MainStreet Bancshares, Inc. (MNSB) FY 2023 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The purpose of this discussion is to focus on significant changes in the financial condition and results of operations of the Company during the years ended December 31, 2023 and 2022. The following discussion supplements and provides information about the major components of the results of operations, financial condition, liquidity and capital resources of the Company. This discussion and analysis should be read in conjunction with the accompanying consolidated financial statements.

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Forward-Looking Statements

This Annual Report on Form 10-K contains certain forward-looking statements and information relating to the Company within the meaning of the Private Securities Litigation Reform Act of 1995 that are based on the beliefs of management as well as assumptions made by and information currently available to management. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words like “believe,” “expect,” “anticipate,” “estimate,” and “intend” or future or conditional verbs such as “will,” “should,” “could,” or “may” and similar expressions or the negative thereof. Important factors that could cause actual results to differ materially from those in the forward–looking statements included herein include, but are not limited to:

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Should one or more of these risks or uncertainties materialize or should underlying assumptions prove incorrect, actual results may vary materially from those described herein. We caution readers not to place undue reliance on forward-looking statements. The Company disclaims any obligation to revise or update any forward-looking statements contained in this Form 10-K to reflect future events or developments. The discussion of the critical accounting policies and analysis set forth below is intended to supplement and highlight information contained in the accompanying Consolidated Financial Statements and the selected financial data presented elsewhere in this Form 10-K.

Critical Accounting Policies

The accounting and financial reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. Accordingly, the financial statements require certain estimates, judgments, and assumptions, which are believed to be reasonable, based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the periods presented. Critical accounting policies comprise those that management believes are the most critical to aid in fully understanding and evaluating our reported financial results. These policies require numerous estimates or economic assumptions that may prove inaccurate or may be subject to variations which may significantly affect our reported results and financial condition for the current period or in future periods.

The accounting principles followed by the Company and the methods of applying these principles conform with accounting principles generally accepted in the United States of America and with general practices within the banking industry. The Company’s critical accounting policies relate to (1) the allowance for credit losses, (2) fair value of financial instruments, and (3) derivative financial instruments. These critical accounting policies require the use of estimates, assumptions and judgments which are based on information available as of the date of the financial statements. Accordingly, as this information changes, future financial statements could reflect the use of different estimates, assumptions and judgments. Certain determinations inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported.

Allowance for Credit Losses: On January 1, 2023, the Company adopted ASU 2016-13 Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (ASC 326). This standard replaced the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (“CECL”) methodology. CECL requires an estimate of credit losses for the remaining estimated life of the financial asset using historical experience, current conditions, and reasonable and supportable forecasts and generally applies to financial assets measured at amortized cost, including loan receivables and held-to-maturity debt securities, and some off-balance sheet credit exposures such as unfunded commitments to extend credit. Financial assets measured at amortized cost will be presented at the net amount expected to be collected by using an allowance for credit losses. See Note 1. Organization, Basis of Presentation, Summary of Significant Accounting Policies, and Impact of Recently Issued Accounting Pronouncements for a more detailed description of methodology and impact of adoption.

Fair Value of Financial Instruments: A portion of the Company’s assets and liabilities is carried at fair value, with changes in fair value recorded either in earnings or accumulated other comprehensive income (loss). These include investment securities available for sale and interest rate loan swaps on qualifying commercial loans. Periodically, the estimation of fair value also affects investment securities held to maturity when it is determined that the Company should record an allowance for credit losses on a security. Fair value determination is also relevant for certain other assets such as other real estate owned, which is recorded at the lower of the recorded balance or fair value, less estimated costs to sell. The determination of fair value also impacts certain other assets that are periodically evaluated for impairment using fair value estimates, including individually evaluated loans.

Fair value is generally based upon quoted market prices, when available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use observable market-based parameters as inputs. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the Company’s creditworthiness, among other things, as well as other unobservable parameters. Any such valuation adjustments are applied consistently over time. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

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See Note 20, Fair Value Presentation, in Notes to Consolidated Financial Statements for a detailed discussion of determining fair value, including pricing validation processes.

