International banking regulators responded to the 2008 financial crisis by increasing capitalization requirements with the Basel III Capital Accords.1 Increased capitalization requirements affect any loan secured by High Volatility Commercial Real Estate (HVCRE). HVCRE loans are credit facilities that finance the acquisition, development, or construction of real property. They typically contain a loan-to-value ratio above 80%, with the borrower contributing less than 15% equity toward the project.2
In the U.S., Basel III is implemented through administrative rules set forth by federal agencies (the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency) and through Congressional legislation. Change is coming up both avenues in the form of an agency rule and a bill known as the Pittenger Bill.3
The Pittenger Bill was passed by the House on November 7, 2017 and awaits Senate review.
The Proposed Rule
Under the proposed agency rule, HVCRE exposure is proposed to be referred to as High Volatility Acquisition, Development or Construction (HVADC) exposure, in an attempt to add more specificity to the description.4
The proposed rule also creates additional clarity and broadens the scope of affected loans by incorporating a “primarily finances” test—in other words, increased capital requirements are required for facilities that primarily finance or refinance HVADC real property,5 as opposed to the existing rule that is understood to impose increased capital requirements only upon loans that solely finance or refinance HVADC real property.
The proposal would further expand the scope of HVADC by removing the capital contribution exemption, which allows borrowers with 15% equity in the project to avoid HVADC classification. The Real Estate Roundtable, Mortgage Bankers Association, and CRE Finance Council all oppose this, describing the change as eliminating a risk-sensitive incentive.6
Acknowledging that more loans will be subject to the new rule, the rule proposes a reduction in the required risk weight for HVADC loans from 150% to 130%.7 In other words, the proposed rule would require banks to reserve capital at a rate of $1.30, rather than the existing $1.50, per $1.00 of credit extended. In comparison, non-HVCRE loans require the bank to reserve $1.00 reserve per each $1.00 of credit extended.8
The proposed rule also clarifies when loans cease being HVADC loans and become newly defined “permanent loans” to which the increased capital requirements no longer apply. A permanent loan is defined as a “prudently underwritten loan that has a clearly identified ongoing source of repayment sufficient to service amortizing principal aside from the sale of the property.”9
The Proposed Law
Like the agency rule, the congressional bill changes the definition of HVCRE and expands the pool of affected loans. The bill is less nuanced than the rule, but the net effect is the same.
The bill does not prescribe specific capital weighting requirements, leaving the 130% or 150% determination to the administrative rule.
Like the rule, the bill makes clear that a loan ceases to be considered an HVCRE loan when: (a) development or construction is complete, and (b) cash flow is sufficient to support the debt service and operating expenses to the satisfaction of the depository institution and determined in a manner that is consistent with its underwriting criteria.10
Finally, consistent with the existing regulation, the proposed law removes current restrictions on cash distributions as long as 15% of the borrower’s equity is invested in the deal.
Regulatory and Legal Changes: How Are Borrowers Benefitted?
The rule is more nuanced and the bill more succinct, but the proposals could benefit borrowers in the following three ways.
First, upcoming changes may allow HVCRE loans to be re-classified once the borrower secures permanent financing. Second, changes may ease current prohibitions on cash distributions. And third, changes that reduce capital requirements will allow banks to provide more competitive terms on loans to finance HVCRE.