By now, anyone who works in the real estate industry is likely to have heard of Basel III and the new requirements for HVCRE Loans. But you may be asking: what is Basel III; what constitutes an HVCRE Loan; and what is the impact to a borrower in real estate deals? The alert below answers these questions.
What is Basel III?
The Basel Committee on Banking Supervision (the "Committee") is an international committee focused on the importance of adequate capitalization in a stable international banking system. To improve regulatory oversight and risk management in the banking sector following the 2008 financial crisis, the Committee adopted a new capital accord commonly referred to as "Basel III". Congress mandated the adoption of Basel III in the United States when it passed The Dodd–Frank Wall Street Reform and Consumer Protection Act. The final rules implementing Basel III took effect on January 1, 2015.
HVCRE Loans
Recent attention on Basel III has focused on the increased risk
weighting of certain High Volatility Commercial Real Estate Loans
(or "HVCRE Loans"), and the corresponding increase in
reserve requirements for banking organizations making such HVCRE
Loans. A typical commercial real estate loan has a risk weighting
of 100% and a capital requirement of 8%. This means that a bank
must reserve at least $8 million in capital to make a $100 million
loan. An HVCRE Loan is assigned a risk rating of 150%. This means
that a bank must reserve at least $12 million in capital to make a
$100 million HVCRE Loan (i.e. $4 million more in reserves).
An HVCRE Loan is any loan from a banking organization that finances
the acquisition, development or construction of real property,
which is not considered to be "permanent financing," and
specifically excludes: (1) loans on 1-4 unit residential
properties; (2) community development loans; (3) agricultural loans
and (4) commercial real estate loans which satisfy the following
requirements:
- The loan-to-value ratio is less than: (a) 65% for raw land; (b) 75% for land development projects; (c) 80% for commercial, multi-family, or other non-residential construction projects; or (d) 85% for already improved property;
- The borrower has contributed capital in the form of cash or unencumbered readily marketable assets of at least 15% of the project's "as-completed" value; and
- The borrower's contributed capital and all of the project's "internally generated capital" is contractually required to remain in the project until the project is sold, or until the loan is either paid off in full or converted to permanent financing.
The HVCRE regulations currently only apply to banking
organizations, although there is some speculation that this could
change to also include loans from insurance companies. Mortgage
REITs and private equity funds that originate commercial real
estate loans are not currently subject to HVCRE regulations.
"Permanent financing" is not defined in the regulations,
but based on an FAQ published in April 2015 by the relevant federal
banking agencies: (1) a loan does not constitute "permanent
financing" if it will have future advances and the
underwriting is based on the "as-completed" value of the
project and (2) "permanent financing" requires, at a
minimum, that the loan satisfy the lender's "normal
lending terms" and "underwriting criteria" for
permanent loans.
Borrower Impact
Increased Pricing: If a loan is classified as an HVCRE Loan, the
lender will face a lower return on its capital as a result of the
higher capital reserve requirement. This will likely lead to
increased pricing on the loan, including a higher interest rate,
for the borrower. If possible, lenders will want to ensure that a
loan is not classified as an HVCRE Loan. Borrowers should expect to
see loan provisions addressing that the exemptions to being
classified as an HVCRE Loan have been satisfied.
Required Capital: In the HVCRE Loan analysis, the loan-to-value
requirement is a relatively straightforward calculation that is
standard for all commercial real estate loans. The requirement that
a borrower will be required to have contributed capital in the form
of cash or unencumbered readily marketable assets of 15% of the
project's "as completed" value is more complicated.
Since such capital must be contributed prior to the disbursement of
any loan proceeds, this requirement may create obstacles to
disbursement of loan proceeds at closing.
Borrowers should first understand what may be included as
"capital" in the form of cash or unencumbered readily
marketable assets. "Capital" includes cash paid to
purchase land and out-of-pocket development expenses. It does not
include: (1) the value of any contributed land (including any
increase in land value that may result from improved market
conditions or a project's entitlements) or (2) any borrowed
money or other collateral pledged in support of the loan, such as a
second mortgage or an unsecured loan. It is unclear whether
proceeds of a mezzanine loan or debt of a borrower's parent
entities may be included as "capital", but a conservative
lender would likely exclude such proceeds. This may cause certain
joint venture structures to look more attractive. Furthermore, the
capital contribution requirements are based on the
"as-completed" value of a project rather than a
project's cost, which is a change from conventional
underwriting practices, and may increase the required capital
contribution for any given project.
Capital Must Remain in the Project: Borrowers must also be aware of
issues related to the requirement that a borrower's contributed
capital and internally generated capital remain in the project
until the project is sold, or the loan is paid in full or converted
to permanent financing. This requirement prohibits a borrower from
making distributions of any contributed equity and traps net
operating income in the project, in each case, during the life of
the loan. It is unclear whether income generated by the project can
be applied to cover a project's expenses. Borrowers should
therefore expect to see increases in required reserves to cover a
project's carrying costs.
Cost Provisions: Borrowers may be tempted to let the lender focus
on the details of ensuring a loan satisfies the requirements
necessary to avoid classification as an HVCRE Loan; however, it is
in a borrower's best interests to focus on this issue as well.
If a loan is determined after closing to constitute an HVCRE Loan
and the lender faces higher reserve requirements and capital costs
as a result, the lender may attempt to pass these costs onto the
borrower through the general cost and indemnification provisions
that are standard in most loan documents. Borrowers should also be
on the lookout for any new or special provisions specifically
related to such costs
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
