By Venture Mortgage Corporation
Concerns about the regulation and financing regarding a segment of commercial real estate designated as “High Volatility Commercial Real Estate” by banking regulators in the U.S. has some borrowers wondering what this designation means for their next round of commercial real estate construction and development financing. Being somewhat ambiguous and carrying with it significant consequences for both borrowers and lenders, it is understandable that clarification is being sought in this matter.
High Volatility Commercial Real Estate, or HVCRE, is a class of loan that meets a series of several criteria, with some exceptions carved out that will be itemized below. According to federal regulators, a loan is classified as HVCRE if “prior to conversion to permanent financing (known as the construction and lease-up period), it finances or has financed the acquisition, development, or construction (ADC) of real property.” These types of loans are widely referred to as “ADC loans”.
There are ADC loans that fall outside of the HVCRE classification:
1) 1-4 family (residential) properties
2) Real property that is considered a community development investment
3) Development or purchase of certain agricultural land.
A loan that does not meet the above criteria can still avoid the HVCRE classification if all of the following qualifications are met:
1) The loan-to-value ratio is less than or equal to 65% for raw land, 75% for land development, and 80% for commercial, non-residential, and multifamily AND;
2) The borrower has contributed, before funding, equity of at least 15% of the appraised “as completed” value. That’s right- as completed, meaning you might forecast a valuation of a completed asset and have that asset overshoot the mark (to your benefit), then be required to contribute additional capital into the project to maintain adherence to the 15% requirement. This contribution must be in the form of cash or unencumbered assets (read: stocks/bonds)- not developer fee credits, not government grants or credits, not pledged unrelated real estate, and loans independent of the project do not count.
3) The contributed equity (see no. 2 above) must remain in the project until the loan is converted to permanent financing, the loan is paid in full, or the property is sold.
So, what does this mean for an investor with a loan classified as HVCRE? A key consideration for developers is that now the cost of contributed land, not the current appraised value, can count toward the equity contribution requirement, which completely disregards any appreciation or holding costs for said land. From the banks’ perspective, according to current interpretations of this regulation, investments considered HVCRE are considered to have a higher risk weight of 150%, as opposed to 100% under previous rules. This increased risk weight requires banks to hold cash reserves 50% higher than they would for a loan not falling under these regulations.
Therefore, bank lenders are reporting increased related costs in the range of 50-150 bps for loans classified as HVCRE, which results in either higher rates for borrowers in this category, or banks choosing to only loan on those transactions that are considered the most profitable. Real estate development, in particular, might be less attractive to developers due to additional capital requirements, causing a reduction in real estate development activity. The hesitation on the part of banks to enter into a transaction which requires them to hold the additional reserves required for these loans is understandable. These reserves could be deployed to other revenue-generating investments throughout the bank and not be tied up in a high-risk endeavor.
How should borrowers view these regulations as they seek capital for acquisition, development, or construction projects? With one thing in mind: “I need 15% of the ‘as completed’ appraised value in HARD CASH to even begin this project.” As the time of this writing, these regulations apply to all banks with over $500 million in assets and all savings and loan holding companies, including community banks, but do not apply to other lending sources (such as life insurance companies). If a commercial real estate investor has concerns that his next project could be subject to these regulations, it might be a good idea to speak with an experienced mortgage banker for consultation and advice. Although the full effects of this relatively new regulation remain to be seen, it is widely agreed that there will be upward pressure on the cost of capital coming from banks for those borrowers looking for maximum leverage, which could induce borrowers to seek alternative sources of commercial real estate debt.