WARNING: High Volatility Commercial Real Estate (HVCRE) AheadMarch 1, 2017
High Volatility Commercial Real Estate (HVCRE) has been an increasingly popular and relevant topic in commercial real estate since the rule was set forth on January 1, 2015 (“Effective Date”) under the Basel III international banking standards. Existing loans as of the Effective Date are not “grandfathered” in, and are still subject to the HVCRE capital requirements imposed on banks. However, banks have differed in the interpretation and application of the HVCRE rules in regards to when the HVCRE capital requirements are triggered. Professionals in commercial real estate should carefully consider how HVCRE rules will impact their clients.
What is HVCRE?
The HVCRE rules, which are applicable to any acquisition, development, and construction (ADC) commercial real estate loans, require lenders to hold 50% more cash reserves to account for any loans that are classified as HVCRE, thereby increasing the weight risk of these loans to 150%.
The rule broadly encompasses the majority of ADC loans, with the exception of one-to-four family residential loans, as well as commercial real estate loans:
(a) that meet the applicable regulatory loan-to-value (LTV) requirements,
(b) where the borrower has contributed cash to the project of at least 15% of the real estate’s “appraised as completed” value prior to the advancement of funds by the bank; and
(c) loans where the borrower’s contributed capital is contractually required to remain in the project until the loan is converted into permanent financing, the property is sold, or the loan is paid in full.
ADC loans that trigger HVCRE rules include provisions which require that all contributed capital and all internally generated capital remain in the project for the life of the loan. Contributed capital can be cash, unencumbered readily marketable assets, or out-of-pocket development expenses. A developer’s “soft costs”, such as brokerage fees, marketing expenses, management fees, or leasing expenses, may be included in the borrower’s capital contribution for the purposes of satisfying HVCRE requirements, so long as the costs are reasonable in comparison to costs of similar services from various third parties.
Borrowers are not allowed to pledge unrelated real estate as collateral to the bank with the intention of that counting towards the 15% capital contribution. Grants from non-profits, municipalities, state or federal agencies also do not count as capital because the grants do not come from the borrower, and in theory, could skew the borrower’s true economic interest in the project. Furthermore, developers are restricted from using buyer’s deposits on units as contributed capital, even in situations where the purchase contract allows for non-refundable deposits.
One of the major issues raised is whether mezzanine debt counts as contributed capital. The answer is ambiguous, and as such, many banks are avoiding mezzanine loans to avoid triggering HVCRE regulations. Mezzanine debt that is provided by the same lender who is providing the ADC loan will not likely be allowed to count towards the capital contribution; however, there is an argument that mezzanine debt from another lender secured (or unsecured) by other unrelated assets might be acceptable, but no official guidance has been provided on this point.
Another issue where banks may face uncertainty under the HVCRE rules is whether borrowers can take distributions once construction is completed and the property is cash-flowing. Typically, the answer is no, though some banks are establishing internal rules to create benchmarks for when loans will be deemed to have converted to permanent financing.
The effect of the HVCRE rule is increasing lenders’ incurred costs, which ultimately get passed on to the borrower through increased origination fees and/or higher interest rates. Non-banks, such as private equity firms and insurance companies, are seeing an opportunity to step into the mezzanine and traditional ADC financing market because they are not subject to the HVCRE regulations. These lenders have become an attractive option for borrowers looking to avoid the restrictions imposed on banks by HVCRE loans.
Increasing the contributed capital requirements has been a significant change to the prior commercial real estate lending guidelines and is having a large impact on developers. Should HVCRE rules be triggered on a project’s financing, developers should budget and plan for the restrictions on cash flow and take advantage of the benefit of including “soft costs” into the capital contribution calculation. Borrowers may also want to seek alternative financing options in order to minimize borrowing costs, and inquire as to lenders’ internal rules and regulations relating to when loans can be deemed converted to permanent financing and distributions from cash flow can be made.
Peggy is an associate in our real estate practice. She handles general real estate matters as well as residential and commercial transactions. If you have any questions relating to HVCRE, or would like to discuss an issue with Peggy, contact her at firstname.lastname@example.org.