The first quarterly Consolidated Reports of Condition and Income for 2015 have been generated and fresh attention is being paid to the possibility of increased risk weighting for many real estate loans. For most banks, savings and loan holding companies and large bank holding companies, new rules for the risk weighting of “High Volatility Commercial Real Estate” (HVCRE) loans went into effect on January 1, 2015. As a result of these new rules, some loans that might have been classified as being risk-weighted at 100 percent are now being risk-weighted at 150 percent.
Most followers of the actions of the multi-national Basel Committee on Banking Supervision, which includes the United States, and the U.S. banking agencies are well aware of the increased focus on capital adequacy and risk management. The Basel Committee’s Basel III Accord took aim at the financial crisis of 2007. The framework developed as part of Basel III led to the Federal Reserve Board’s promulgation of rules in 2003 which implement both the Basel III Accord and the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules were also approved and promulgated by the OCC and the FDIC. One small part of these rules focus on lending institution exposure to real estate loans.
The final rules amount to hundreds of pages of text and one such final rule relates to what U.S. banking agencies classify as HVCRE loans. In what amounts to a material change to past practice, HVCRE loans are required to be risk-weighted at 150 percent. HVCRE loans include all loans that finance the acquisition, development and construction of commercial real estate, with important exceptions. One to four family residential properties, certain loans for the purchase or development of agricultural land, and certain loans for projects that qualify as community development investment are exempt from the HVCRE classification.
Also, as elucidated in the FDIC’s final rule codified in Title 12 of the Code of Federal Regulations in Part 324, a commercial real estate loan may avoid the HVCRE classification if:
- the loan-to-value ratio (LTV) is equal to or less than the maximum supervisory LTV (which is 80% for commercial construction loans), and
- the borrower contributes capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out of pocket) of at least 15% of the real estate project’s “as completed” appraised value, and
- the borrower contributed the amount of capital before the advance of funds under the loan and the borrower’s 15% is contractually required to remain in the project until the loan is converted to a permanent loan, sold or paid off.
These rules were finalized in 2013 but the first quarter of 2015 presented the first opportunity for banks to grapple with the new rules. Naturally, if such work has not already been done, financial institutions should take immediate action on reviewing real estate loan portfolios in light of the new rules. Among other things, “as completed” appraisals for real estate projects must be reviewed for the “as completed” appraised value. Borrower contribution to the capital of the project must be calculated. Loan documents should be analyzed to determine whether contributed capital is contractually required to remain in the project. And, looking ahead, care should be taken in insuring that future real estate loans include appropriate contractual provisions to address these points.