The Basel III regulations adopted by U.S. regulators last year directly impact commercial real estate in a number of important ways: It changes the risk weighting of various real estate credit exposures, including increasing the risk weight assigned to delinquent loans and altering the landscape of mortgage servicing. However, while all changes have the potential to dramatically change the commercial mortgage market, the biggest potential impact comes from the introduction of so-called the High Volatility Commercial Real Estate (HVCRE) loans.
US Basel III has received attention and interest from numerous financial specialists within the banking industry and has been greeted with varying levels of enthusiasm. In particular, US Basel III directly impacts commercial real estate in a number of important ways including by (i) changing the risk weighting of various real estate credit exposures, including so-called high volatility commercial real estate loans, (ii) automatically increasing the risk weight assigned to loans that are more than 90 days past due or in non-accrual, and (iii) imposing new limits on the amount of mortgage servicing rights that may be included in the calculation of Tier 1 Capital as well as changing the risk weighting for those mortgage servicing rights.
High Volatility Commercial Real Estate Loans
HVCRE loans are deemed to be riskier than other credit exposures and, effective January 2015, all acquisition, development or construction loans, whenever made, that can be classified as HVCRE loans will be assigned a risk weighting of 150%.3 This new risk weighting represents a significant departure from the risk weighting approach to real estate assets in Basel I and II, both of which charged a risk weight of 100% to some real estate loan assets and 50% to others. The net effect is a substantial increase (by half) in the capital required to be reserved in respect of certain real-estate loans by banking organizations subject to the final rule.
An HVCRE loan is defined under the Final Rule4 as a loan that is not a “permanent” loan and which finances the acquisition, development, or construction of real property (ADC) unless the
1. One- to four-family residential properties,
2. Real property that qualifies as an “investment in community development” or a “qualified investment”
3. Agricultural land, or
4. Commercial real estate properties in which
a. the loan to value ratio is less than or equal to the applicable
regulator’s supervisory limit on loan to value ratios;5
b. the borrower has contributed capital, in the form of cash,
unencumbered readily marketable assets or out-pocket-expenses
(incurred and paid by the borrower), of at least
15% of the real estate’s appraised “as completed” value; and
c. the borrower has contributed such capital prior to the lender
making any advances and such capital contributed by the
borrower, or internally generated by the project, is contractually
required to remain in the project for the “life of the project”.
Per the Final Rule, the “life of the project” ends only when the project is sold or the loan is converted to “permanent” financing or is paid in full. The banking organization providing the ADC Loan may also provide permanent financing provided such permanent financing is subject to the banking organization’s underwriting criteria for long-term mortgage loans.
The provisions of the Final Rule pertaining to HVCRE loans went into effect in January 2015, and all banking organizations subject to risk based capital reporting requirements were required to determine by March 31, 2015, the status under the Final Rule of each of their ADC Loans.
Unfortunately, the Final Rule does not provide much guidance on how to apply the exemption criteria, which has left those banking organizations subject to the Final Rule in a state of uncertainty as to how and when the HVCRE designation may be avoided. Both banks and other interested parties6 have sought clarifications on the rule and have raised a number of questions and issues including (i) whether an HVCRE Loan can be rehabilitated” after closing; (ii) whether the cash paid for raw land at purchase may count towards the borrower’s required capital contribution; (iii) whether the borrower may include appreciated land value as part its required capital contribution; and (iv) whether the required capital contribution may be made with borrowed funds, and the point at which the developer may withdraw capital from the project.
In April 2015, the Agencies published a set of “frequently asked questions” (FAQs)7 and responses. Their responses covered many, but not all, of the issues raised by interested parties and with varying degrees of clarity.
In response to FAQ #1, the Agencies stated in no uncertain terms
that a loan which at the time of funding is an HVCRE Loan cannot
be rehabilitated by subsequent injections of capital from the borrower.
The borrower’s required capital contribution must be made before any portion of the loan is funded. Some lenders have begun to
introduce provisions requiring the borrower to contribute additional
equity as necessary to maintain the 15% capital requirement. In
the context of a non-recourse loan, some of these provisions may
not play well with borrowers and, in light of the Agencies’ response,
may be of little utility.
On a different but related topic, the Agencies indicated that an ADC
Loan, which is required to be risk-weighted as an HVCRE Loan
at closing due to a loan-to-value ratio in excess of the applicable
supervisory limits, cannot be reclassified upon the receipt of a new
appraisal or valuation reflecting a new loan-to-value ratio that no
longer exceeds the prescribed supervisory maximum. Thus an ADC
Loan which by definition has become less risky will nonetheless
continue to bear a risk weight of 150%.