Derivative Financial Instruments: The Bank recognizes derivative financial instruments at fair value as either other assets or other liabilities in the consolidated statement of financial condition. The Bank’s derivative financial instruments include interest rate swaps with certain qualifying commercial loan customers and dealer counterparties. Because the interest rate swaps with loan customers and dealer counterparties are not designated as hedging instruments, adjustments to reflect unrealized gains and losses resulting from changes in fair value of these instruments are reported as non-interest income or non-interest expense, as applicable. The Bank’s interest rate swaps with loan customers and dealer counterparties are described more fully in Note 19 in the December 31, 2023, Consolidated Financial Statements.

Selected Financial Data

The following table sets forth summarized historical consolidated financial information for each of the periods indicated. This information should be read together with the accompanying consolidated financial statements included in this Form 10-K. The historical information indicated as of and for the years ended December 31, 2023,and 2022 has been derived from the Company's audited consolidated financial statements for the years ended December 31, 2023, and 2022. Historical results set forth below and elsewhere in this Form 10-K are not necessarily indicative of future performance

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Analysis of Results of Operations for the Years Ended December 31, 2023 and 2022

Net Income

The following table sets forth the principal components of net income for the periods indicated.

Net income for the year ended December 31, 2023, was $26.6 million, a decrease of $0.1 million, or 0.3% compared to $26.7 million earned during the year ended December 31, 2022. The decrease in net income was due to increases in interest expense of $34.3 million and an increase of non-interest expenses of $6.1 million compared to the same period in the prior year. Despite increases in interest expense, net interest income increased $5.9 million, primarily driven by increased volume of loans and increase in interest rates.

Net Interest Income and Net Interest Margin

Net interest income is the principal component of the Company’s income stream and represents the difference, or spread, between interest and fee income generated from earning assets and the interest expense paid on deposits and borrowed funds. Net interest margin, stated as a percentage, is the yield obtained by dividing the difference between interest income generated on earning assets and the interest expense paid on all funding sources by average earning assets. Fluctuations in interest rates as well as changes in the volume and mix of earning assets and interest-bearing liabilities can impact net interest income and net interest margin.

Net interest income before provision for or recovery of credit losses totaled $75.9 million for the year ended December 31, 2023, compared to $70.0 million for the year ended December 31, 2022. The increase in net interest income was driven by an increase in loan production and increase in interest rates on variable rate credits and loans that repriced during the year ended December 31, 2023.

The net interest margin was 4.08% for the year ended December 31, 2023, compared to 4.19% for the year ended December 31, 2022, on a fully tax equivalent basis. The decrease in net interest margin primarily resulted from an increase of interest expense on our interest bearing liabilities that outpaced the increase in interest income. The primary drivers of increased interest expense came from money market and time deposits. The increase in the federal funds target rate impacted our maturing wholesale deposits that had to reprice in a higher interest rate environment, which increased margin pressure on our loan portfolio and other interest earning assets. Management made efforts to replace these deposits with callable wholesale deposits, allowing more optionality for future rate movements.

The yield for the year ended December 31, 2023 for the loan portfolio was 7.00% compared to 5.47% for the year ended December 31, 2022. The increase primarily reflects the maturity of lower yielding loans and higher yields on new and variable rate loans based on higher interest rates during the year. The Federal Reserve increased its targeted benchmark interest rate to a range of 525 - 550 basis points in 2023, which impacted yields obtained on new loans throughout the year.

For the year ended December 31, 2023, the yield on the taxable investment securities portfolio was 2.67% compared to 2.20% for the year ended December 31, 2022. For the year ended December 31, 2023, the yield on the tax-exempt investment securities portfolio was 3.57% compared to 3.48% for the year ended December 31, 2022. The increase in both categories was primarily due to rates on variable securities increasing with the current rate environment and lower yields on investment securities maturing during the period.

