High Volatility Commercial Real Estate ("HVCRE") exposure has recently become an area of increasing interest for commercial real estate lenders. The Basel III Final Rule (the "Final Rule") defines an HVCRE loan as a credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development or construction of real property ("ADC Financing"). There are a few exceptions to this broad HVCRE classification, but only one appears applicable to the type of ADC Financing typically originated by our lender clients. This exception states that ADC Financing will avoid HVCRE classification if it satisfies each of the following three conditions:
(i) The loan-to value ("LTV") is less than or equal to the applicable maximum amount (which is 65% for raw land, 75% for land development, 80% for commercial, multifamily, and other non-residential construction, 85% for 1-4 family residential construction and 85% for improved property construction).
(ii) The borrower has contributed capital of at least 15% of the appraised "as completed" value; and
(iii) The borrower contributed the amount required by clause (ii) above before the lender advances funds, and the capital contributed by the borrower, or internally generated by the project is contractually required to remain in the project for the life of the project, which ends when the ADC Financing is converted to permanent financing or sold or paid in full.
Clause (iii)'s obligation for lenders to contractually require that internally generated capital remain in the project during the life of the project appears on its face somewhat draconian. Does this actually mean if more than the minimum 15% is contributed, that such excess is also trapped, seemingly punishing the better capitalized projects? Does it also mean that all capital generated during the term of the loan must also be retained such that no distributions may be made during the term of the ADC Financing? Or, does it simply mean that 15% of the capital, whether contributed or internally generated, must remain in the project, with a borrower being able to distribute any excess amounts?
While the latter approach may be more reasonable and rational, that does not appear to be correct. Read literally, clause (iii) requires a lender's loan documents to contractually require a borrower to retain all capital, whether contributed or internally generated in the project for the life of the project. The 15% is only mentioned in clause (ii) which appears to be an independent requirement from clause (iii). Further, spokespeople from both the FDIC and OCC have recently confirmed to us that this literal reading is the correct reading and their current position. That said, a spokesperson from the OCC has stated that the regulators understand that clause (iii) creates a potentially untenable requirement for many lenders to impose on borrowers and that the regulatory agencies "are currently re-analyzing their position." Although this may provide some hope for the future, it does nothing to address the potentially untenable position lenders currently find themselves in given that any contractual provision contained in the ADC Financing documents that tracks clause (iii) will not be well received by borrowers.
We have been working with several of our lenders to address this issue in their loan documents while trying to be cognizant of the realities of the market. In drafting such language, the following should be kept in mind: (1) clause (iii) requires an express contractual restriction; (2) if a loan is classified as an HVCRE, the lender may be faced with increased costs related to that loan, which costs should be included in the increased cost indemnification loan provisions; and (3) any covenant addressing the HVCRE classification should take into account that such regulations may very well change prior to the subject loan's maturity date.
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