As previously mentioned, the federal banking regulators have been working on a FAQ on the topic. The interagency FAQ was published on April 6, 2015. While there were no surprises in what was published there were a number of takeaways from the FAQ that lenders need to keep in mind and I have added those to my previous list of FAQ. Under Basel III, as a general rule, a lender applies a 100% risk weighting to all corporate exposures, including bonds and loans. There are 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 covered in the March 26 posting as fleshed out by the Interagency FAQ:
1. When does the borrower’s capital contribution need to be put into the project? This point cannot be underscored enough, the borrower’s capital; contribution must be made before the bank advances funds. This is a key trigger point for the HVCRE analysis. Miss this target and the loan will be treated as HVCRE for the life of the loan, regardless of whether the borrower injects additional capital at a later date.
2. Do I get a pass on the ADC loans I made last year before the rule went into effect? No. There is no grandfathering of existing loans. Look at your loan documentation to determine if you are able to pass along the increased costs to the borrower. 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.
3. Can a borrower simply pledge unrelated real estate as collateral to the bank and have that count toward the 15% capital contribution? No. Again, this goes against the idea that the capital must be actually contributed to the project before it can be counted. Logically, this should also apply to cash collateral that is merely “pledged” as opposed to being injected into the project.
4. Are SBA loans exempted from coverage as HVCRE? There is no automatic exemption simply because a loan is guaranteed by the SBA. If, however, an acquisition and development loan qualifies as a community investment loan then it will be exempt.
5. Grants from non-profits, municipalities, state or federal agencies don’t count as capital. Any number of people have tried to convince the regulators that a grant of this type should be treated as a capital but the regulators have decided against it. Their take on it is that because grants do not come from the borrower they would essentially disguise the borrower’s actual economic interest in the transaction.
6. What if the borrower simply wants to buy an empty lot as part of their corporate strategy of creating a land bank for possible development in the future? The loan is generally treated as an ADC credit regardless of whether the borrower has a current plan for developing the property. The loan may fall outside of HVCRE if it is set up in the form of “permanent financing.” Exactly what that means in terms of industry custom and practice seems a bit vague.
7. How do you handle mix-used property that has components of CRE as well as one-to-four family residential real estate? You are permitted to bifurcate the loan into its two different constituencies and treat only the CRE portion for purposes of the HVCRE analysis.
8. What if rising real estate values cures a LTV violation that causes a loan to be treated as HVCRE? The Interagency FAQ does not say why a bank would lend money to begin with on a project that fails to meet regulatory LTV requirements in the first place but assuming a bank did extend such a credit, the fact that values have risen to cure the violation does not cure the HVCRE status of the loan, it remains in that state until the loan is converted to permanent financing.
9. Does the fact that the developer has obtained a certificate of occupancy mean that a loan has reached the permanent financing stage? No.
10. 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.
11. Is land treated the same as cash? Cash used to purchase land is a form of borrower contributed capital under the HVCRE definition.
12. 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.
13 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.
14. Does the fact that there is a new updated appraisal change the analysis? No.
15. Can a developer use condo purchaser deposits as equity? No. This has been a hot topic in a number of states where developers are allowed by law and purchase contracts to use a buyer’s deposit in the construction of the condo project. It would not be unusual, for example, to find that that a developer building a $100 million condo project had $30 million or more in the way of buyer deposits that it could use in the project.
16. How are securities measured? Securities are treated as equity when they have been liquidated and turned into cash and used in the project.
17. 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.
18. What about soft costs? Reasonable and customary soft costs expended by the developer such as developer fees, leasing expenses, brokerage commissions and management fees would be considered to be contributed equity. Likewise site preparation expenses such as engineering or permits would also be included.
19. 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.
20. 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.
21. 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.