Since its implementation, the High Volatility Commercial Real Estate (HVCRE) rules have created certain questions and concerns for banks and borrowers alike in real estate lending transactions. Bi-partisan legislation (H.R. 2148) introduced by Congressmen Robert Pittenger (R-NC) and David Scott (D-GA)1 in the House of Representatives would address some of the market issues arising out of the rules' provisions.
Currently, a loan to a borrower for acquisition, development or construction (commonly referred to as an ADC loan) may avoid HVCRE classification with its accompanying heightened reserve requirements by, among other things, satisfying a regulatory agency-set maximum LTV and by a borrower demonstrating that it has (i) contributed cash or unencumbered readily marketable assets, (ii) paid certain development expenses out of pocket, or (iii) contributed land, all aggregating at least 15% of the real estate's "as completed" appraised value.
HVCRE's 15% rule presents a number of concerns including that (i) it restricts a borrower's ability to include the full value of the real property as equity, (ii) it traps a borrower's initial capital (equity) contribution as well as capital "internally generated" by the project throughout the life of the loan, and (iii) it fails to define adequately when a loan converts to permanent financing and thereafter becomes exempt from HVCRE. Let's explore these three concerns further.
First, current language penalizes borrowers as it does not permit contribution credit for the appreciation in value of the land. H.R. 2148 revises the definition of "value of real property" to include the appraised value of the real property regardless of whether the value comes from cash used to purchase the property or its appreciation.
Second, the existing rule requires that all contributed equity remain in the project until the loan is paid in full or the loan is converted to permanent financing. Regardless of a lender's equity requirements in construction lending generally, the application of HVCRE can serve to trap a borrower's cash in the project and restrict the parties' ability to negotiate for any return of capital consistent with the lender's applicable underwriting guidelines. For example, if the applicable construction loan requires the borrower to contribute equity in the amount of 40% of the project's as-completed appraised value, and the borrower has negotiated with the lender for an earnout at stabilization that would reduce the borrower's equity to 15% of the as-completed appraised value, the current HVCRE rules would prohibit lender from advancing the earnout. H.R. 2148 does not appear to prohibit internally-generated capital from being withdrawn from the project. While it's not free from doubt, H.R. 2148 can be read to mean that capital contributed over and above the 15% threshold need not remain in the project so long as the borrower continues to satisfy the minimum equity requirement of 15%. Therefore, and returning to our example, the new bill may permit the lender to advance the negotiated earnout.
Third, while H.R. 2148 provides that a loan on property where construction has been completed and with sufficient cash flow to support debt service and property expenses may be reclassified as a non-HVCRE ADC loan in accordance with the bank's applicable permanent loan underwriting criteria, the bill does not define when a project is considered "complete". The current Frequently Asked Questions2 state that a certificate of occupancy is not sufficient to transform an HVCRE loan into permanent financing. Accordingly, questions remain as to whether a project will be considered complete at the time the lender advances a final draw, when an open punchlist is complete, or when some other test is met.
The new bill also seeks to better define HVCRE ADC loans generally, as well as to provide for an exemption to loans made prior to January 1, 2015. Additionally, new acquisition financings or refinancings, in each case of an existing income producing property, secured by a mortgage on such property, may be excluded should the bill become law. Similarly, mortgage loans for improvements to existing income-producing real property would not be HVCRE if the property's cash flow covered debt service and expenses, as determined by the lender in accordance with its underwriting criteria for permanent financing.
Interestingly, the proposed legislation does not address the issue of whether mezzanine debt can be treated as a qualifying capital contribution or whether preferred equity may be treated the same as common equity for HVCRE purposes.
Although a number of industry groups have lent their support in favor of H.R. 2148 and would welcome the changes incorporated therein, it remains to be seen whether the bill will be reported to the full House by the House Committee on Financial Services, and if so reported, whether it will be in the same form as it was introduced. Currently, no similar bill has been introduced in the Senate. Those following the bill's progression should not dismiss the possibility that in lieu of its passage, changes may come about in the form of agency rulemaking or additional or replacement FAQs. Alternatively, if the Financial CHOICE Act of 2017, recently passed by the House, ultimately becomes law, certain banks may be exempt from the HVCRE rules altogether. In the meantime, lenders and borrowers will continue to face questions and concerns as they close ADC loans.
1. Additional co-sponsors include Mark Walker (R-NC), Dennis Ross (R-FL), Ann Wagner (R-MO), Andy Barr (R-KY), Scott Tipton (R-CO), and Steve Stivers (R-OH).
2. Frequently Asked Questions on the Regulatory Capital Rule dated April 6, 2015, issued by the Office of the Comptroller of the Currency, the Federal Reserve Board, and the Federal Deposit Insurance Corporation.
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