The rate paid on interest bearing deposits increased to 3.61% during the year ended December 31, 2023, from 1.14% during the year ended December 31, 2022. This increase was a result of higher rates paid on all outstanding deposits in conjunction with the increasing rate environment throughout the year.

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The rate paid on FHLB borrowings and federal funds purchased for the year ended December 31, 2023 was 4.90% and 5.36%, respectively, compared to the prior year of 1.45% for FHLB borrowings and no interest paid on federal funds purchased.

The following table sets forth the major components of net interest income and the related yields and rates for the year ended December 31, 2023, compared to the year ended December 31, 2022.

Average Balances, Net Interest Income, Yields Earned and Rates Paid

The following table shows for the periods indicated the total dollar amount of interest from average interest-earning assets and the resulting yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates, and the net interest margin. All average balances are based on daily balances.

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Rate/ Volume Analysis

The following table presents the effects of changing rates and volumes on net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the prior columns. For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately, based on the changes due to rate and the changes due to volume.

Provision for Credit Losses

We establish a provision for credit losses, which is charged to operations, in order to maintain the allowance for credit losses at a level we consider necessary to absorb expected credit losses that are both probable and reasonably estimated at the balance sheet date. In determining the level of the allowance for credit and off-balance sheet losses, we consider past and current loss experience, evaluations of real estate collateral, current and future economic conditions, volume and type of lending, adverse situations that may affect a borrower’s ability to repay a loan and the levels of non-performing loans. The amount of the allowance is based on estimates, and actual losses may vary from such estimates as more information becomes available or economic conditions change.

This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as circumstances change as more information becomes available. The allowance for credit losses on loans is assessed on a monthly basis and provisions are made for credit losses on loans as required in order to maintain the allowance. The allowance for off-balance sheet credit is assessed quarterly and provisions are made to maintain the allowance.

The provision for credit losses on loans decreased to a loan loss provision of $1.9 million for the year ended December 31, 2023, compared to the prior year which ended at loan loss provision of $2.4 million. The provision for credit losses on off-balance sheet exposure was a net recovery of $301 from the original establishment of $1.3 million upon the adoption of CECL. The decrease in provision for credit losses on loans was primarily driven by loan growth as well as increasing qualitative factors within our model assumptions for increased levels of past dues and potential weaknesses in underlying collateral for certain asset classes. The recovery of credit losses for off-balance sheet exposure was driven by fluctuations in our revolving credit line utilization rates as of December 31, 2023. Loan originations decreased $152.3 million, which totaled $599.9 million for the year ended December 31, 2022 compared to loan originations of $447.6 million for the year ended December 31, 2023. Non-performing loans were $21,000 at December 31, 2022 and $1.0 million at December 31, 2023.

On September 22, 2022, the Company completed the sale of a loan note for a customer that had stopped making payments and declared bankruptcy. The Company incurred a loss of $211,000 on this transaction that was properly accounted for in its Statement of Income as a loss on the sale of a loan. This credit had previously identified weaknesses and deemed to be of substandard quality with an appropriate reserve allocation. We determined that the best course of action was to sell the note at a discount to an interested party. Had the loan sale not occurred, the Company would have recorded a specific allocation to the provision for loan losses and proceeded with an orderly liquidation of collateral.

During the year ended December 31, 2023, substandard loans increased $11.7 million for a balance of $21.2 million. During the year ended December 31, 2023, special mention loans increased $19.0 million to $19.0 million. During the year ended December 31, 2023, watch list loans increased $33.7 million to $58.7 million. Management does not believe any significant loss exposure currently exists in these loans. During the year ended December 31, 2023, there was $468,000 in charge-offs recorded and recoveries of $22,000 were received. During the year ended December 31, 2022, there were no charge-offs recorded and recoveries received of $19,000.

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Non-Interest Income

Our primary sources of non-interest income are service charges on deposit accounts, such as interchange fees and statement fees, income earned on bank owned life insurance, fees earned from executing interest rate swaps on commercial loans, and gains realized on the sale of the guaranteed portion of Small Business Administration (“SBA”) loans.

