The Federal Reserve, OCC and FDIC have (finally) issued the Final HVCRE Rule (for background, our analysis of the 2018 Notice of Proposed Rulemaking and 2019 Notice of Proposed Rulemaking are here and here), regarding High Volatility Commercial Real Estate (HVCRE) regulations that affect acquisition, development or construction (ADC) loans made by banking organizations that are subject to the capital rule, including bank holding companies, savings and loan holding companies and U.S. intermediate holding companies of foreign banking organizations. The Final HVCRE rule becomes effective April 1, 2020. Here are the Top 10 takeaways from the Final HVCRE Rule:
10. Few Major Changes from EGRRCPA. The Final HVCRE Rule largely conforms to the reforms brought by the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) (thankfully!). See Numbers 8, 7, 3 and 1 on our list for new developments and clarifications, some of which bring relief and others new headaches.
9. 2 out of 3 Prongs Remain Vague. By now we’ve all become well-acquainted with the three prong EGRRCPA test for what classifies as an HVCRE Loan: a loan (1) that primarily finances or refinances the acquisition, development, or construction of real property, (2) that has the purpose to provide financing to acquire, develop, or improve such real property into income-producing real property, and (3) the repayment of which depends upon the future income or sales proceeds from such property. In the Final HVCRE Rule, regulators passed, notwithstanding requests for clarity, on the opportunity to provide clarity around the “primarily finances” and “purpose” prongs.
8. Borrowed Funds Can Qualify as Contributed Equity. Funds borrowed from a third party (such as another banking organization, an owner or parent organization, or a related party) count for the 15% borrower equity required to be contributed so long as “such borrowed funds are not derived from, related to, or encumber the project … or encumber any collateral that has been contributed to the project.” Does this mean mezzanine loans count as contributed equity? Preferred Equity? This could be a game-changer, folks!
7. Option to Re-Evaluate Loans Made After January 1, 2015. The Final HVCRE Rule is effective April 1, 2020. Lenders may (but are not required to) re-evaluate any loans made after January 1, 2015 and before April 1, 2020 to conform to the revised rule. While we normally aren’t eager to have to open up old loan files (it can feel like looking at pictures from prom – you have to trust us that this was “market” at the time!), the possibility of freeing up capital for new investment makes that an attractive option. Remember, all loans made prior to January 1, 2015 remain exempt from HVCRE.
6. Multi-Phase Projects Can (In Some Instances) Rely on Single Appraisal. The 15% required capital contribution is based on the “as completed” appraised value of a project. However, for projects with multiple phases (and advances), lenders were unsure as to whether each specific advance required a separate appraisal. The regulators clarified that they expect each project phase being financed by a credit facility (but what if one loan finances multi-phases, all of which were contemplated at origination?) has an appraisal (boo!) but will accept when “appropriate” and in accordance with the lender’s underwriting, a single appraisal that covers a multi-phase project. Put that in the column of not unnecessarily raising costs for borrowers (but hold your celebration until you read Number 5 on our list)!
5. As-Completed Appraisals Required. Regulators were unmoved by requests to rely on “as-is” appraisals, instead pointing to the plain language of EGRRCPA to reinforce that (except for raw land loans and loans where appraisal regulations allow evaluations to be used in lieu of appraisals), lenders must rely on the “as-completed” appraised value to calculate the 15% required capital contribution of the borrower. We tried!
3. Land Development Loans are HVCRE. In keeping with 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) qualify as HVCRE (unless the loan otherwise meets an exemption). We expected this would happen as there isn’t much of a retort to the argument that these lots are not cash flowing. And, even still, some of these loans may qualify for the “community development” exemption.
2. Lenders May Reclassify Loans as non-HVCRE. In keeping with EGRRCPA, the Final HVCRE Rule allows an HVCRE Loan to be converted to a “Non-HVCRE Loan” upon (1) the substantial completion of the development or construction (the “Substantial Completion Test”) and (2) the property generating enough cash flow to support its debt service and expenses in accordance with the bank’s underwriting criteria for permanent financings (the “Cash Flow Test”). This means it is possible that a loan that at-origination qualified as an HVCRE loan does not have to adhere to the regime for its entire term. The ability to reclassify a loan as no longer falling under HVCRE is a relief for lenders and borrowers alike – converted loans will be subject to a lower risk weighting (100% instead of 150% – which frees up capital for new projects). That said, the regulators did not provide clarification on how to satisfy the Substantial Completion Test or the Cash Flow Test, instead explaining that the determination will rely on the lender’s loan underwriting standards for permanent financings (which should be “prudent, clear, and measurable”). We’d anticipate loan documents will delineate both a Substantial Completion Test and Cash Flow Test so all parties are aware of when and how reclassification can occur.
1. Loan Modification and/or Material Alterations to Project Require Re-Evaluation. We know the regulators love to keep us on our toes and this Final HVCRE Rule is no exception. Like we said, the regulators mostly adhered to EGRRCPA. However, they departed (maybe…definitely hope not) in one major way: by adding (in the commentary) that loan modifications or material changes to a loan’s underwriting would require the lender to re-evaluate whether or not the loan falls under HVCRE. Wait, what? Under the 2018 NPR, the regulators proposed that the determination of whether or not a loan is HVCRE occur once: at origination. That proposal gave lenders clarity. Now, a lender needs to monitor a loan throughout its life to make sure that it doesn’t fall under HVCRE. Really!? The regulators provided the following examples of changes that would require re-evaluation: (i) increases to the loan amount, (ii) changes to the size and scope of the project, (iii) removing all or part of the 15% minimum capital contribution in a project (so does this mean that there needs to be ongoing testing to be sure the 15% contribution remains in the deal? What if the 15% is solely satisfied based on the land contributed- do we need new appraisals periodically?), or (iv) other instances where the loan’s underwriting materially changes (for example, when a project changes from relying on the sale of condo units for repayment to instead relying on rental income for repayment). It’s not clear whether this commentary is really intended to apply to every HVCRE loan and to broaden the scope of EGRRCPA (especially since the regulators specifically said that “[t]his final rule conforms this definition to the statutory definition of “high volatility commercial real estate acquisition, development or construction (HVCRE ADC) loan,” in accordance with section 214 of… EGRRCPA”). If this is really meant to be a change, then this would certainly seem to fit the old “hiding an elephant in a mouse hole.” But- this language does appear and is ambiguous enough to be dangerous! Stay tuned for more on this topic.