The Agencies’ response to another question makes clear that cash used to purchase land that is subsequently contributed to a project may be counted as borrower contributed capital in satisfaction of the 15% capital requirement, so long as the borrower has provided satisfactory evidence of cash payment. However, while helpful, the answer still leaves unanswered an important question — how will appreciated value in excess of the original purchase price of the property be treated? May a borrower who purchased property for cash and then held it while it appreciated in value contribute the appreciated value of the property as part of the required
15% capital requirement? To not give credit for demonstrated appreciation in value seems an unfair outcome. A borrower who purchased a property for $100,000 and held it (and maintained it and paid taxes on it) long enough for it to have appreciated to $250,000 will be worse off with a deemed capital contribution of only $100,000 than the borrower who has just bought that same property for $250,000 and is credited with a capital contribution in such amount.8 One argument for the Agencies’ response is that cash actually paid is a clear and objective measure for purposes
of determining the amount of capital the borrower has contributed. However, given the willingness to rely on appraisals in so many other
contexts, including for purposes of determining the “as-completed”
value of the project under the Final Rule, any reluctance to give credit for the demonstrated appreciated value of the contributed property contribute will be difficult to understand.
That the borrower should be required to have real skin in the game is a recurring theme in the Agencies’ responses to the FAQs. The required 15% capital contribution may not be satisfied through the borrower’s pledge of unrelated and otherwise unencumbered real property; a collateral pledge as security for an obligation is conditional and therefore not a contribution. The 15% capital contribution also cannot be made with (a) the proceeds of a loan from a third party lender secured by a second lien on the project, (b) the proceeds of a loan which is made to the borrower independent of the ADC Loan by the banking organization funding the ADC Loan, or (c) the proceeds of grants from non-profit organizations.
There are, however, several alternative sources of capital which the Agencies appear either not to have considered, or if they have considered them, have not yet determined to reject as an acceptable means of achieving the 15% capital requirement. The first alternative is unsecured debt or debt, secured by some other asset completely unrelated to the project. Given the Agencies’ view on grants and the importance of having a meaningful stake in the project, it may be that borrower debt of any kind that is not entirely recourse in nature will not get much traction with the Agencies.
A second alternative is mezzanine debt secured by ownership interests (direct or indirect) in the borrower. An important distinction from the first alternative is the identity of the borrower — typically a mezzanine loan is not made to the developer but rather to an entity that directly or indirectly owns the developer. The developer receives the proceeds of the mezzanine loan as a contribution of equity from its up tier owner and not as debt. The third option is another common source of capital in real estate transactions — preferred equity. The Mortgage Bankers Association is of the view that any infusion of capital into the borrower is for the good,
although it is also quick to point out that any direct infusion of
capital ought not to have the attributes of debt — such as maturity
dates, security and payment defaults.9
In order to avoid classification as an HVCRE Loan, an ADC Loan must contain contractual provisions which require “the capital contributed by the borrower, or internally generated by the project . . . to remain in the project throughout the life of the project.”10 In its comment letter dated January 26, 2015, the Mortgage Bankers Association requested guidance on permitted uses of capital.11 In April 2015, the Mortgage Bankers Association, perhaps sensing where things were headed, commented that one reading of the Final Rule would require that a borrower must be contractually prohibited from withdrawing capital in excess of the 15% capital requirement for the entire life of the project and urged the Agencies to focus their guidance on permitted uses of capital rather than
on an absolute prohibition on the use of capital.12 In response, the
Agencies seem to have adopted the less favorable reading of the
Final Rule and stated that the borrower must be prohibited from
withdrawing both its contributed capital and any internally generated
capital until the life of the project has concluded.
As further pointed out by the Mortgage Bankers Association, some projects are capable of generating capital during the course of development and construction (e.g. sale of pads).13 If the Final
Rule is read to prohibit the withdrawal of any capital in excess of
Real Estate Finance in the Era Of Basel III the 15% capital requirement, such borrowers will be precluded from covering the debt service, trade debt and operating costs of the project.