The following table presents, for the periods indicated, the major categories of non-interest income:

Non-interest income decreased $1.2 million, or 24.7%, to $3.6 million for the year ended December 31, 2023 from $4.8 million for the year ended December 31, 2022. The decrease in non-interest income was primarily due to a decrease in swap fee income and mortgage origination fees decreasing $379,000 for the year ended December 31, 2023. The Company did not recognize any fees on interest rate swaps for commercial loans for the year ended December 31, 2023 down from $619,000 for the year ended December 31, 2022. The Company also recognized $251,000 in planned operating losses in other fee income related to two New Market Tax Credit investments during the year ended December 31, 2023. Bank owned life insurance income increased $61,000 for the year ended December 31, 2023, compared to the year ended December 31, 2022, due to the rising rate environment throughout 2023. The deposit service fees decreased $271,000 for the year ended December 31, 2023, as compared to the same period in 2022, due to a decrease in customer activity.

Non-Interest Expense

Generally, non-interest expense is composed of all employee expenses and costs associated with operating our facilities, obtaining and retaining customer relationships and providing bank services. The largest component of non-interest expense is salaries and employee benefits. Non-interest expense also includes operational expenses, such as occupancy and equipment expenses, professional fees, advertising expenses and other general and administrative expenses, including FDIC assessments, communications, travel, meals, training, supplies and postage. The following table presents, for the periods indicated, the major categories of non-interest expense:

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Non-interest expense increased $6.1 million or 15.5% to $45.1 million for the year ended December 31, 2023 from $39.1 million for the year ended December 31, 2022 primarily as a result of increases in salary and employee benefits of $4.5 million, FDIC insurance of $494,000 and Franchise tax of $405,000. Salaries and employee benefits expense increased by $4.5 million to $28.3 million for the year ended December 31, 2023 from $23.8 million for the year ended December 31, 2022 primarily as a result of increasing our personnel team members by 18 employees. FDIC insurance increased $494,000, or 77.6%, to $1.1 million for the year ended December 31, 2023 from $637,000 for the year ended December 31, 2022. While the Company was not included in the special assessment directly related to four bank failures, the FDIC is increasing the reserve ratio within its insurance fund. Franchise tax expense increased $405,000, or 28.3%, to $1.8 million for the year ended December 31, 2023, due to consistent growth of the Company's capital and earnings profile. Many of the non-interest expense categories remained consistent for the year ended December 31, 2023 compared to the year ended December 31, 2022 as management continues to exercise judicious expense controls.

Income Tax Expense

Income tax expense decreased $475,000, or 7.1%, to $6.2 million for the year ended December 31, 2023 from $6.7 million for the year ended December 31, 2022. The decrease in federal income tax expense for the year ended December 31, 2023 compared to the same period a year earlier was driven by continued investments in projects that provide tax credit incentives and further the mission of our community development entity. The Company is able to apply and claim a research and development tax credit for its associated work in developing a software platform. The Company has invested in projects that generate tax credits through the Low Income Housing Tax Credits ("LIHTC") program as well as NMTC projects. As a result of tax regulation, the Company has included assessments in income tax expense for state tax liabilities during 2023. For the year ended December 31, 2023, the Bank had an effective tax rate of 19.0%, compared to effective federal tax rate of 20.1% for the year ended December 31, 2022.

Avenu, a division of MainStreet Bank

Analysis of Results of Operations for the Year Ended December 31, 2023

Net Income

The following table sets forth the principal components of net income (loss) for the Avenu division of MainStreet Bank for the periods indicated. All amounts set forth are included in the Results of Operations for the Year Ended December 31, 2023 and 2022 for MainStreet Bancshares, Inc. unless indicated otherwise.

