By Jay Maddox
Amid the flurry of economic news last month, Congress enacted the Economic Growth, Regulatory Relief and Consumer Protection Act (S.2155) that contained a long list of rollbacks of post-recession regulations under the Dodd-Frank Act. The good news for banks and borrowers is that this bill includes important clarifications and modifications to the previous High Volatility Commercial Real Estate (HVCRE) requirements promulgated in 2015 under Basel III that make it easier for banks to make acquisition, development and construction (“ADC”) loans.
The original rules required banks to carry 150 percent risk-weighting for loans categorized as HVCRE, meaning the banks would have to maintain 50 percent more regulatory capital against such loans than for to non-HVCRE loans. When the original HVCRE rules went into effect, there was significant outcry from both banks and borrowers. Many banks simply classified all construction loans as HVCRE, curtailing their lending capacity.
The HVCRE rule opened the floodgates for non-bank lenders such as private loan funds that weren’t subject to risk-based capital rules. The influx of capital from these lenders helped to maintain some competitive market stability, but for the most part, the HVCRE rules were considered over-reaching, and constrained the bank construction lending market.
In response to many banks’ complaints about the complexity, ambiguity, and difficulty of implementing HVCRE rules, Federal bank regulatory agencies formally proposed changes during 2017 that would have created a new category subject to a reduced 130 percent capital surcharge called high volatility acquisition, development or construction (“HVADC”) credit risk exposure. Banks would have been required to classify virtually all commercial real estate loans as HVADC, except for permanent loans where project income is sufficient to cover debt service, regardless of the borrower’s equity contribution.
While the regulators’ proposed revisions were easier to interpret, they were still considered over-reaching, and left unanswered some important considerations that the final bill approved by Congress was intended to resolve. The new legislation includes a new definition of an HVCRE ADC loan.
What Borrowers Should Expect
Here is a quick summary of the key changes under HVCRE ADC that benefit banks and borrowers alike:
- As before under HVCRE, loans that are less than 80 percent of completed value, when the borrower’s capital contribution is at least 15% of the completed value, remain exempt from the 150% capital surcharge.
- Borrowers can now count the appreciated market value of their equity in the property (rather than the purchase price, which would be much lower) toward their capital contribution, whereas under HVCRE this was excluded. Counting market equity was common industry practice before HVCRE, and this is a very welcome change..
- Borrowers can now take cash distributions from the property provided the minimum 15% equity contribution is maintained, whereas under the original HVCRE rules distributions were prohibited.
- Once development and construction are substantially completed and the property generates cash flow sufficient to cover debt service and expenses, it can be re-classified as non-HVCRE ADC. The original HVCRE rule did not spell out the conditions for re-classification.
These revisions to the FDIC code mandated by the new Congressional legislation that was signed by the president are likely to be adopted by regulators via a set of new regulations. Industry groups such as the Mortgage Bankers Association and the CRE Finance Council are providing initial guidance to regulators as they craft the new rules to help ease the transition.
The new legislation goes a long way to softening and clarifying the original HVCRE regulations and mandates the FDIC to change the rules. Of course, there can be no assurance that banks will aggressively re-enter the construction lending market. However, these changes may result in more banks increasing allocations, which should provide borrowers more options and better pricing and deal execution.