by Ron Holmes
(A Dec 2016 update to this topic can be found here.)
One of the most under-discussed major changes in the real estate development industry in recent years are the new Basel III Regulations (the “Regulations”) affecting construction and real estate lending. If you are not familiar with these Regulations, READ ON.
Beginning January 1, 2015 commercial bank lending institutions are subject to additional capital reserve requirements for certain High Volatility Commercial Real Estate (“HVCRE”) loans. Based on a Federal Deposit Insurance Corporation study of the recent 2008 financial crisis, which found that many banks that failed during that period in time carried high volumes of real estate acquisition, development or construction (“ADC”) loans, federal banking agencies created a new category of ADC loan – the HVCRE loan – which subjects commercial bank lending institutions (defined as those lenders affiliated with a depository institution) to increased capital reserve requirements to offset potential losses from HVCRE loans. It is also important to note that while the Regulations did not take effect until 2015, there is no “grandfather” clause, and as such, ADC loans made prior to 2015 are also subject to the Regulations.
So, what are these new regulations exactly?
Well, to begin with, all loans made for the purpose of acquiring, developing or causing construction to be completed on real property from a commercial bank lender (as defined above) are considered to be HVCRE loans, unless the loan falls into an exception provided by the Regulations.
As mentioned, if the loan is considered a HVCRE loan, then the lender is required to carry an increased capital reserve of 150%, meaning that a bank lender is now required to retain 50% more capital to offset losses from these types of loans than previously required. The lending institution is required to hold the higher capital reserve requirement throughout the life of the loan, thereby potentially making ADC loans both more expensive and less available from commercial lenders.
To avoid an ADC loan being categorized as a HVCRE loan, a borrower is required to have more “skin in the game.” First, the leverage on loans cannot exceed a certain threshold, depending on the purpose of the loan (e.g., whether it be to acquire raw land, develop commercial property, develop single/multi-family housing, etc.). Second, a borrower must contribute and maintain at least 15% equity of the real estate’s appraised as-completed value throughout the life of the project. The 15% equity threshold includes only cash or other readily marketable assets contributed at closing. Thus, the 15% threshold is determined based on the land’s original basis.
What this means for the developer that wants to buy and hold land for future development is that any appreciation in land value cannot count toward the 15% equity the developer must bring to the table at the time the developer seeks funding for those future projects to avoid the HVCRE categorization. One more tid-bit: since the HVCRE loan regulations require a borrower to maintain 15% equity throughout the life of the loan, this also means developers or borrowers cannot make distributions that would allow the retained equity to dip below the 15% threshold until the loan is converted to permanent financing, paid off in full, or the project is sold.
So, what is the result of these new Requirements?
Construction and development loans are potentially more expensive, real estate development as an industry is less profitable, and many developers may begin to turn to non-bank lenders, taking these loans out of the banking system and into more risky, unregulated sectors. While the true long-term effect of the Regulations remains to be seen, the Regulations are something that developers and lenders alike certainly must consider in any longterm business strategy or development planning.