By Alexandra Pacurar
During the past two years, the High Volatility Commercial Real Estate (HVCRE) rule influenced acquisition, development and construction loans by raising the capital reserve requirement from 8 to 12 percent. Also, an HVCRE loan carries a risk weight of 150 percent compared to 100 percent for non-HVCRE loans. The regulation impacts traditional lenders, like banks, that denounced the fine line between the two types of credit facilities.
These standards, introduced as part of the Basel III agreement, aim to avoid another downturn by ensuring that banks are capitalized and can function despite volatile market conditions. This has made it more difficult for developers and investors to obtain financing for their projects or acquisitions. A bipartisan bill, H.R. 2148, meant to clarify which loans qualify as HVCRE was introduced by Congressmen Robert Pittenger and David Scott in April. Real estate lawyer Gregg Loubier, a partner at Alston & Bird’s Finance Group, explained the implications of this bill passing and why he thinks it won’t happen anytime soon.
MHN: How has the HVCRE rule impact bridge and mezzanine lending so far?
Gregg Loubier: The HVCRE rule has made some construction and bridge lending disadvantageous for regulated banks because, on the one hand, an HVCRE loan decreases profits by requiring higher loan capital reserves. On the other hand, compliance with the exceptions to the HVCRE rule can create burdens on the borrower that make the loan product less competitive with offerings from non-regulated real estate lenders.
Some banks assume that any acquisition, development or construction loan should be classified as HVCRE, which avoids an effort to comply with the rule’s exceptions and its impact on loan structure. A loan that satisfies the exceptions will have characteristics that can be disadvantageous to the borrower. The primary sources of difficulty are the 15 percent contributed capital requirement and the requirement that the borrower must retain internally-generated capital.
Mezzanine lending may be less directly impacted by the HVCRE rule than other construction, development and acquisition loans.
MHN: What about construction lending?
Loubier: Banks provide the lion’s share of U.S. construction loans although non-bank lenders have stepped in to fill the void where banks have retreated. Non-bank lenders may be more expensive for borrowers, but are often more flexible on the level of required equity contribution and other terms, which may or may not reflect the absence of regulatory burdens. Non-bank lenders often market their ability to close loans quickly, which provides a service to the borrower worth paying for and satisfies the non-bank lenders’ imperative to place investment capital to satisfy investor return expectations.
There is some anecdotal evidence that banks have increased warehouse lending to non-bank construction and bridge lenders and so-called note-on note lending to continue participating in that market without the regulatory burdens of direct construction and bridge lending.
MHN: What are the implications of the clarifications of HVCRE regulation for bank and non-bank lenders?
Loubier: The bill will allow distribution of internally-generated capital during the life of the project provided the 15 percent equity contribution is maintained. The bill will allow the borrower to count the appraised value of the land as determined under FIRREA (The Financial Institutions Reform, Recovery, and Enforcement Act of 1989) standards, rather than a lower book value, when calculating the equity contribution. The rule would no longer apply to many bridge loans by removing loans financing improvements to existing income-producing property if the existing cash flow is sufficient to support the debt service and expenses of the real property loan collateral.
The bill clarifies that a loan may be reclassified as non-HVCRE upon the completion of construction or development and when cash flow generated by the project is sufficient to support debt service and expenses of the property.
MHN: How would this bill create an equal opportunity for bank and non-bank lenders?
Loubier: If the clarifications proposed are implemented, banks will benefit when loans more easily satisfy the HVCRE exceptions, thus improving the attractiveness of the loan product and reducing the regulatory burden of additional capital reserves. Non-bank lenders bring certain competitive advantages to construction and bridge lending irrespective of the bank regulatory burden. Non-bank lenders will continue therefore to play an important role, although, if banks exploit any competitive advantages of relaxed regulation, non-banks could experience somewhat stronger competition which may reduce borrower costs.
MHN: How likely is a boost in construction lending if the bill passes?
Loubier: The impact of HVCRE regulation on the volume of construction lending has been difficult to quantify, and it is likely the advantages of relaxed regulations will be equally challenging to gauge. The release of the proposed bill demonstrates that legislators believe the HVCRE rule has complicated construction and bridge lending in ways perhaps not originally intended when the rule was created to satisfy the mandate under Dodd-Frank. Bank construction and bridge lending may increase if the bill is passed and implemented, although we should be cautious in our predictions.
MHN: What do borrowers need to understand about establishing and maintaining a minimum level of equity in a property?
Loubier: Borrowers need to know that, while these reforms have not been enacted, two aspects of these proposed changes will likely directly improve the terms of their loans. The current appraised value of the property (not just the purchase price) may be counted toward the 15 percent equity contribution. Capital internally generated by the project would no longer be required to remain in the project.
MHN: What is the current status of the bill?
Loubier: H.R. 2148 was referred to the House Financial Services Committee on April 26, 2017. No further action has been taken. The House focused its efforts instead on passing the Financial CHOICE Act of 2017, which did not include HVCRE reform. The CHOICE Act is unlikely to pass in the Senate. Though the passing of H.R. 2148 is unlikely, it does serve as a strong template for action by the agencies to streamline the regulations.
The report issued by the U.S. Department of the Treasury on June 12, 2017, reaffirmed the administration’s commitment to HVCRE reform, as did the Joint Report to Congress, a regulatory review submitted by Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the National Credit Union Administration on March 21, 2017.
Image courtesy of Alston & Bird