In order to shield lenders from overly risky commercial real estate loans, in 2013 the Office of the Comptroller of the Currency, the Federal Reserve, and the Federal Deposit Insurance Corporation (the "Agencies") instituted a regulatory capital rule requiring heightened capital reserves for "high volatility commercial real estate" (HVCRE) loans. This HVCRE classification has been subject to regulatory scrutiny and revision since its inception. Due to the severity of the consequence associated with HVCRE loans, which often include increased interest rates, it is important for both borrowers and lenders to follow the continuing development of the HVCRE regulatory framework.

Basel III – Introduction of the HVCRE Classification

Following the global financial crisis of 2007-2008, the Basel Committee on Banking Supervision agreed to and released Basel III, a global regulatory framework which established capital standards for commercial real estate loans. The development of Basel III was a direct response to the significant role risky commercial real estate loans played in the 2007-2008 crisis. Though Basel III itself does not have the force of law, the Agencies adopted a revised regulatory capital rule under the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 to incorporate Basel III into United States law and to impose higher capital requirements on loans categorized as "HVCRE" loans.

To better counter the risks banks face with certain types of real estate exposures, the Basel III capital rule strengthened capital requirements applicable to banks supervised by the Agencies by increasing capital requirements for HVCRE loans. Accordingly, the capital rule subjected certain acquisition, development and construction (ADC) loans with HVCRE exposure to a 150% risk weight. This heightened risk weight requires lenders of credit facilities which meet the definition of an HVCRE loan to retain 12% of the loan's value in capital, as opposed to the usual 8% requirement.

The capital rule defined an HVCRE loan as "a credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction of real property." The rule included an exception for the following four types of facilities:

1. One- to four-family residential properties;
2. Certain properties which would qualify as investments in community development;
3. "The purchase or development of agricultural land, provided that the valuation of the agricultural land is based on its value for agricultural purposes and the valuation does not take into consideration any potential use of the land for non-agricultural commercial development or residential development"; or
4. Commercial real estate projects in which: |
   1. The loan-to-value ratio (LTV) is less than or equal to the applicable regulator's maximum LTV, which is typically 80% for commercial construction loans;
   2. 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% of the real estate's appraised "as completed" value; and
   3. The borrower contributed the amount of capital required  before the bank advances funds under the loan, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project until the loan is paid in full or converts to permanent financing.

See 12 C.F.R. §§3.2, 217.2, 324.2.

Regulatory Clarification of HVCRE Loans

In response to uncertainty surrounding interpretation of HVCRE exposure, on May 24, 2018, the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) was enacted to update the definition of HVCRE exposure to reflect a new statutory definition of an HVCRE ADC loan. The EGRRCPA serves to clarify which ADC loans are subject to heightened capital treatment and to prevent heightened capital treatment for less risky loans.

The EGRRCPA defines an HVCRE ADC loan as "a credit facility secured by land or improved real property that, prior to being reclassified by the depository institution as a non-HVCRE ADC loan":

1. primarily finances, has financed, or refinances the acquisition, development, or construction of real property;
2. has the purpose of providing financing to acquire, develop, or improve such real property into income-producing real property; and
3. is dependent upon future income or sales proceeds from, or refinancing of, such real property for the repayment of such credit facility.

See 12 U.S.C. §1831bb.

This new definition includes notable modifications to the prior definition of HVCRE exposure. Perhaps most significantly, this new definition applies only to loans that primarily finance ADC activities and that are secured by land or improved real estate, while the old definition applied to all loans that finance ADC activities. This new definition exempts credit facilities whose primary purpose is anything other than the financing of ADC activities.

In addition, whereas the old definition of HVCRE exposure precluded reclassification prior to a loan's conversion to permanent financing, the new definition permits banks to reclassify an HVCRE ADC loan as a non-HVRCE ADC loan, in accordance with the financial institution's loan underwriting criteria for permanent financings, upon: a) the substantial completion of the development or construction of the real property, and b) the sufficiency of cash flow generated by the real property to support the property's debt service and expenses.

