by Clifton D. Beech
Ron Holmes wrote an article last winter about High-Volatility Commercial Real Estate (“HVCRE”) loans, which gave an introduction and background to the concept. As a refresher, BASEL III regulatory capital rules went into effect on January 1, 2015, introducing the concept of HVCRE. These regulations require all loans meeting the HVCRE definition to be reported separately from other commercial real estate (“CRE”) loans and are to be assigned a risk weighting of 150% of risk-based capital purposes. This results in banking entities being required to hold 50% more capital against HVCRE exposures compared to standard CRE loans. Loans in existence prior to January 1, 2015 are not grandfathered and are still subject to HVCRE regulations. Of course, the enhanced lender reserve requirements result in enhanced borrower limitations.
Importantly, HVCRE regulations apply only to certain acquisition, development, and construction (“ADC”) loans, and not all commercial real estate loans. However, we have noticed banks and credit facilities are routinely inserting HVCRE provisions into loan agreements although the loans are not ADC loans. Thus, it is important to know if your loan is an ADC loan.
The Office of the Comptroller of the Currency (“OCC”) states that an ADC Loan, in its simplest form, is a loan to “finance the land acquisition, land preparation, and construction of a single residential or commercial building.” The OCC then defines land acquisition as financing the acquisition of undeveloped land. Development loans are the funding of the preparation of land for construction, which includes infrastructure improvements such as sewer or water pipes. Construction loans are the financing of construction or renovation of any property other than one-to-four family residential dwellings. A defining characteristic of whether a loan is a construction loan is if the value of the project is real or is only an estimate of the value at the time of completion of the project. For example, the acquisition of a property with a loan that includes significant renovations would be an ADC loan. If the acquisition loan includes only the amount to purchase the developed property, then the loan is not ADC.
Permanent loans are not ADC loans and therefore are not subject to HVCRE. Typically, a construction loan converts to a permanent loan once the construction is complete and perhaps after a lease up period. Upon conversion to a permanent loan, the loan is no longer an ADC loan and, thus, not subject to HVCRE requirements.
Even if your loan is considered ADC, there are a few exceptions that allow the loan to avoid HVCRE regulations. A loan secured by one-to-four family residential projects are never subject to HVCRE regulations, as are properties that qualify as an investment in a community development project. Agricultural land securing a loan is typically not HVCRE. Finally, an ADC loan that meets the following three requirements will not require HVCRE provisions: (1) The project’s loan-to-value is less than or equal to the maximum supervisory loan-to-value limits1 (s) has contributed cash capital to the project prior to the advancement of funds, encumbered readily marketable assets, land to be contributed to the project, or other out-of-pocket development expenses, where the aggregate of such contributions is at least 15% of the real estate project’s as completed value; and (3) the borrower-contributed capital is contractually required to remain throughout the life of the project, either until the loan is converted to permanent financing or the debt is paid in full.
A word to the wise: don’t assume a loan is an ADC loan just because the loan documents incorporate HVCRE provisions. If you do, you may be saddled with equity requirements and limitations on available cash distributions which are not legally required.
1 Current loan-to-value ratio requirements are: raw land – 65%; land development – 75%; commercial, multi-family, and other nonresidential construction – 80%; 1-4 family residential or improved property – 85%