In 2013, the Federal Reserve Board adopted rules to implement Basel III, a regulatory framework of reform measures for the banking industry issued by the Basel Committee on Banking Supervision (BCBS). These measures include a set of recommendations on banking regulations which, in general, aim to ensure banks are sufficiently capitalized to withstand volatile market conditions such as those that marked the financial crisis of 2008. Effective Jan. 1, 2015, as part of the Basel III regulations, banking organizations are required to set aside more capital in reserve when making commercial real estate loans considered “high-volatility commercial real estate (HVCRE) exposures” than what had been historically required for typical commercial real estate loans. Under the HVCRE rules, a non-HVCRE commercial real estate loan carries a risk weight of 100 percent, whereas an HVCRE loan has a risk weight of 150 percent; in other words, a lender is required to maintain 50 percent more capital on reserve against an HVCRE loan – a significant increase.
Under the current regulations, an HVCRE loan is a credit facility that, prior to conversion to permanent financing, finances the acquisition, development or construction (ADC) of real property. There are a few notable exceptions to HVCRE classification, including loans on one to four residential properties, community development loans, agricultural loans and commercial real estate projects in which (1) the loan-to-value ratio is less than or equal to the applicable maximum amount (which is 80 percent for commercial, multifamily or other nonresidential construction projects), (2) the borrower has contributed capital in the form of cash or unencumbered readily marketable assets of at least 15 percent of the project’s “as completed” value, and (3) the borrower has contributed the amount of capital required above before the lender advances funds, and such 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 (with the life of the project concluding only when the loan is converted to permanent financing, is sold or is paid in full). The current HVCRE rules do not exempt loans made prior to the effective date of the regulations from classification as HVCRE. Furthermore, the current HVCRE rules do not state when an HVCRE loan can be declassified by a bank and thus is no longer subject to the restrictive capital standards imposed by the HVCRE regulations.
Naturally, determining whether a loan qualifies as HVCRE under the regulations has become a topic of increasing interest for lenders and borrowers. Since their inception, the HVCRE rules have led to uncertainty in the commercial real estate finance industry, given the broad classification of what is considered an HVCRE loan under the regulations. This uncertainty has resulted in increased costs for both lenders and borrowers, as banks are unsure which loans should be classified as HVCRE loans or when such loans can be deemed non-HVCRE, thereby freeing the bank of the increased capital reserve restrictions and tying up less of the bank’s capital.
On April 26, 2017, Congressman Robert Pittenger, R-N.C., and Congressman David Scott, D-Ga., introduced the Clarifying High Volatility Commercial Real Estate Loans bill (H.R. 2148), a bipartisan bill that seeks to clarify capital requirements for HVCRE loans. The spirit of the bill is to clearly define what qualifies or does not qualify as an HVCRE loan. Among other clarifications, the bill would exempt loans made prior to Jan. 1, 2015, from HVCRE status and would allow an ADC loan to be deemed a “non-HVCRE loan” once the project is completed and cash flow being generated by the real property is sufficient to support the debt services and operating expenses of the real property. H.R. 2148 is in the first stage of the legislative process and is expected to be considered by the House Committee on Financial Services before being sent to the House or Senate as a whole.
The text of H.R. 2148 can be found here.