High Volatility Commercial Real Estate (HVCRE) Loans
Lenders are struggling to comply with new federal regulations applicable to “risky” commercial real estate loans. Loans that constitute High Volatility Commercial Real Estate (“HVCRE”) exposure require banks to carry 50% more capital than for other loans, which could spell trouble for borrowers by way of higher interest rates and fees and more onerous loan provisions.
In late 2010 in response to the global financial crisis, the international Basel Committee on Banking Supervision developed the Third Basel Accord. Commonly known as Basel III, the Accord sought to increase bank liquidity and decrease bank risk exposure, with a goal of strengthening banks’ capital requirements. In the United States, Basel III (along with the Dodd-Frank Act) resulted in the implementation of new federal banking regulations on January 1, 2015.
The new regulations create a subset of commercial real estate loans now classified as High Volatility Commercial Real Estate or HVCRE loans. An HVCRE loan is a loan used for the acquisition, development, or construction of real property, unless the loan satisfies three criteria: (1) the loan-to-value (“LTV”) ratio is less than or equal to the applicable federal regulatory maximum (e.g., 80% for commercial construction loans); (2) the borrower contributes unencumbered capital to the project of at least 15% of the project’s appraised “as completed” value; and (3) the borrower contributes the capital required by clause (2) before receiving any loan advances, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout its life (i.e., until the loan is “converted to permanent financing or is sold or paid in full”). Loans secured by one- to four- family residential projects, property that qualifies as an investment in a community development project, or purely agricultural property are exempt from HVCRE designation.
Detractors of the HVCRE regulations have correctly noted the LTV ratio requirement is rarely relevant to a loan’s HVCRE status because most commercial real estate loans already require lower LTV ratios than the HVCRE regulations. Therefore, the 15% capital contribution requirement and the project capital retention requirement are the main factors in HVCRE designation. Criticisms of those requirements are not in short supply, with many real estate trade associations urging regulators to modify the rules and adjust their implementation. For example, critics advocate for the regulations to conform with the industry practice of recognizing land’s appreciated value as the borrower’s contributed capital. The HVCRE regulations only consider land’s purchase price towards the 15% contribution requirement and ignore any appreciation in the land’s value between the time of purchase and the receipt of loan proceeds. However, regardless of possible changes in the years ahead, lenders must consider HVCRE regulations when negotiating acquisition, development, and construction loans due to their impact on the lender’s regulatory capital requirements.
On its face, the regulations target lenders by mandating that lenders apply a 150% risk-weight to HVCRE loans when determining the necessary regulatory capital, as opposed to the 100% used for non-HVCRE loans. In effect, a lender’s $20 million HVCRE loan must be backed by the same regulatory capital as a $30 million non-HVCRE loan. The result desired by regulators is clear: either borrowers must put more equity at risk in acquisition, development, and construction projects, thus avoiding HVCRE designation, or lenders must hold additional capital against loans for such projects. The recent financial crisis showed bank regulators that loans with construction or lease-up risk are more likely to cause bank losses than other loans. The HVCRE rules force borrowers to have more skin in the game unless lenders reserve for the risk. Therefore, while the regulation applies to lenders, a loan’s HVCRE classification impacts borrowers and lenders alike.
Impacts On Lending
HVCRE regulations could have several impacts on commercial real estate lending: (1) lenders increase interest rates and fees for HVCRE loans to account for the impact on the lender’s regulatory capital; (2) borrowers obtain loans from nonbank lenders; (3) banks make fewer acquisition, development, or constructions loans; and (4) borrowers and banks structure loans to avoid HVCRE status. When borrowers and banks decide to proceed with acquisition, construction, or development loans and aim to avoid HVCRE designation, banks will need to carefully consider the regulations’ impact on loan provisions, and the documentation required from borrowers.
Lenders carry the regulatory burdens of the HVCRE regulations and shoulder the risks if borrowers and lenders incorrectly believe a loan is not HVCRE. Therefore, it is vitally important for borrowers, lenders, and their counsel to understand HVCRE regulations and prepare for their impact on commercial real estate development loans from the beginning of loan negotiations through the life of the project.
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