For the year ended December 31, 2023, the Avenu division recorded net income of $51,000. As the Company develops the software and ramps up the resources needed to operate a new division, elevated levels of non-interest expenses are anticipated. The Avenu division held $45.0 million in average non-interest bearing deposits which provides tremendous value to the Company, while simultaneously establishing a new division. Avenu is developing a comprehensive hosted BaaS software platform that will provide Fintechs with a subledger integrated within a regulatory compliant framework, easily connectable application programming interfaces ("APIs"), and access to banking payment networks. The Avenu team will deploy the platform in 2024.

Comparison of Statements of Financial Condition at December 31, 2023 and at December 31, 2022

Total Assets

Total assets increased $109.7 million, or 5.7%, to $2.0 billion at December 31, 2023 from $1.9 billion at December 31, 2022. The increase was primarily the result of increases of $127.5 million in gross loans receivable, $5.5 million in computer software, and $2.8 million in accrued interest receivables. These increases were offset by a decrease in available-for-sale securities of $2.7 million and a decrease of $5.0 in other assets, which was primarily impacted by fluctuations in market value of our executed loan swaps.

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Investment Securities

We use our securities portfolio to provide a source of liquidity, provide an appropriate return on funds invested, manage interest rate risk, meet collateral requirements, assist in achieving Community Reinvestment Act (CRA) objectives, and meet regulatory capital and liquidity requirements. Our investment policy is established and reviewed annually by the Board of Directors. We are permitted under federal law to invest in various types of liquid assets, including United States Government obligations, securities of various federal agencies and of state and municipal governments, mortgage-backed securities, time deposits of federally insured institutions, subordinated debt of other financial institutions, equity securities, certain bankers’ acceptances and federal funds.

Our investment objectives are to maintain high asset quality, to provide and maintain liquidity, to establish an acceptable level of interest rate and credit risk, to provide an alternate source of low-risk investments when demand for loans is weak and to generate a favorable return. The Board of Directors has the overall responsibility for the investment portfolio, including approval of our investment policy. The Board of Directors is also responsible for implementation of the investment policy and monitoring investment performance. The Board of Directors reviews the status of the investment portfolio on a quarterly basis, or more frequently if warranted.

Generally accepted accounting principles require that, at the time of purchase, we designate a security as held to maturity, available-for-sale, or trading, depending on our ability and intent to hold such security. Debt securities available for sale are reported at fair value, while debt securities held to maturity are reported at amortized cost. We do not maintain a trading portfolio. Establishing a trading portfolio would require specific authorization by the Board of Directors.

The total investment securities portfolio, including both investment securities available for sale and investment securities held to maturity, was $77.2 million at December 31, 2023, a decrease of $3.1 million compared with December 31, 2022. At December 31, 2023, the investment securities portfolio includes $59.9 million of investment securities available for sale and $17.3 million of investment securities held to maturity compared to $62.6 million of investment securities available for sale and $17.6 million of investment securities held to maturity at December 31, 2022.

The Company did not sell any securities within the investment portfolio for the year ended December 31, 2023 or 2022.

For available-for-sale securities, management evaluates all investments in an unrealized loss position on a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. If the Company has the intent to sell the security, or it is more likely than not that the Company will be required to sell the security, the security is written down to fair value, and the entire loss is recorded in earnings.

Portfolio Maturities and Yields. The composition and maturities of the investment securities portfolio at December 31, 2023, are summarized in the following table. Maturities are based on the final contractual payment date, and do not reflect the effect of scheduled principal repayments, prepayments, or early redemptions that may occur. Adjustable-rate mortgage-backed securities are included in the period in which interest rates are next scheduled to adjust. The Company does invest in both taxable and non-taxable municipal securities. No material changes occurred in the non-taxable security portfolio for the year ended December 31, 2023.

Weighted average yield is calculated as the tax-equivalent yield on a pro rata basis for each security based on its relative amortized cost.

