Since my last post, the Economic Growth, Regulatory Relief, and Consumer Protection Act (which some are referring to as EGRRCPA – oof.) was signed into law by President Trump on May 24th. Section 214, titled, “Promoting Construction and Development on Main Street,” amends the Federal Deposit Insurance Act to clarify what loans are subject to HVCRE, when loans are measured for HVCRE exposure and what we call loans subject to HVCRE (spoiler alert: it’s not HVCRE!). Long story short, despite all the grumblings about this reform, Dodd-Frank has not gone the way of the Dodo. Here’s what we know, what we think we know and what we think you may be able to do.
What We Know
- (For loans made after May 24th) HVADC is out – HVCRE ADC is in.
Under Public Law 115-174, regulators “may only require a depository institution to assign a heightened risk weight to a high volatility commercial real estate (HVCRE) exposure (as defined in 12 C.F.R. 324.2) under any risk-based capital requirement if such exposure is an HVCRE ADC loan”. So, after all the back and forth with HVCRE and HVADC, it is finally settled: only those loans classified as “HVCRE ADC” can be subject to HVCRE. Wait, what?? (We hope this means that the regulators will abandon HVADC…).
So, what is an HVCRE ADC loan? An HVCRE ADC loan is a credit facility secured by land or improved real property that (A) primarily finances, has financed, or refinances the acquisition, development, or construction of real property; (B) has the purpose of providing financing to acquire, develop, or improve such real property into income-producing real property; and (C) is dependent upon future income or sales proceeds from, or refinancing of, such real property for the repayment of such credit facility.
Let’s start with the good: thankfully, the revised definition clarifies that only credit facilities secured by land or improved real property are subject to HVCRE ADC. One addition to the definition from the prior incarnation is that an HVCRE ADC loan “primarily finances” acquisition, development or construction. We have no idea what “primarily finances” means – 50%, 60%, 95%? But – maybe this ambiguity is good. Should we be racing to the regulators to fill in all of the “grey”? If we do that, we have no room to make calculated and reasonable decisions (that are good for the bank and the borrower) and ask forgiveness (if it ever comes to that!) later.
Another new addition to HVCRE ADC is the requirement that the loan “has the purpose” of providing financing for ADC. Again – what does this even mean? We are in new territory with the regulators being concerned about the “purpose” of a loan. How do you even figure this out? “Purpose” seems to be in the eye of the beholder. And, when is the “purpose” decided? At origination? Hopefully! Banks should not be required to continuously monitor the borrowers’ use of funds in order to be technically compliant.
We’re not thrilled that unimproved land (without any construction or development component) still falls under HVCRE ADC, especially where the loans are fully guaranteed (how much sense does that make?).
Further, we worry that now that any loan that “has financed” the acquisition, development or construction of real property could potentially fall under HVCRE ADC, does that mean that a loan made after January 1, 2015, that, “had financed” the acquisition of real property but wasn’t previously subject to HVCRE now would be? Practically, probably not, but well worth the thought exercise (at least to us dorky lawyers).
- HVCRE ADC loans are not:
- Loans that are secured by one- to four-family residential properties, real property that would qualify as an investment in community development or agricultural land;
- Loans to acquire, refinance or make improvements to existing income-producing properties with cash flow generated by the real property that can support its debt service and expenses (in accordance with the bank’s underwriting criteria for permanent financings);
- Commercial loans with (i) an LTV less than or equal to current standards as determined by the regulators, (ii) a borrower contribution (in cash, marketable assets, out-of-pocket development expenses or real property and improvements) of at least 15% of the appraised “as completed” value and (iii) such contribution was made prior to any advance under the credit facility (and such contribution is required to remain in the project until the loan is reclassified as non-HVCRE ADC); and
- Loans made prior to January 1, 2015.
It’s now clear (at least as clear as these things get) that ground-up construction is HVCRE ADC (Yup – makes sense…risky lending deserves some regulation) and already improved property (that IS cash flowing sufficiently to pay debt service and expense) is NOT HVCRE ADC. And that’s where banks find themselves with a lot more breathing room: now, the “construction-lite” loans where the property is improved, cash flowing and the loan is being made to finance some sort of renovation, face list or tenant improvements may NOT be HVCRE ADC (depends).
