Lenders who finance commercial real estate exposures should be aware of new regulations that impose harsher capital requirements on certain “high volatility commercial real estate,” or HVCRE, exposures. In June 2013, the FDIC, OCC, and Federal Reserve jointly approved proposed rules intended to implement new international banking standards, known as the Basel III Capital Accords, as well as establish new risk-based and leverage capital requirements for financial institutions, as required by Dodd-Frank. The rules have been in effect for all banks since January 1, 2015, having applied to the largest banks one year prior.
Under the rules, an HVCRE exposure is defined as “a credit facility that, prior to conversion to permanent financing, finances or has had financed the acquisition, development, or construction (“ADC”) of real property,” if it fails to satisfy any of the following three capital requirements:
- The loan-to-value ratio must be less than or equal to the applicable maximum supervisory loan-to-value ratio in the regulatory agencies’ real estate lending standards (80% for most commercial real estate loans).
- The borrower must contribute capital to the project in the form of cash or unencumbered, readily-marketable assets (or development expenses paid out-of-pocket) of at least 15% of the real estate’s appraised “as-completed value.”
- The borrower must have contributed the required capital before the lender advanced funds under the credit facility, and the capital must be contractually required to remain in the project until the credit facility is converted to permanent financing or is paid in full.
For purposes of determining whether or not exposure qualifies as HVCRE, the subject real estate’s as-completed value must be appraised at the time the loan is made. In order to meet the 15% capital requirement, the borrower may count cash expended by the borrower to purchase the land, but not the current market value of the land. This means that if a borrower purchases a tract of land and holds it vacant for a number of years, during which time the value increases considerably, the appreciated value is not taken into account in determining whether the exposure is HVCRE, but only the borrower’s cash basis in the land. The borrower may also count soft costs, such as brokerage fees, leasing expenses, and management fees, paid out-of-pocket by the borrower toward the 15% capital requirement, but may not count any grants from nonprofit organizations or government agencies. Furthermore, the borrower may not borrow additional funds from the same lender providing the ADC financing in order to meet the 15% requirement.
All ADC loans are subject to the rules, even those made prior to the effective date of the rules. The rules list certain facilities excepted from HVCRE classification, such as those that finance one-to-four-family residential properties, community development investments, and agricultural land.
If an exposure is designated as HVCRE, the rules require that the lender assign a 150% risk weight to the exposure, resulting in a requirement that the lender hold 50% more capital in its reserves compared to an otherwise identical non-HVCRE loan (which would be assigned a 100% risk weight). Furthermore, once a loan is designated as HVCRE, it remains HVCRE for the life of the loan, regardless of any additional contributions of capital by the borrower or subsequent appraisals of the as-completed value; the loan may not be reclassified according to the bank’s internal underwriting standards until the expiration of the full term of the loan, even if construction is completed significantly earlier than the loan’s maturity date.
Understandably, the real estate industry has responded negatively to the HVCRE rules. During the comment period before the rules’ adoption, several commenters asserted that the 150% risk weight was too high for secured loans and would hamper local commercial development. The Commercial Real Estate Development Association (the “NAIOP”) has been particularly critical, claiming that the regulations “mov[e] the better loans out of the banking system” and “could increase the cost of capital, or decrease its availability, for commercial real estate loans.” The American Bankers Association notes that since the HVCRE rules apply only to banks and not to nonbank lenders, banks will be at a competitive disadvantage in the commercial real estate market.
The CRE Finance Council argues that the capital requirements needed to avoid HVCRE status are not only costly but also counterproductive. Since the borrower cannot remove capital from a project at any point during the life of the project without triggering an HVCRE designation, the borrower has the incentive to contribute only the 15% minimum required by the regulations, whereas in the past borrowers were often willing to contribute more capital into their ADC projects. The Mortgage Bankers Association is urging regulators to revise the rules to allow a reasonable use of internally generated capital.
A major point of contention regarding the rules concerns the valuation of land contributed as capital. In a comment letter to the regulatory agencies, several real estate and banking organizations argued in favor of using the value of contributed land, rather than its purchase price, for purposes of determining the amount of contributed capital. The use of the as-completed value of the project, rather than its cost, in loan-to-value and capital contributions calculations also worries banks. One bank credit risk manager recounted a situation in which his bank approved a loan for which the borrower contributed 25% of the cost. However, the as-complete appraised value was so high that the cash equity contribution fell short of the 15% requirement under the rules, thus triggering an HVCRE classification. As this example demonstrates, the new regulations may paradoxically classify the most profitable projects as among the most risky.