April 17, 2015
One of the lesser noticed changes in the new Basel III capital regime for U.S. banks is the super-capital charge for so-called "High Volatility Commercial Real Estate" (HVCRE) loans. Effective January 1, 2015, HVCRE loans carry a capital charge that is 50 percent higher than the capital charge for other commercial real estate loans. Because the final Basel III capital rule and accompanying preamble did not contain much gloss on how to apply the HVCRE test to particular transaction structures, the U.S. federal banking agencies[1] have released answers to 17 "frequently asked questions" (FAQs) about the HVCRE test.[2]
Although a start, the FAQs unfortunately leave unanswered many questions that are relevant to particular transaction structures. Given the super-capital charge, banks and developers will wish to consider HVCRE issues carefully until the U.S. regulators provide substantially more clarity on them.
I. U.S. Basel III Capital Rules
Responding to views that, in the Financial Crisis, banks globally were not sufficiently well capitalized to withstand shocks to the financial system, bank regulators worldwide have sought to increase the quality and quantity of bank capital. In July 2013, the U.S. bank regulators issued final rules implementing this new "Basel III" capital regime.
As implemented, Basel III contains two approaches: the Standardized Approach and the Advanced Approaches. The first is a rules-based approach under which categories of bank assets are assigned particular risk-weights. The second allows certain banks to use internal models to calculate the amount of capital to be assigned to particular assets. Under the "Collins Amendment" to the Dodd-Frank Act, however, banks that are permitted to use the Advanced Approaches must calculate their capital under the Standardized Approach as well, and they must use the Standardized Approach if the Advanced Approaches would result in less capital being maintained. As a result, the Basel III Standardized Approach is relevant to all banks.
Under the Standardized Approach, HVCRE loans carry a heightened capital charge. For a non-HVCRE commercial real estate loan, the loan is assigned a risk weight of 100 percent – the same amount as for an unsecured loan to a corporate entity. A HVCRE loan, by contrast, is assigned a risk weight of 150 percent. As a result, a banking entity must maintain 50 percent more capital against such HVCRE exposures. At a time when banks are struggling to achieve desired returns-on-equity due to the new heightened capital requirements, this additional 50 percent requirement is significant.
The HVCRE rule does not apply to nonbank lenders, and so is another example of the advantages in the post-Dodd Frank era of lending by companies that are not affiliated with depository institutions.
II. Definition of HVCRE Loans
With respect to commercial real estate, the final rule defines an HVCRE loan as "a credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property," subject to certain exclusions.
An ADC loan can avoid being classified as an HVCRE loan if it satisfies each of the following three conditions:
- The loan-to-value (LTV) ratio must be less than or equal to the applicable maximum loan-to-value ratio mandated by the bank regulators for particular types of loans, which are:
- Raw land – 65%
- Land development – 75%
- Construction – commercial, multifamily (co-op/condo), and other nonresidential – 80%
- Construction – 1-4 family residential – 85%
- Construction – improved property – 85%
- The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15 percent of the real estate’s appraised "as completed" value; and
- The borrower contributes the amount of capital required by the preceding paragraph before the bank advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project in a manner sufficient to continue to satisfy the 15% requirement.
With respect to the third condition, the capital rule states that "[t]he life of a project concludes only when the credit facility is converted to permanent financing or is sold or paid in full." The same bank providing the ADC financing may provide the permanent financing as long as such permanent financing facility "is subject to the bank’s underwriting criteria for long-term mortgage loans."
III. U.S. Federal Banking Agency FAQs
The preamble to the final U.S. Basel III capital rules did not provide much guidance on how to apply the HVCRE test. In January 2015, the U.S. Mortgage Bankers Association submitted a letter raising a series of questions about the test.[3] On April 6th, the U.S. federal banking agencies released answers to 17 FAQs, as part of a series of FAQs on the Basel III capital rules as a whole. The most important answers to the FAQs are described below.
First, loans that were in existence before January 1, 2015 are not grandfathered.[4] As a result, such loans must be analyzed as to whether they pass the HVCRE test. It is to be remembered that certain loan documentation may contain provisions permitting banks to pass on "increased costs" (or similar language) arising out of the Dodd-Frank Act and regulatory reform. Such provisions will need to be analyzed to determine whether they cover the HVCRE super-capital charge in the event an existing loan is determined to be a HVCRE exposure.
Second, the federal banking agencies re-iterated that the value to be considered for purposes of the 15 percent capital test is "as-completed" value, not "as-stabilized" value. "As-completed" value "reflects the property’s market value as of the time that development is expected to be completed."[5] This is a material distinction, and one that may cut differently for different asset classes.
