and control portfolio risk through effective underwriting policies, systems, and internal controls is crucial to a sound ADC lending program. 

Part 365 of the FDIC Rules and Regulations requires FDIC-supervised institutions to adopt and maintain written policies that establish appropriate limits and standards for all real estate loans, including ADC loans. The institution's board of Directors is responsible for establishing appropriate risk limits, monitoring exposure, and evaluating the effectiveness of the institution's efforts to manage and control risk. The level and complexity of risk-monitoring techniques for ADC lending should be commensurate with the level of real estate activity and the nature and complexity of the institution's market. When crafting internal guidelines for ADC and other real estate lending programs, the board should carefully consider the Interagency Guidelines for Real Estate Lending Policies, which can be found under Appendix A to Part 365. In particular, the following items within the Interagency Guidelines should be noted. 

* Underwriting Standards - Underwriting standards for construction and development loans should address the following items, commensurate with the size and complexity of the project: 

* Supervisory Loan-to-Value Limits - Institutions should establish their own loan-to-value (LTV) limits for real estate loans; however, these internal limits generally should not exceed the LTV limits suggested within the interagency guidelines. While the interagency LTV limits can be exceeded under certain conditions for individual credits, loans exceeding the interagency guidelines should be noted as such on the bank's records. In addition, the aggregate amount of loans exceeding the interagency LTV guidelines should be reported to the board at least quarterly and the total amount of those loans should not exceed 100 percent of the bank's total capital. Moreover, within the 100 percent of capital limitation, the total amount of non-1-4 family residential real estate loans exceeding the LTV limits should not exceed 30 percent of total capital. 

* Exceptions to Policy - The board of Directors is responsible for establishing standards for reviewing and approving exceptions to loan policy. The approval of any loan that is an exception to policy should be supported by a written justification that clearly sets forth all of the relevant credit factors supporting the underwriting decision. Exception loans of a significant size should be individually reported to the institution's board of Directors. The institution should monitor compliance with its internal policies and maintain reports of all exceptions to policy. Such reports will be reviewed by examiners during the course of regular examinations to determine whether the institution's exceptions are adequately documented and are appropriate in view of all the relevant credit considerations. 

The above list represents a partial summary of the interagency guidelines and is not intended to be comprehensive nor all-inclusive. Institutions are encouraged to refer to Part 365 and Appendix A to Part 365 for additional guidance. If you have any questions, please contact your Division of Supervision Regional Office for further assistance. 

Distribution: FDIC-Supervised Banks (Commercial and Savings) 

NOTE: Paper copies of FDIC financial institution letters may be obtained through the FDIC's Public Information Center, 801 17th Street, NW, Room 100, Washington, DC 20434 (800-276-6003 or (703) 562-2200).