New Rules May Spell Big Changes for Banks, Borrowers

By Jay Maddox

U.S. bank regulators recently proposed new rules for the risk classification of acquisition, development and construction (ADC) loans, which could have important implications for borrowers. Under existing bank rules, ADC loans are classified as high volatility commercial real estate (HVCRE) exposure, unless certain tests are met. HVCRE loans carry a 150 percent risk weighting, meaning the banks have to maintain 50 percent more regulatory capital against such loans as compared to non-HVCRE loans. Bank construction lending has slowed somewhat, partly as a result of these rules.  

In response to many banks’ complaints about the complexity, ambiguity and difficulty of implementing HVCRE rules, federal bank regulatory agencies have formally proposed new rules that are intended to simplify it. The new rules are subject to comments from banks by year-end, then a vote by the Basel Committee for Banking Supervision. As a result, these proposed rule changes may be modified or amended before they are implemented. In any event, borrowers should be aware of their potential impact.

Out with HVCRE, in with HVADC

Under the proposed rules, a new category would be created to replace HVCRE: high volatility acquisition, development or construction (HVADC) credit risk exposure. HVADC would consist of any credit facility (secured or unsecured) that is primarily used to finance or refinance: acquisition of vacant or developed land; land development; or construction, including ground-up or additions/modifications to existing structures. Under HVADC, the key test for declassification is whether project income is sufficient to cover debt service— there is no loan-to-value or minimum equity test. Additionally, the loan must be “prudently underwritten,” a term that is not clearly defined.

Going forward, virtually all CRE loans, except for permanent loans, would now be classified as HVADC, including bridge loans for transitional or pre-stabilized properties. This change effectively broadens the future risk categorization, which is probably not good news for banks or borrowers. However, HVADC would be subject to a reduced 130 percent capital charge, rather than 150 percent under HVCRE, and it is much simpler to interpret.

Exceptions to HVADC

• Existing HVCRE loans would be grandfathered.
• There is also some flexibility for multi-purpose credit facilities that would only be classified as HVADC if more than half the proceeds are used for ADC.
• ADC loans to corporate owner-users that later convert to permanent financing may be exempt.
• An HVADC loan can later be declassified when the property reaches breakeven or better debt coverage.

Implications for Borrowers

Overall, the amount of loans subject to HVADC classification will be larger than under the HVCRE definition. Essentially all CRE-related loans, with few exceptions, are now HVADC. This will make it even more challenging to obtain ADC financing from banks, which will now be faced with a higher cost of doing business. While some will elect to absorb the cost, others will likely modify their lending programs and/or increase their loan pricing. We can expect more competition from unregulated loan funds and REITs that can provide more flexibility and greater proceeds, but generally charge higher rates. Since these lenders are constantly shifting their target lending parameters, borrowers may want to work closely with capital markets professionals who can run a competitive process that will result in the best available execution.