The Trump administration and Congress have lots on the agenda: tax reform, financial regulation reform, job creation (think infrastructure spending, maybe?) and more. While it seems unlikely that much of anything "real" is going to happen anytime soon or even this year (other than more drama, more tweets and more Trump-isms), there's some hope for a fix for the many failings of the High Volatility Commercial Real Estate (HVCRE) Rule.
But first- a little background- the HVCRE Regulations of the Fed, OCC and FDIC became effective January 1, 2015 and apply to any acquisition, development or construction (ADC) loans made by any bank. If the loan is an ADC loan, unless one of the 4 enumerated exemptions is satisfied (click here for more information on the exemptions), the loan will be subject to a 150% risk weighting requirement (instead of the previous 100% risk weighting requirement). This means that a $10 million HVCRE loan is treated as $15 million toward the bank's risk weight total. The regulators have explained that ADC loans are inherently riskier than other loans and therefore those risks need to be mitigated by requiring banks to hold more capital against such loans. The result desired by the regulators is clear: either borrowers must put more equity at risk in acquisition, development and construction projects, thereby avoiding an HVCRE designation, or lenders must hold additional capital against loans if they want to make these riskier loans. The overall effect of the rule is that it adversely impacts borrowers (think higher interest rates, more onerous lending requirements, less liquidity in the market place etc.) and lenders (think- effects on competition between banks and nonbanks, less profits, increased costs of regulation etc.) alike. For those of you who aren't living in HVCRE land and would like more information, please click here, here and here.
Now- back to recent events. On April 26, 2017, in a show of bi-partisan support, Rep. Pettenger (R-NC) and Rep. Scott (D-GA) introduced HR 2148 in the House. HR 2148 seeks to amend the existing HVCRE Regulations to clarify and improve the rule which has created confusion and unnecessary costs in commercial real estate lending. The introduction of HR 2148 is a step in the right direction.
We can hope, but HR 2148 is not yet the law of the land and may never be, which means that, at least for the time being, we are stuck with the HVCRE Regulations that went into effect on January 1, 2015.
The Rule is opaque and confusing. There have been continued efforts by our many trade organizations to engage the regulators on a further clarification of the Rule through additional FAQs or other guidance, but so far that effort has failed. Based upon recent Call Reports from the banking community, the Rule is being enforced in wildly different ways and there still seems to be confusion amongst bankers and certainly amongst the borrower community whose loan pricing and accessibility of credit may be significantly impacted by this Rule.
In light of all this, we thought it would be helpful to bust some of the most pervasive myths about the Rule based upon what we know at this time:
- Misses or footfalls on HVCRE compliance can be cured – FALSE– HVCRE is tested at origination. An ADC loan must satisfy HVCRE criteria (or be scoped out of HVCRE) when the loan is closed, or the loan is not exempt and additional required capital must be set aside by the bank. There is NO way to CURE this after origination. I should also note that reverse is true- if the loan meets an HVCRE exemption at origination or is made pursuant to lender's then permanent underwriting criteria (so is not HVCRE at all), it doesn't then become an HVCRE loan after origination because of some event (an increase in LTV, for example).
- The borrower can contribute additional capital to an existing HVCRE loan after funds have initially been advanced to exempt the loan from the definition of HVCRE. – FALSE See above. It's tested once at origination (but if the borrower wants to contribute more dollars, the lender may take it...it just won't fix any HVCRE-related issue).
- Soft costs are not part of the borrower's contributed capital as development expenses. – FALSE – Certain soft costs may be considered part of the borrower's contributed capital, so long as the expenditure of such funds is reasonably deemed to contribute to the completion value of the project and are reasonable.
- The "as stabilized" value can be used to determine whether the loan is an HVCRE exposure. – FALSE–Only the "as completed" value can establish market value for purposes of determining HVCRE exposure.
- Land contributed to a new development does not count. – FALSE– The relevant test is whether the borrower has contributed capital in the form of cash or readily marketable assets or paid development costs out of pocket equal to at least 15% of the real estate's "as completed" value. Contributed land is treated as the contribution of cash to the project at its acquisition basis. Note that appreciation in the value of contributed land does not count.
- I can pay the mezz lender interest from property cash flow.- FALSE– The loan must be converted to permanent financing, sold or paid in full before any internally generated capital may be distributed to the owner. Paying the mezz lender is not a project cost.
- For HVCRE compliance purposes, the borrower is required to maintain records pertaining to how any HVCRE exemption is satisfied.– FALSE– The onus is on the bank to adequately document and to maintain records showing that the loan meets the exemption criteria.
- If the loan is a 10-year fixed rate loan then it is considered permanent financing. – TRUE (maybe...probably) – HVCRE does not include permanent financing. Unfortunately, permanent financing is a term on which the regulations have little to add except to say that "permanent financing" is subject to the "bank's underwriting criteria for long-term mortgage loans". An FAQ published in April 2015 by the OCC, the Fed and the FDIC adds that a loan cannot be classified as permanent financing if it is "based on the 'as completed' value of a project" and "there will be any future advances on the loan."
- A loan made to acquire property where there is no development or construction component is NOT an HVCRE loan. – FALSE– A loan made to a borrower to be used to acquire property only IS an HVCRE loan unless the loan was made pursuant to the bank's permanent financing underwriting criteria. The HCRE regulation covers acquisition, development, OR construction loans.
- An ADC loan is able to convert to a non-HVCRE loan upon the happening of some event- like receipt of the final certificate of occupancy or substantial completion of the project. – FALSE– According to the FAQs and the regulation, the test for when an ADC loan is able to convert to a loan that is no longer subject to HVCRE is that the loan is then subject to the bank's underwriting criteria for permanent financing. As an aside, the FAQs suggest that this must be done with a new loan but the regulation itself talks about "conversion" or sale or payment in full of the existing loan.
We at Crunched Credit continue to follow the HVCRE Regulation and will continue to keep you updated as to recent developments.
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.