Third, it is clear that proceeds constituting liabilities on the balance sheet of the borrowing development company cannot count as capital for purposes of the 15 percent test. Two FAQs address this point: the federal banking agencies stated that a second bank’s loan in the form of a second mortgage on a property does not count as capital contributed by the borrower;[6] and an unrelated loan from the bank that is originating the ADC loan to a borrower cannot be counted as capital contributed by the borrower.[7]
Fourth, land value may count toward the 15 percent test, but the FAQs address only two situations. When land is paid for with cash and then contributed to the project by the development company, the cash used to purchase the land is a form of borrower contributed capital.[8] Pledging unencumbered but unrelated land as collateral, however, does not count as borrower contributed capital, because the land is not considered "contributed."[9] There are, however, many other means short of direct borrowing by which a development company may obtain land, and the FAQs address only the cash purchase and pledge of unrelated land fact patterns.
Fifth, "soft costs" that a developer pays that contribute to the "completion and value of the project" can count as "development expenses" that count for purposes of the 15 percent test.[10] These would include interest and other development costs such as fees and pre-development expenses, and also may include costs paid to related parties provided that the costs are reasonable in comparison to third-party costs.
Sixth, a grant from a state or federal agency or municipality is not considered as capital contributed by the developer because "it does not come from the borrower, [and] it does not affect the borrower’s level of investment and therefore does not ensure that the borrower maintains a sufficient economic interest in the project."[11]
Seventh, an appraisal received after origination that shows that the LTV ratio no longer exceeds the maximum LTV ratio will not suffice to remove the loan from HVCRE status – it is only the LTV ratio at origination that counts.[12]
Finally, the federal banking agencies are attaching particular significance to the requirement that 15 percent of development company capital must remain in the project throughout the project’s life. For purposes of the 15 percent test, "the loan documentation must include terms requiring that all contributed or internally generated capital remain in the project throughout the life of the project;" the borrower "must not have the ability to withdraw either the capital contribution or the capital generated internally by the project prior to obtaining permanent financing, selling the project, or paying the loan in full."[13]
* * * * *
Although certain of the FAQ answers are helpful, considered as a whole, they seem to be focused on low hanging fruit. If one compares the FAQs to the questions posed by the Mortgage Bankers Association, it is clear that the federal banking agencies left significant HVCRE questions unresolved. No statements were made as to the following issues, which indeed are only a portion of the questions raised:
- Whether a bank can recognize appreciated land value as part of the 15 percent equity requirement, given that any appreciated land value will be counted in the denominator as part of the "as completed" value of the project.
- Whether preferred equity or mezzanine or subordinated debt financing provided by a third party can count toward the 15 percent requirement.
It is hoped that the federal banking agencies return to these questions, and other questions that have been raised, promptly. In view of the punitive capital treatment for a HVCRE loan, it is further hoped that the federal banking agencies characterize as HVCRE exposures only those structures where it is clear that the borrowing entity has an insufficient economic interest in the property in question such that the risks of the transaction to the borrowing entity justify the super-capital charge.
[1] The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation administer the Basel III capital rules for national banks and federal thrifts, state member banks, and state non-member banks and state-chartered thrifts respectively.
[2] https://fdic.gov/regulations/capital/capital/faq-hvcre.html.
[3]https://www.mba.org/Documents/Comment%20Letters/MBA%20HVCRE%20Supplimental%20Letter%20%281-26-15%29.pdf.
[5] FAQ 6. By contrast, "as stabilized" value reflects the value of the property "as of the time the property is projected to achieve stabilized occupancy."
Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions or Real Estate practice groups, or the authors in the firm’s New York office:
Arthur S. Long (212-351-2426, [email protected])
Noam I. Haberman (212-351-2318, [email protected])
Please also feel free to contact the following practice group leaders and members:
Real Estate Practice Group:
Jesse Sharf – Los Angeles (+1 310-552-8512, [email protected])
Fred L. Pillon – San Francisco (+1 415-393-8241, [email protected])
Alan Samson – London (+ 44 (0)20 7071 4222, [email protected])
Eric M. Feuerstein – New York (+1 212-351-2323, [email protected])
Drew C. Flowers – Los Angeles (+1 213-229-7885, [email protected])
Andrew A. Lance – New York (+1 212-351-3871, [email protected])
Erin L. Rothfuss – San Francisco (+1 415-393-8218, [email protected])
© 2015 Gibson, Dunn & Crutcher LLP