Basel III Regulations, HVCRE Loans and the Impact on Lending in Real Estate– November 22, 2016 by Brandon Coates

Basel III is a regulatory framework that was approved by the Federal Reserve back in 2013 and was intended to strengthen the regulation, supervision and risk management of the banking sector.  Generally, the new regulations require banking organizations to maintain higher capital levels and limit the definition of what is included in the calculation of capital. While the regulations went into effect in January 2015, the banking industry is still interpreting the new regulations and determining what the impact will be on their real estate lending strategies.

Impact on Real Estate Lending

One key aspect of the regulations, specifically for real estate lending, is the classification of certain loans into the high volatility commercial real estate (HVCRE) category. This classification is defined as “a credit facility that finances or has financed the acquisition, development or construction (ADC) of real property.” 
 
Previously, the capital rules applied a risk weighting of 100% to all commercial real estate exposures.  Under the new regulations, any HVCRE exposure held by a banking organization requires a risk weighting of 150%. Therefore, a loan in the past that required $1 million to be held in reserves, will now require $1.5 million to be held in reserves. 
 
These additional capital requirements are having a significant impact on lending decisions and strategies in the banking industry. In short, banks are deciding on a case-by-case basis if the bank will absorb the costs associated with keeping more capital, or if those costs will be passed to the borrower in the form of fees or higher rates.

Exceptions to HVCRE

Certain ADC loans are exempt from the HVCRE classification. The exemptions include ADC loans related to one- to four-family residential properties, real property that would qualify as community development investments, or loans to businesses or farms with gross revenues of $1 million or more.
 
Other ADC loans may be exempt from the HVCRE classification if they meet all of the following criteria:

  1. The loan must have a loan-to-value ratio (LTV) of less than or equal to 80%.

  2. The borrower must contribute capital to the project in the form of cash or unencumbered marketable assets of at least 15% of the appraised “as complete” value of the project.

  3. The borrower’s capital must be contributed prior to bank funding and the capital must remain in the project throughout the life of the project.

Of those criteria, #1 and #3 are typically met as most lenders are more conservative than the 80% LTV threshold, and most lenders will require all capital to be contributed prior to funding and held through the project. However, criteria #2 is where developers can trip the HVCRE classification. 
 
Traditionally, banks required capital of 15% or more of the project’s cost. Now, that requirement has increased to 15% of the appraised completed value, requiring the borrower to round up more capital.  Additionally, banks previously considered the appreciated value of land as part of the 15% equity. Now, only the cash expended to purchase the land will be taken into account. Contributing appreciated property, therefore, will not carry the weight that it had previously and borrowers will have to look at alternative strategies to meet the 15% requirement. One option would be for borrowers to sell the land at the appreciated value, but that would result in taxable income. This regulation has created an interesting dilemma between banking strategy and tax strategy.
 
The new regulations are complex and interpretations can vary from bank to bank. Work closely with your accounting team to help ensure your loan is not classified as HVCRE. 
 
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.