The above exemptions are substantially similar to the original HVCRE regime (so repurchase facilities and loan on loans are exempt, as is mezzanine debt secured by borrower equity with ADC), with a few important tweaks: first, the calculation of what counts as Borrower equity contributions is different and second, the div stopper is less onerous.
As we all know, to be exempt from HVCRE ADC, Borrower must have 15% equity in the deal. The equity contributed can come in the form of cash, development costs spent at the property, and the value of the land (based on a current appraisal). Note, under the old HVCRE regime, the value of the property was determined at acquisition, so no appreciation benefit was given. Now, the appraisal will be based on the “as completed” value of the property (so borrowers can get the benefit of an appreciation in land value making holding onto real property well worth it!).
In addition, under the new HVCRE ADC rules, if the property starts cash flowing, the cash can be distributed to the borrower’s equity holders so long as the 15% contributed capital described above stays in. Whereas under the old regime, no money could be leaked out during the life of the loan. Hooray! Gotta celebrate each victory!
- Loans that are made under the HVCRE ADC regime can be “reclassified” as a Non-HVCRE ADC loans.
Probably the biggest breakthrough in the reform is the ability to reclassify loans. This allows banks to reduce their capital stack once the loan is stabilized. Under the new regime, a loan can be converted to a “Non-HVCRE ADC Loan”:
- Upon the substantial completion of the development or construction; or
- Once the property generates enough cash flow to support the debt service and expenses in accordance with the bank’s underwriting criteria for permanent financings.
Going forward, loan documents for HVCRE ADC loans should build in mechanics (or not- the language seems to suggest the bank can reclassify on its own but borrowers may want some certainty built in) for reclassification (e.g., upon substantial completion, satisfaction of a DY/DSCR test, etc.) as this would remove the div stopper and allow internally generated cash flow (above the 15% required capital contribution) to be dispersed (mezzanine lenders rejoice!). We would expect to see, at a minimum, a spread step-down in the interest rate too…maybe? There are other ways too we can think of to handle the “cash flow” test which we will be discussing with our clients.
Giving borrower’s greater optionality may be one way to make “Main Street” like banks again.
What We DON’T KNOW
The Federal Reserve, Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation issued a statement on July 6, 2018, clarifying that banks “may refine [estimates regarding HVCRE ADC loans] in good faith as they obtain additional information but will not be required to amend previously filed regulatory reports as these estimates are adjusted.” In addition, the agencies gave banks the option to continue to report and risk-weight HVCRE exposures in a manner consistent with the current instructions, until the agencies take further action. The agencies also indicated that they plan to promulgate regulatory revisions in the future. In response, Representative Pittenger and others sent a letter to the agencies on August 1st, thanking them for their assurances that the agencies will work to conform the existing regulations to EGRRCPA.
We too are jazzed up about the promised regulations. We’d like to see (at a minimum) the following addressed (or maybe we don’t…are we better off with ambiguity so then we can ask for forgiveness later?):
- What does “primarily finances” mean?
- When does a loan “ha[ve] the purpose” of providing financing for ADC?
- When is development “substantially” complete?
- What is the “cash flow” test?
- It’s clear that HVCRE ADC supersedes the old rule for loans made after May 24, 2018 (and provides grandfathering for loans made prior to January 1, 2015), but it’s unclear what it does to loans made from January 1, 2015 – May 24, 2018. Are these loans now subject to HVCRE ADC for re-classification? We would like for clarity (although maybe we already have it) that the new HVCRE ADC applies to those loans as well.
- Can mezzanine debt and preferred equity count for the 15% Borrower equity contribution test?
Check back in the coming weeks as we discuss the above and consider whether the FAQs apply to HVCRE ADC and the fate of HVADC. The forthcoming regulations, coupled with how banks adapt to HVCRE ADC will determine whether we finally got the major HVCRE reform we’ve been looking for or if EGRRCPA failed to move the needle. In the meantime, we will be sitting here musing over the new HVCRE ADC legislation, thinking of creative solutions to a problem someone has got to have.