As discussed in a prior blog , Basel III regulations governing high volatility commercial real estate (HVCRE) went into effect. The HVCRE rules require lenders to assign a higher risk weighting to loans for the acquisition, development or construction (ADC) of commercial real estate. The higher risk weighting may be avoided 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.
Should SBA 504 loans, the purpose of which are to promote economic development and create and retain jobs, be exempt from the HVCRE rules because ADC loans that qualify as community development investments are exempt from the HVCRE regulations?
SBA 504 loans, authorized by Title V of the Small Business Investment Act (15 U.S.C. § 695 – § 697g), provide small businesses with long term financing to acquire, construct, develop or improve fixed assets such as owner-occupied commercial real estate and heavy machinery. Financing is provided by a lender and a community development company (CDC). In a typical SBA 504 transaction, lender financing will provide 50% of the project costs secured by a first priority lien on the real estate and other 504 collateral, CDC financing will provide up to, but not more than, 40% of project costs secured by a second priority lien on the 504 collateral, and the borrower will typically contribute 10% of the project costs. The real estate must be at least 51% owner-occupied for existing buildings and 60% owner-occupied for new construction.
It is understandable that lenders would be concerned whether a SBA 504 loan is subject to HVCRE regulations. The HVCRE regulations and those governing the SBA 504 loan program are different and, in connection with construction loans, inconsistent.
A SBA 504 construction loan, in most cases, will require the borrower to contribute 10% to the project. Unlike a HVCRE loan which requires a borrower to contribute 15% of the “as completed” appraised value of the project, the SBA 504 loan requires the borrower to contribute 10% of the total project costs (see 13 C.F.R. § 120.910 (a)(4)), except to the extent that the SBA project involves the “acquisition, construction, conversion or expansion of a limited or single purpose building or structure”, in which case the borrower’s contribution is required to be at least 15% of the project costs (See 13 C.F.R. § 120.910(a)(2)). Where lenders may be most concerned is that period of time during the lender has a loan at a 90% LTV until the CDC loan is funded. The interim period is, in most cases 45 days, except in the case of a construction loan. The CDC loan does not fund until construction is completed which then requires the lender to hold a 90% LTV loan for a significantly longer period of time. The lender’s risk is typically mitigated by the CDC loan upon completion, reducing the lender’s LTV to 50%, and additional collateral such as payment and construction guaranties from the principal of the borrower and other business collateral beyond the 504 collateral.
As noted above, the HVCRE rules exempt ADC loans that otherwise qualify as community development investments. The purpose of SBA 504 loans is to promote economic development and create and retain jobs. Lenders may receive credit under the Community Reinvestment Act for making SBA 504 loans. Federal regulations governing community reinvestment define community development, in part, as “activities that promote economic development by financing businesses or farms that meet the size eligibility standards of the Small Business Administration’s Development Company or Small Business Investment Company Programs” set forth in 13 C.F.R. § 121.301 (see 12 C.F.R. § 345.12). It would seem that ADC loans made under the SBA 504 program are exempt from the HVCRE regulations because SBA 504 loans qualify as community development investment, but the question will remain pending clarification by federal regulators.