The new risk weighting rules applicable to commercial real estate are now fully in effect for all banks. The rule flows out of the new capital rulemaking carried out by the federal banking agencies as a result of Basel III. As a general rule, the agencies agreed to apply a 100% risk weighting to all corporate exposures, including bonds and loans. There were various exceptions to that rule, one of which involves what is referred to as “High Volatility Commercial Real Estate” (“HVCRE”) loans. Simply put, acquisition, development and construction loans are viewed as a more risky subset of commercial real estate loans and are assigned a risk weighting of 150%.
HVCRE is defined to include credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property, unless the facility finances:
- One- to four-family residential properties;
- Real property that would qualify as a community development investment;
- agricultural land; or
- Commercial real estate projects in which:
- The loan-to-value ratio is less than or equal to the applicable regulator’s maximum amount (i.e., 80% for many commercial bank transactions);
- The borrower has contributed 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 percent of the real estate’s appraised ‘‘as completed’’ value; and
- The borrower contributed the amount of capital before the lender advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.
Developers and lenders have been looking at the guidance and applying it to real world situations. Here are some of the issues:
What is the “life of the project”?
The life of a project concludes only when the credit facility is converted to permanent financing or is sold or paid in full. The ADC lender may provide the permanent financing as long as the permanent financing is subject to the lender’s underwriting criteria for long-term mortgage loans.
Is land treated the same as cash?
Cash used to purchase land is a form of borrower contributed capital under the HVCRE definition.
Is financing an owner occupied building considered HVCRE?
No, a loan permanently financing owner-occupied real estate is not considered to be HVCRE. Not every commercial real estate loan falls into the ADC category.
Does the developer get any benefit from the increased value of purchased land?
No. This continues to be a hot button issue for banks and developers. The value of the real property contributed is measured as of the date the property was purchased, not today’s value. Lenders should be aware that examiners will be looking for evidence in the file of how the cash valuation is determined, i.e., sales contract, canceled check, etc.
Does the fact that there is a new updated appraisal change the analysis?
No.
Can a developer use condo purchaser deposits as equity?
No.
What about grants from a local municipality, a state or the federal government?
Grants will not constitute equity.
How are securities measured?
Securities are treated as equity when they have been liquidated and turned into cash and used in the project.
Can the developer borrow his equity?
Mezzanine debt, loans from the same lender that is providing the ADC financing or financing from a second mortgage on the ADC project are not allowed. Arguably, borrowing from another lender on either an unsecured or secured by other assets would be fine.
What about leasing costs and site preparation expenses?
Reasonable and customary soft costs expended by the developer such as leasing and brokerage expenses would be considered to be contributed equity. Likewise site preparation expenses would also be included.
What about any existing ADC loans that are currently on a lender’s books?
Existing loans are not grandfathered and a lender will need to apply the increased risk weighting to any existing loan that qualifies for HVCRE treatment.
Can a lender recoup its increased expenses on any existing loans that must now be treated as HVCRE?
Lenders must examine their loan documentation very carefully to determine if it is authorized to pass along any increased funding expenses. Some loan agreements cite increased funding costs arising from regulations promulgated under Basel III as a “change of law” which allows the lender to pass the increased expense on to the borrower. Other loan agreements may be silent on the issue. Even if the lender is authorized to pass the expense along, competitive factors may mitigate against it.
Are small banks having assets less than $500 million exempt from the HVCRE rule?
No. Some of the capital rules adopted under Basel III do not apply to certain “small bank holding companies” but according to both the FDIC and the Federal Reserve, the HVCRE risk weighting rules apply to all banks, regardless of size.
What types of loans qualify as community investment?
Generally speaking, any loan which would typically qualify as a permissible investment for Community Reinvestment Act purposes should meet the test.
We expect that the Federal Reserve, the OCC and the FDIC will be providing additional guidance in the forms of a FAQ in the very near future and we will publish new guidance when we receive it.
