Just when you thought the regulators had forgotten about HVCRE ADC, they issued a new notice of proposed rulemaking like they were Beyoncé surprise-dropping a new album. And then…they disappeared again! We were waiting for more news before alerting our readers but nothing has come to date. To bring those not in the HVCRE ADC-hive up to speed, the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) reformed the capital rule for acquisition, development and construction loans (HVCRE ADC exposures or loans) back in May 2018, but the regulations have yet to be conformed to the statutory regime.

Under the current statutory framework, an HVCRE ADC loan is a credit facility secured by land or improved real property which (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. Among other exceptions, the current statutory regime includes an exemption for loans that finance the acquisition, development, or construction of one- to four-family residential properties (the paragraph 2(i)(A) exemption).

On July 12, 2019, the Federal Reserve, FDIC and OCC released a Notice of Proposed Rulemaking (2019 NPR), in response to comments submitted to their September 2018 Notice of Proposed Rulemaking (2018 NPR). The 2018 NPR was meant to conform the regulatory capital rule to the updates brought about in EGRRCPA and the 2019 NPR supplements the previous proposal to narrow the paragraph 2(i)(A) exemption.

Under the 2019 NPR, loans that solely finance the process of preparing land for the construction of one- to four-family residential structures (such as, laying sewers, water pipes and similar improvements) (land development loans) would fall under the HVCRE ADC framework and require a higher risk weight assessment. In other words, in order to qualify for the paragraph 2(i)(A) exemption, the loan would also need to finance the subsequent construction of one- to four-family residential structures on the land. The regulators note that such land development loans should be held at a higher risk weight because they generate no cash flow and require other sources of cash for debt service.

Put simply, a loan to acquire and construct one-to four-family residential properties would be assigned a 100% risk weight but a loan to acquire and develop the land for future construction of one-to four-family residential properties would require a 150% risk weight (unless the loan meets another exemption). Remember, whether or not a loan is subject to the heightened risk requirements of HVCRE ADC is determined once: at origination. In other words, if the loan was not HVCRE ADC at origination, a lender need not monitor it throughout its term. One and done!

The 2019 NPR means we are getting closer to having regulatory resolution with respect to HVCRE ADC. The comment period for the 2019 NPR ended August 22, 2019 so we could see a final rule before yearend. In the meantime, for all loans originated on or after January 1, 2015, lenders may either apply the new statutory rule on a best efforts basis or classify loans according to the superseded regulatory definition until the final rule is in effect. For now – it’s status quo until we have final rules. We expect that lenders run a preliminary HVCRE ADC analysis during negotiation of the term sheet (please reach out if you would like to discuss Dechert’s HVCRE ADC Decision Tree, which makes it easy to determine at the outset whether or not a loan is HVCRE ADC).

The Dechert team is always happy to discuss HVCRE ADC (which we believe is a tamable beast, but a beast nonetheless). As always, come to Crunched Credit for updates on the upcoming regulations and discussions on the practical implications of HVCRE ADC on commercial real estate lending and remember – we make house calls! We would be happy to do a teach-in or host a Q&A session on the changes. Please let us know if that would be helpful and we’d be happy to set up a time.

The text of the proposed revised rule is below:

High volatility commercial real estate (HVCRE) exposure means:

(1) A credit facility secured by land or improved real property that, prior to being

reclassified by the FDIC-supervised institution as a non-HVCRE exposure pursuant to paragraph

(6) of this definition —

  • Primarily finances, has financed, or refinances the acquisition, development, or construction of real property;
  • Has the purpose of providing financing to acquire, develop, or improve such real property into income-producing real property; and
  • Is dependent upon future income or sales proceeds from, or refinancing of, such real property for the repayment of such credit facility; provided that:

(2) An HVCRE exposure does not include a credit facility financing— (i) The acquisition, development, or construction of properties that are—

  • One- to four-family residential properties;
  • Real property that would qualify as an investment in community development; or
  • Agricultural land;
  • The acquisition or refinance of existing income-producing real property secured by a mortgage on such property, if the cash flow being generated by the real property is sufficient to support the debt service and expenses of the real property, in accordance with the FDIC-supervised institution’s applicable loan underwriting criteria for permanent financings;
  • Improvements to existing income-producing improved real property secured by a mortgage on such property, if the cash flow being generated by the real property is sufficient to support the debt service and expenses of the real property, in accordance with the FDIC-supervised institution’s applicable loan underwriting criteria for permanent financings; or
  • Commercial real property projects in which—

(A) The loan-to-value ratio is less than or equal to the applicable maximum supervisory loan-to-value ratio as determined by the FDIC;

(B) The borrower has contributed capital of at least 15 percent of the real property’s appraised, ‘as completed’ value to the project in the form of—

  • Cash;
  • Unencumbered readily marketable assets;
  • Paid development expenses out-of-pocket; or
  • Contributed real property or improvements; and

(C) The borrower contributed the minimum amount of capital described under paragraph (2)(iv)(B) of this definition before the FDIC-supervised institution advances funds (other than the advance of a nominal sum made in order to secure the FDIC-supervised institution’s lien against the real property) under the credit facility, and such minimum amount of capital contributed by the borrower is contractually required to remain in the project until the HVCRE exposure has been reclassified by the FDIC-supervised institution as a non-HVCRE exposure under paragraph (6) of this definition;

(3) An HVCRE exposure does not include any loan made prior to January 1, 2015;

(4) An HVCRE exposure does not include a credit facility reclassified as a non-HVCRE exposure under paragraph (6) of this definition.

(5) Value Of contributed real property.—For the purposes of this definition of HVCRE exposure, the value of any real property contributed by a borrower as a capital contribution is the appraised value of the property as determined under standards prescribed pursuant to section 1110 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (12 U.S.C. 3339), in connection with the extension of the credit facility or loan to such borrower.

(6) Reclassification as a non-HVCRE exposure.—For purposes of this definition of HVCRE exposure and with respect to a credit facility and an FDIC-supervised institution, an FDIC-supervised institution may reclassify an HVCRE exposure as a non-HVCRE exposure upon—

  • The substantial completion of the development or construction of the real property being financed by the credit facility; and
  • Cash flow being generated by the real property being sufficient to support the debt service and expenses of the real property, in accordance with the FDIC-supervised institution’s applicable loan underwriting criteria for permanent financings.

(7) For purposes of this definition, credit facilities that do not finance the construction of one- to four-family residential structures, but instead solely finance improvements such as the laying of sewers, water pipes, and similar improvements to land, do not qualify for the one- to four-family residential properties exclusion in paragraph 2(i)(A).