On January 1, 2015, the final Basel III rules regarding
regulatory capital for banks with greater than $500 million in
assets and all savings and loan holding companies took effect.
Basel III imposes new rules for high volatility commercial real
estate (HVCRE) which the regulations define as a credit facility
that finances the acquisition, development or construction (ADC) of
real property. The HVCRE rules may affect the availability and
pricing of commercial real estate mortgage capital.
Regulators use the risk weight total of a bank’s
risk-weighted assets to calculate how much capital a bank needs to
sustain itself through challenging markets. Subject to certain
exceptions, the regulations assign a 150 risk weighting to HVCRE
loans which means that for purposes of risk weighting a $10 million
HVCRE loan will count as $15 million toward the bank’s risk
weight total.
Loans that finance the acquisition, development and construction of
one to four family residential properties, projects that qualify as
community development investment and loans to businesses or farms
with gross revenue exceeding $1,000,000 are exempt from the HVCRE
classification.
A commercial real estate ADC loan may avoid the HVCRE classification if:
- the loan-to-value ratio (LTV) is equal to or less than 80%
- the borrower contributes capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development costs out of pocket) of at least 15% of the real estate project’s “as completed” appraised value, and
- the borrower’s 15% is contributed to the project before the lender advances any funds under the loan and remains in the project until the loan is converted to a permanent loan or paid off.
The LTV requirement is typically not an issue as lenders tend to
be more conservative with LTVs typically in the 65% to 70% range
for ADC loans.
The second exemption, which requires the borrower to contribute 15%
in cash or unencumbered readily marketable assets to the project,
deviates from traditional lender requirements in two important
ways. Traditionally, borrower equity was calculated as a percentage
of the total project costs. Now, a borrower is required to inject
15% of equity into the project measured against the project’s
“as completed” appraised value which, inevitably, is
higher than the total project costs thus requiring a borrower to
put more equity into a project.
Also, lenders traditionally counted the current value of the
land towards the borrower’s equity requirement. Under the new
HVCRE rules, a borrower who acquires the project property
concurrently with or in a reasonable time prior to the loan closing
is not impacted as the acquisition cost for the land counts towards
the borrower’s 15% equity requirement. On the other hand, a
borrower who either bought and held land for the right market
conditions or contributes land that has long been held by the
borrower will likely find itself limited to the land’s
acquisition cost rather than the current market value toward its
equity requirement. As a result, borrowers will have to obtain
other sources of capital to satisfy the 15% equity requirement
which may adversely affect the project’s feasibility.
The effect the HVCRE rules have on ADC lending remains to be seen.
It is not clear that all smaller financial institutions are
currently fully complying with the new rules in bidding for ADC
loans, which may result in a temporary competitive advantage in
pricing and equity requirements. Long term, the new rules may
result in banks reallocating capital to investment options with a
higher return thereby limiting financing available for commercial
real estate. So long as interest rates remain at or near historic
lows, ADC lending seems to remain a popular investment for some
banks such as M&T Bank which expanded its construction loan
portfolio by 15% in 2014 to 7.6% of its total loan portfolio while
other lenders take a more conservative approach to construction
lending.
It remains to be seen whether construction lending remains strong
under the new HVCRE rules.
This article is presented for informational purposes only and is not intended to constitute legal advice.