January 1, 2015 marked a dreadful day for certain borrowers and banks. On January 1, 2015, new regulatory capital rules, known as Basel III, went into effect for many banks that provide commercial real estate financing (“Qualifying Lenders”). These new banking regulations make it more costly and less profitable for Qualifying Lenders to finance certain acquisition, development and construction (“ADC”) loans, thereby making such loans more difficult to obtain and/or more expensive for borrowers.
Under the new regulations, all ADC loans will be classified as High Volatility Commercial Real Estate (“HVCRE”) loans, unless the loan secures one of the four types of collateral listed below. If an ADC loan is not used to finance one of the below and, therefore, the ADC loan is classified as an HVCRE loan, then, under the new regulations, the loan is considered riskier than a non-HVCRE loan. As a result, the new regulations require that all Qualifying Lenders maintain 50% more capital in their reserves against such riskier HVCRE loans. Qualifying Lenders will likely pass this increased cost on to their borrowers. Importantly, these new regulations also apply retroactively, therefore, Qualifying Lenders must evaluate their existing ADC loans to determine if such loans must be classified as HVCRE loans. If any existing ADC loans must be classified as HVCRE loans, then Qualifying Lenders who wish to pass on the newly incurred costs to their borrowers will need to review their loan documents to determine if this is permitted.
If the ADC loan is used to finance one of the following, then the ADC loan will not be classified as an HVCRE loan:
- one-to-four family residential properties;
- real property that would qualify as a community development investment;
- agricultural land; or
- commercial real estate projects in which:
a. the project’s loan to value ratio is less than or equal to the maximum loan to value ratio set forth in applicable regulations (i.e., 65% for raw land; 75% for land development; 80% for commercial, multi-family and other non-residential construction; 85% for 1-4 family residential construction; and 85% for improved property);
b. the borrower has contributed capital to the project in an amount equal to at least 15% of the real estate project’s “as completed” appraised value before any loan proceeds have been advanced; and
c. the capital referenced above in item b., or capital internally generated by the project in the amount sufficient to maintain the 15% requirement, is contractually required to remain in the project throughout the life of the loan.
A borrower who plans to develop property for something other than one-to-four family residential, community development investment or agricultural, must satisfy the elements listed above at items 4.a. through c. in order to avoid the increased costs associated with HVCRE loans. U.S. federal banking agencies have provided further guidance on how a borrower may satisfy some of these elements:
A. Capital/Asset Contribution to the Project: the following are examples of capital/assets that borrower may contribute to satisfy the 15% requirement
- land, purchased with cash, that is contributed to the project (note: the value of this land is determined as of the date the land was purchased; the borrower does not get the benefit of any increase in value);
- out-of-pocket development expenses paid by the developer-borrower such as brokerage fees, marketing expenses and cost feasibility studies;
- reasonable soft costs included in development expenses such as interest and fees related to pre-development expenses, developer fees, leasing expenses, brokerage commissions and management fees; and
- cash expended by the developer-borrower to acquire a site, including engineering or permitting expenses directly related to the project.
Examples of assets that cannot be used to satisfy the 15% requirement include: borrower-owned real estate from an unrelated project pledged as collateral; financing from a third party lien-holder; assets contributed to the project after loan proceeds have been advanced; and cash received in the form of grants (whether from not-for-profits, municipalities or other government agencies).
Importantly, the qualifying capital/assets must be contributed to the project before any loan proceeds are advanced. If the qualifying capital/assets are not timely contributed to the project, then the loan will be classified as an HVCRE loan for the life of the loan even if qualifying capital/assets are contributed to the project after proceeds have been advanced to the borrower.
B. “As Completed” Appraised Value: means the property’s market value as of the time the project is expected to be completed (note: this is different from “as stabilized” value, which means the property’s market value as of the time the property is projected to achieve stabilized occupancy). A Qualifying Lender may only consider the “as completed” appraised value for purposes of determining whether the ADC loan must be classified as an HVCRE loan.
C. Life of the Loan: the “life of the loan” expires when the loan is converted to permanent financing or the debt is paid in full. The loan documents must include terms that prohibit the borrower from withdrawing the contributed capital/assets (or internally generated capital in the amount required) until the expiration of the life of the loan.
Given that these regulations are still fairly new, we will continue to monitor any changes and provide updates and further information as it becomes available.