Furthermore, the new definition of HVCRE ADC loans retains and modifies the original four HVCRE exemptions. In relation to the exemption for commercial real estate, under the new definition, banks are permitted to count the value of appreciated property toward a borrower's required 15% capital contribution, whereas the old definition only counted the purchase price. In addition, the exemption for commercial real estate was also modified to permit withdrawals of capital contributed by the borrower, or internally generated by the project, prior to conversion to permanent financing so long as such withdrawals are not made against the borrower's 15% contribution.

Moreover, the EGRRCPA added new HVCRE exceptions. To start, all loans made prior to January 1, 2015, are categorically exempted from HVCRE classification. In addition, the new law exempts credit facilities which finance:

1. "the acquisition or refinance of existing income-producing real property secured by a mortgage on such property, if the cash flow being generated by the real property is sufficient to support the debt service and expenses of the real property, in accordance with the institution's applicable loan underwriting criteria for permanent financings"; and
2. "improvements to existing income-producing improved real property secured by a mortgage on such property, if the cash flow being generated by the real property is sufficient to support the debt service and expenses of the real property, in accordance with the institution's applicable loan underwriting criteria for permanent financings."

See 12 U.S.C. §1831bb.

Though the new HVCRE ADC loan definition went into effect in 2018, the Agencies issued a statement later that year in which they advised banks that, when determining which ADC loans are subject to the 150% risk weight, until advised otherwise, they may either choose to continue to apply the original regulatory definition of HVCRE exposure, or they may choose to apply the EGRRCPA's definition of an HVCRE ADC loan. See Board of Governors of the Federal Reserve System Federal Deposit Insurance Corporation Office of the Comptroller of the Currency, Interagency statement regarding the impact of the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) (July 6, 2018).

Practical Implications

The application of a heightened risk weight to HVCRE ADC loans, when no regulatory exemption applies, has forced banks to reckon with the need for increased capital reserves. Accordingly, funding HVCRE ADC loans is less cost-effective for banks. To counter this, banks have reduced loan proceeds and charged higher interest rates for HVCRE ADC loans in order to pass the increased costs on to borrowers. As of March 2018, interest rates for HVCRE loans were subject to an estimated 35-basis-point increase. See David Glancy and Robert Kurtzman, Federal Reserve Board of Governors, How do Capital Requirements Affect Loan Rates? Evidence from High Volatility Commercial Real Estate (March 27, 2018).

In order to avoid incurring higher interest rates for ADC loans, borrowers can: a) maintain an LTV less than or equal to the applicable regulator's maximum LTV, which is 80% for construction loans; b) contribute at least 15% of the "as completed" value of the property in cash or unencumbered marketable assets prior to any bank advances; and c) maintain contributed capital of at least 15% in the project until the loan is paid in full or converts to permanent financing. By taking these measures, borrowers can avoid having their credit facilities being classified as HVCRE ADC loans and subjected to the heightened risk weight.

Takeaways

As the HVCRE classification is relatively new, its regulatory framework has been subject to continuous scrutiny by the Agencies. For instance, in June the Agencies proposed another modification to the definition of an HVCRE loan. This proposal seeks to limit the exclusion for one- to four-family residential properties to financing for structures and to expand the heightened risk weight to credit facilities for one- to four-family properties which solely finance land development activities without any construction of one- to four-family residential structures.

Because the HVCRE classification can significantly impact loan amounts and interest rates, borrowers must consider the regulation's impact when initially preparing project budgets. Due to the continued regulatory interpretation and examination of the HVCRE classification, banks and borrowers would be prudent to closely monitor regulations and proposed modifications related to HVCRE loans.

Michael Ostrowsky is chair of the Real Estate Practice at Bressler, Amery & Ross in Florham Park. Eli Tarlow is an associate in the practice.