The Dodd-Frank Wall Street Reform Consumer Protection Act (Dodd-Frank Act) continues to pose challenges for banks, and that includes lenders that finance the development of real estate. While the federal government is not telling banks how to underwrite loans, it has imposed restrictive parameters on those loans it considers risky, such as construction loans.
Effective Jan. 1, 2015, capital rules were implemented for all banks and thrifts that finance the acquisition, development or construction of real property that is classified as high volatility commercial real estate (HVCRE). HVCRE loans are subject to a risk-weight of 150% as opposed to 100% for non-HVCRE commercial real estate loans.
Dodd-Frank requires that lenders require satisfactory equity on a development project; otherwise, they may have to classify the loan as HVCRE which substantially impacts the loan’s yield to the bank because of this additional 50% reserve on the bank’s balance sheet.
If the loan is classified as HVCRE, each bank will have to weigh several factors to determine if it is willing to give up substantial yield to do the loan. If not, the bank could require a higher spread which could lead to three scenarios:
- Some banks are leaning toward two-tiered pricing—if a loan is not high volatility, the loan terms are one amount; if it is, the price of the loan will be more.
- The bank requires more equity from the developer.
- Based on a healthy existing relationship with the developer, the bank might be willing to put more reserves aside; the same might apply to building a new relationship with a particular developer.
The key takeaway from this for developers is that the new HVCRE requirements mean that banks will be making decisions about deals on a case-by-case basis, examining each opportunity and each relationship. Some developers will find they need to pay more for the loan.
While some smaller banks seem to be slower to adapt the requirements, most midsize and national banks are fully on board with the requirements, reserving more capital and adjusting their pricing models.
To help explain the impact of HVCRE loans on the real estate industry, here are four questions and answers.
1.) Which loans are classified as HVCRE?
A loan is classified as HVCRE when the borrower does not contribute at least 15% of the project capital. To avoid having a loan classified as HVCRE, the borrower must contribute project capital—cash or unencumbered assets—of at least 15% of the real estate project’s appraised “as completed” value. (Note: deferred developer’s fees do not count toward the 15%).
This point is important—it’s not the project cost that applies when determining the 15% equity requirement, even when that cost has been well documented with estimates and construction invoices. The appraiser’s “as completed” value is sometimes higher than the certified project cost.
Dodd Frank further requires that the borrower contributes the required capital before advancement of funds by the bank, and any capital contributed (or internally generated by the project) is contractually required to remain in the project for the duration of the HVCRE loan; therefore, no return of capital is permitted until the project is complete.
2.) Are there any exceptions?
Qualified community development projects, such as those financed with a combination of New Markets Tax Credits and historic tax credits, are exempt from the HVCRE classification. Residential one to four-family properties are exempt as are agricultural land based upon agricultural value of the land.
3.)What is the timing for return of equity to investors?
Equity can’t be distributed back to developers and investors until the project is complete. Upon completion, the loan must be sold, converted to permanent financing or paid in full to no longer be classified as HVCRE. Remember, any capital contributed is required to stay in the project for the life of the project. That means no distributions of capital, even when a portion of the development is being leased.
It’s interesting to note that some developers may complete the project in one year but only lease out 90% of the building. Why? It may be in their interest to delay the conversion to market financing to continue paying interest-only and delay the amortization that kicks in with permanent financing. However, the down side is that the loan agreement may stipulate that they can’t pay back their investors until 100% of the project is leased.
4.) What should real estate developers do?
Real estate developers should be aware of HVCRE and determine their best approach to financing. For example, a developer could come up with 10% cash and 5% percent attributed to the original purchase value land value to meet the new equity requirements. Keep in mind, deferred developer’s fees cannot be used toward the 15% requirement.
There remains some ambiguity around some HVCRE requirements. Building industry associations have asked regulators for better definition around some of these requirements and to make them more manageable. We’ll continue to keep you posted on updates as they become available.
For more information about HVCRE loans or other real estate and construction matters, please contact Roger Gingerich, CPA/ABV, CVA, CCA, at (440) 605-7129 or email@example.com.