While many ADC Loans will be structured to include reserves for interest and other expected expenditures during the period of construction, developers able to generate capital from, for example, the sale of pads may prefer to avoid costly reserves and cover certain operating costs on their own. This prohibition on the withdrawal of internally generated capital becomes even more problematic after the project is completed, but not stabilized (and therefore not yet eligible for permanent financing); the project may be throwing off enough income to scrape by, but under the
Agencies’ current interpretation of the Final Rule the borrower
is not going to have access to these funds to cover the costs of
operation and ramp up.
Moreover, in a typical construction loan, payment recourse, if any, burns off upon completion of construction, along with the built in reserves. At that point, the borrower may be completely reliant on the project cash flow to cover operating expenses, taxes and the other items critical to the sound and proper operation of a project. If not permitted to access that cash flow is the borrower then required to take another loan or to infuse additional equity notwithstanding the non-recourse nature of the loan? This flies in the face of today’s commercial real estate lending practices and it seems unlikely that sophisticated borrowers will stand for this.
The jury is still out on how ultimately banking organizations will respond to the new regulatory capital rules embodied in US Basel III. Some speculate in respect of the HVCRE Rule that regulated banking organizations will decrease their activity in commercial real estate lending and that there will be an uptick in the number of mortgage REITS and private equity funds originating commercial real estate loans.14
Increasingly commercial banking is a relationship business; many banking organizations will think long and hard before abandoning such a significant component of the relationship. That said, those banking organizations wishing to stay in the commercial real estate lending business will need to adjust their business models and
expectations of profitability, and in some cases banking organizations
unable or unwilling to suffer lower profitability may be forced to try and pass the 150% capital charge along to borrowers through higher interest rates or to get out of the business.
In any event, the more closely aligned the HVCRE Rule can be made to be with industry realities, the more likely it is that banking organizations will continue to be able to offer commercial real estate loan products that are desirable to both the banking organizations and their customers.
1 Ms. Spyksma works in the Law Department of Wells Fargo Bank, N.A.
as a Capital Markets Counsel.
2 Nothing contained in this paper shall be construed as legal, tax or
accounting advice. The views herein expressed are solely those of the
author and do not necessarily represent or reflect the views of Wells
Fargo Bank, N.A. The author reserves the right to assert positions
contrary to those stated in this paper.
3 78 Fed. Reg. 62181.
4 78 Fed. Reg. 62165.
5 65% in the case of raw land, 75% in the case of land development, for
construction loans, 80% in the case commercial, multifamily and other
non-residential property, and 85% in the case of 1 to 4 family dwellings,
and 85% for already improved land (12 CFR part 34, subpart D; 12 CFR
Part 160, subparts A and B; 12 CFR part 208, appendix C).
6 e.g. the Mortgage Bankers Association, the CRE Finance Council, and
the Real Estate Roundtable.
7 “High Volatility Commercial Real Estate (HVCRE) Exposures”, Frequently
Asked Questions on the Regulatory Capital Rule, Office of the Comptroller
of the Currency, Board of Governors of the Federal Reserve System,
Federal Deposit Insurance Corporation, March 31, 2015.
8 Mortgage Bankers Association’s supplemental letter dated January
26, 2015, addressed to the Comptroller of the Currency, the Board of
Governors of the Federal Reserve and the Federal Deposit Insurance
Corporation, p. 3. Mortgage Bankers Association’s follow-up letter dated
April 1, 2015, addressed to the Comptroller of the Currency, the Board
of Governors of the Federal Reserve and the Federal Deposit Insurance
Corporation, p. 5.
9 Mortgage Bankers Association’s follow-up letter dated April 1, 2015,
addressed to the Comptroller of the Currency, the Board of Governors of the
Federal Reserve and the Federal Deposit Insurance Corporation, p. 4.
10 78 Fed. Reg. 62165
11 Mortgage Bankers Association’s supplemental letter dated January
26, 2015, addressed to the Comptroller of the Currency, the Board of
Governors of the Federal Reserve and the Federal Deposit Insurance
Corporation, pp. 3-4.
12 Mortgage Bankers Association’s follow-up letter dated April 1, 2015,
addressed to the Comptroller of the Currency, the Board of Governors of
the Federal Reserve and the Federal Deposit Insurance Corporation, p. 3.
13 Mortgage Bankers Association’s follow-up letter dated April 1, 2015,
addressed to the Comptroller of the Currency, the Board of Governors
of the Federal Reserve and the Federal Deposit Insurance Corporation,
14 “Banking Regulators to Vote on Basel III Implementation in U.S.”,
Commercial Real Estate Direct Staff Report, July , 2013.