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Loan Portfolio

Our primary source of income is derived from interest earned on loans. Our loan portfolio consists of loans secured by real estate as well as commercial business loans and consumer loans, substantially all of which are secured by corresponding deposits at the Bank. Our loan customers primarily consist of small- to medium-sized businesses, professionals, real estate investors, small residential builders and individuals. Our owner occupied and investment commercial real estate loans, residential construction loans and commercial business loans provide us with higher risk-adjusted returns, shorter maturities and more sensitivity to interest rate fluctuations, and are complemented by our relatively lower risk residential real estate loans to individuals. Our lending activities are principally directed to our market area consisting of the Washington, D.C. and Northern Virginia metropolitan areas.

Loan Portfolio Maturities and Yields. The following table summarizes the scheduled repayments of our loan portfolio at December 31, 2023. Demand loans, having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less. Maturities are based on the final contractual payment date and do not reflect the impact of prepayments and scheduled principal amortization.

The following table sets forth our fixed and adjustable-rate loans at December 31, 2023, that are contractually due after December 31, 2023.

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The following table shows our loan originations, participations, purchases, sales and repayment activities for the periods indicated.

Loans, net of unearned income, totaled $1.7 billion at December 31, 2023, an increase of $127.5 million from December 31, 2022. The increase in total loans was primarily driven by growth in the overall loan portfolio, with increases in multifamily residential real estate, as well as in construction and land development credits.

A significant portion of the loan portfolio consists of commercial, construction and commercial real estate loans, primarily made in the Washington, D.C. metropolitan area and secured by real estate or other collateral in that market. Although these loans are made to a diversified pool of unrelated borrowers across numerous businesses, adverse developments in the Washington, D.C. metropolitan real estate market could have an adverse impact on this portfolio of loans and the Company’s income and financial position. While our basic market area is the Washington, D.C. metropolitan area, the Bank has made loans outside that market area where the applicant is an existing customer, and the nature and quality of such loans was consistent with the Company's lending policies.

The federal banking Agencies issued guidance in 2006 which addresses institutions’ with increased concentrations of commercial real estate (CRE) loans.  The guidance does not establish specific CRE lending limits; rather, it promotes sound risk management practices and appropriate levels of capital that will enable institutions to continue to pursue CRE lending in a safe and sound manner.  In developing this guidance, the Agencies recognized that different types of CRE lending present different levels of risk, and that consideration should be given to the lower risk profiles and historically superior performance of certain types of CRE, such as well-structured multifamily housing finance, when compared to others, such as speculative office space construction. As discussed under “CRE Concentration Assessments,” institutions are encouraged to segment their CRE portfolios to acknowledge these distinctions for risk management purposes. The guidance focuses on those CRE loans for which the cash flow from the real estate is the primary source of repayment rather than loans to a borrower for which real estate collateral is taken as a secondary source of repayment or through an abundance of caution. Thus, for the purposes of the guidance, CRE loans include those loans with risk profiles sensitive to the condition of the general CRE market (for example, market demand, changes in capitalization rates, vacancy rates, or rents). CRE loans are land development and construction loans (including 1- to 4-family residential and commercial construction loans) and other land loans. CRE loans also include loans secured by multifamily property, and nonfarm nonresidential property where the primary source of repayment is derived from rental income associated with the property (that is, loans for which 50 percent or more of the source of repayment comes from third party, nonaffiliated, rental income) or the proceeds of the sale, refinancing, or permanent financing of the property. Excluded from the scope of this Guidance are loans secured by nonfarm nonresidential properties where the primary source of repayment is the cash flow from the ongoing operations and activities conducted by the party, or affiliate of the party, who owns the property.

As part of their ongoing supervisory monitoring processes, the Agencies use certain criteria to identify institutions that are potentially exposed to significant CRE concentration risk. An institution that has experienced rapid growth in CRE lending, has notable exposure to a specific type of CRE, or is approaching or exceeds the following supervisory criteria may be identified for further supervisory analysis of the level and nature of its CRE concentration risk:

The Agencies use the criteria as a preliminary step to identify institutions that may have CRE concentration risk. Because regulatory reports capture a broad range of CRE loans with varying risk characteristics, the supervisory monitoring criteria do not constitute limits on an institution’s lending activity but rather serve as high-level indicators to identify institutions potentially exposed to CRE concentration risk.

