New capital rules have consequences

As a result of the Dodd-Frank Wall Street Reform Consumer Protection Act (the Dodd-Frank Act), new capital rules were implemented for all banks and thrifts effective by Jan. 1, 2015.

Under the new capital rules, credit facilities that finance the acquisition, development, or construction (ADC) of real property are classified as high volatility commercial real estate (HVCRE). Classification as HVCRE occurs for the period of the project; upon completion of a project and either repayment of the loan or movement to permanent financing, such loan is no longer classified as HVCRE.

What does HVCRE classification mean?

Bank and thrift capital rules calculate capital requirements using ratios that primarily include a denominator of total risk-weighted assets. HVCRE loans are subject to a risk-weight of 150 percent beginning Jan. 1, 2015. By contrast, a non-HVCRE commercial real estate loan is subject to a 100 percent risk-weight. This means that a bank requires roughly one-third more capital under the new capital rules to have the same amount of regulatory capital for any HVCRE loan held as an asset. By structuring commercial real estate loans to satisfy an exception to HVCRE status, bankers can more effectively use capital and mitigate risk. Developers are wise to understand these new requirements to better understand term sheets and changes in market conditions that may affect deal structures. The criteria for exception from HVCRE status is intended to mitigate the risk of loss presented by the lending criteria and because of that risk mitigation the risk-weight for such loans is 100 percent.

Establishing exceptions to HVCRE status

A financing for ADC can avoid HVCRE status if:

• It concerns:
  • Residential one- to four-family properties,
  • Agricultural land based upon agricultural value of the land, or
  • A qualified community development project.
• Alternatively, a commercial real estate project can avoid HVCRE status by satisfying a three-part test:
  • The loan-to-value (the LTV) ratio is less than or equal to following applicable maximum supervisory loan-to-value ratios;
  • Borrower must contribute project capital—cash, unencumbered assets, or development expenses—of at least 15 percent of the real estate project’s appraised “as completed” value; and
  • Borrower must contribute the required capital before advancement of funds by the bank and any capital contributed (or internally generated by the project) must be contractually required to remain in the project for the life of the project.

What does this mean for terms of commercial real estate project credit facilities?

The LTV requirements mentioned above for commercial real estate projects are typically not an issue for lenders. The second criteria, which requires the borrower to contribute 15 percent in cash or unencumbered readily marketable assets to the project, deviates from traditional lender requirements in two important ways. First, under the new rules, a borrower is required to inject 15 percent of equity into the project measured against the project’s “as completed” appraised value, which, typically is higher than the total project costs thus requiring a borrower to infuse more equity into a project to satisfy this prong of the HVCRE exemption. Secondly, lenders have traditionally counted the current value of the land towards the borrower’s equity requirement. Under the new HVCRE rules, a borrower that held land for the right market conditions or contributes land that has long been held by the borrower will likely find it is limited to the land’s acquisition cost, rather than the current value of the land.

For more information, please contact the attorney listed below.