On January 1, 2015, the final Basel III rules regarding regulatory capital for banks with greater than $500 million in assets and all savings and loan holding companies took effect. Basel III imposes new rules for high volatility commercial real estate (HVCRE) which the regulations define as a credit facility that finances the acquisition, development or construction (ADC) of real property. The HVCRE rules may affect the availability and pricing of commercial real estate mortgage capital.
Regulators use the risk weight total of a bank’s risk-weighted assets to calculate how much capital a bank needs to sustain itself through challenging markets. Subject to certain exceptions, the regulations assign a 150 risk weighting to HVCRE loans which means that for purposes of risk weighting a $10 million HVCRE loan will count as $15 million toward the bank’s risk weight total.
Loans that finance the acquisition, development and construction of one to four family residential properties, projects that qualify as community development investment and loans to businesses or farms with gross revenue exceeding $1,000,000 are exempt from the HVCRE classification.
A commercial real estate ADC loan may avoid the HVCRE classification if:
- the loan-to-value ratio (LTV) is equal to or less than 80%
- the borrower contributes capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development costs out of pocket) of at least 15% of the real estate project’s “as completed” appraised value, and
- the borrower’s 15% is contributed to the project before the lender advances any funds under the loan and remains in the project until the loan is converted to a permanent loan or paid off.
The LTV requirement is typically not an issue as lenders tend to be more conservative with LTVs typically in the 65% to 70% range for ADC loans.
The second exemption, which requires the borrower to contribute 15% in cash or unencumbered readily marketable assets to the project, deviates from traditional lender requirements in two important ways. Traditionally, borrower equity was calculated as a percentage of the total project costs. Now, a borrower is required to inject 15% of equity into the project measured against the project’s “as completed” appraised value which, inevitably, is higher than the total project costs thus requiring a borrower to put more equity into a project.
Also, lenders traditionally counted the current value of the land towards the borrower’s equity requirement. Under the new HVCRE rules, a borrower who acquires the project property concurrently with or in a reasonable time prior to the loan closing is not impacted as the acquisition cost for the land counts towards the borrower’s 15% equity requirement. On the other hand, a borrower who either bought and held land for the right market conditions or contributes land that has long been held by the borrower will likely find itself limited to the land’s acquisition cost rather than the current market value toward its equity requirement. As a result, borrowers will have to obtain other sources of capital to satisfy the 15% equity requirement which may adversely affect the project’s feasibility.
The effect the HVCRE rules have on ADC lending remains to be seen. It is not clear that all smaller financial institutions are currently fully complying with the new rules in bidding for ADC loans, which may result in a temporary competitive advantage in pricing and equity requirements. Long term, the new rules may result in banks reallocating capital to investment options with a higher return thereby limiting financing available for commercial real estate. So long as interest rates remain at or near historic lows, ADC lending seems to remain a popular investment for some banks such as M&T Bank which expanded its construction loan portfolio by 15% in 2014 to 7.6% of its total loan portfolio while other lenders take a more conservative approach to construction lending.
It remains to be seen whether construction lending remains strong under the new HVCRE rules.