The Company holds a concentration in commercial real estate loans. As of December 31, 2023, construction, land development and other land loans represented 137.7% of consolidated risk-based capital. Total commercial real estate loans as defined by the Agency guidance represented 372.5% of consolidated risk-based capital. During the prior 36 months, the Company has experienced an increase in its commercial real estate portfolio by 55%.

The management team has extensive experience in underwriting commercial real estate loans and has implemented and continues to maintain heightened risk management procedures and strong underwriting criteria with respect to its commercial real estate portfolio. The Board of Directors has established internal maximum limits on CRE as an asset class overall as well as sub limits within CRE by property class, to better manage and control the exposure to property classes during periods of changing economic conditions. The Board of Directors also has minimum targets for regulatory capital ratios that are in excess of well capitalized ratios.

Our risk management process begins with a robust underwriting program. The underwriting and risk rating of all loans is completed by an underwriting team that is independent of the originating lender(s). The underwriting analysis of commercial real estate loans includes pre-origination stress testing utilizing the portfolio stress testing methods to fully understand the potential exposure before we originate the credit. Once originated, each loan receives ongoing quarterly stress tests to evaluate the risk profile over the life of the credit.

We stress test earning assets on a quarterly basis and measure the results against the Bank's risk-based capital. For commercial loans, residential real estate loans, owner-occupied commercial real estate loans and consumer installment loans, we multiply the total outstanding amount for each loan category by our highest quarter historical loss for that category as a surrogate in order to calculate a stressed loss.

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For our non-owner occupied commercial real estate loans, we use three separate methodologies in our stress test. If a property fails more than one of the three tests, we extend the test with the highest exposure value and add an additional 10% for selling costs.

We stress test the construction lending portfolio by applying exponential discounting (using a "k factor" of 2) to each project based upon its percentage of completion. The project is stressed using the as-is and as-complete appraised values and assumes 10% selling costs.

For all other loans, we utilize the Bank's historic loss rates or if not available, the average loss rates of UBPR Group 4 banks, for bank owned life insurance we utilize default rates from S&P Global ratings, and for securities we obtain an independent fair market value and if it is less than the book value, we subtract the fair market value from the book value to determine the stress loss. For The following table shows the Company's earning assets and the results of the stress test performed for the periods indicated.

(1) Net tax effective loss at the statutory rate of 21%

The total estimated stress test loss is deducted from capital and we recalculate the capital ratios. As shown in the tables below, as of December 31,
2023, and
2022 the post-stress capital ratios well exceed our Board target ratios as well as Agency minimums (with buffer).

The Company employs an external loan review firm to conduct ongoing reviews of the loan portfolio. During the year ended December 31, 2023, the independent external loan review firm reviewed approximately 55% of the entire portfolio by outstanding dollar balance. The external review did not identify any material underwriting or ongoing portfolio management concerns.

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The following two tables break down the December 31, 2023 and December 31, 2022 non-owner occupied CRE portfolio balances by showing the current balance in each sub-category and location. The tables also display very favorable weighted average interest rates and weighted average loan-to-values for both periods. The weighted average occupancy percentages are also broadly favorable for both periods.

The Company also underwrites and originates owner-occupied commercial real estate loans. These loans are typically term loans made to support properties that rely upon the operations of the business occupying the property for repayment. The Agencies specifically excluded owner-occupied commercial real estate from their concentration guidance, as the primary source of repayment is the cash flow from the ongoing operations and activities conducted by the party, or affiliate of the party, who owns the property.

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The following two tables depict a well-diversified portfolio of owner-occupied commercial real estate as of December 31, 2023 and December 31, 2022.  The properties are distributed nicely among the Company's footprint. This loan segment continues to perform very well and is supported by strong loan-to-values (LTVs). The following table sets forth our owner-occupied CRE portfolio by the business industry groups that occupy the properties for the periods indicated.