In the wake of the 2007-08 financial crisis, there has been an increased focus on the risk management and capital adequacy of financial institutions. High Volatility Commercial Real Estate (HVCRE) rules collectively issued by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and Board of Governors of the Federal Reserve System (collectively, the Regulators) that went into effect as of January 1, 2015, require regulated lenders to assign risk weights of 150% when determining reserve requirements for certain construction, development and acquisition loans for purposes of capital adequacy and risk management. Risk weight is used to determine the capital requirement or Capital Adequacy Ratio (CAR) for financial institutions, which is a measurement of the amount of capital a financial institution must hold in relation to its risk-weighted assets. Different classes of assets may have different risk weights associated with them, and Regulators track the CAR of financial institutions to ensure they can absorb a reasonable amount of loss.
The HVCRE rules apply to credit facilities, the proceeds of which were or are to be used to finance the acquisition, development or construction of real property (excluding one-to-four-family residential properties, the purchase and development of certain agricultural land or projects that qualify as community development investment). The HVCRE rules are retroactive and apply to loans originated prior to the effective date of the HVCRE rules.
In determining which types of loans might fall outside HVCRE classification, the Regulators have indicated that the primary factor is whether the loan is considered to be permanent financing. A loan cannot be classified as permanent financing if the project being financed has not yet been completed or if there will be any future advances on the loan.
Commercial real estate loans which otherwise would be classified as HVCRE may nevertheless avoid HVCRE classification if they satisfy each of the following conditions for exemption: (a) the loan-to-value (LTV) ratio is less than or equal to the maximum supervisory LTV ratio, which is 80% for commercial, multifamily and other non-residential construction loans; (b) the borrower contributes capital to the project, or has paid development expenses out-of-pocket, of at least 15% of the real estate's "as completed" value; and (c) the borrower (i) contributes the capital referenced in (b) before any funds are advanced under the credit facility, and (ii) is contractually obligated, pursuant to the terms of the loan documents, to keep such funds in the project until the credit facility is converted to permanent financing, the project is sold or the loan is paid in full. In accordance with the foregoing, the borrower may, in no event, have the ability to withdraw either its capital contribution or the capital generated internally by the project prior to obtaining permanent financing, selling the project or paying the loan in full.
It is important to note that in determining the LTV ratio for purposes of HVCRE classification of a loan, the "as completed" value of the project must be used and not the "as stabilized" value, which reflects the projected market value of a property upon reaching stabilized occupancy. The Regulators have issued Interagency Appraisal and Evaluation Guidelines which define "as completed" as a property's market value as of the time development is expected to be complete. Therefore, lenders should ensure that all appraisals moving forward contain an "as completed" value in addition to any "as-is" or "as stabilized" values in order to evaluate HVCRE weighting compliance.
If an updated appraisal results in an LTV ratio less than 80% (whereas it previously was over 80%), does that mean the loan can be removed from HVCRE weighting if it meets the other exemption criteria? According to the Regulators, the answer is no. Lenders must consider the LTV ratio at origination of the loan, and any loan that exceeded the 80% LTV threshold at origination would remain subject to HVCRE classification until it converts to permanent financing.
Further, lenders should be aware that the extension of the maturity date of a construction loan, either by amendment or the exercise of an extension option, may not be sufficient to classify a loan as permanent financing in an effort to avoid HVCRE weighting requirements. The Regulators have indicated that converting a loan to permanent financing generally "would involve a new credit facility in the form of a term loan replacing the acquisition, development and construction loan."
The three important items for commercial real estate lenders to consider (with respect to prospective loans as well as their current portfolios) are:
- whether the LTV ratio of a project at the time of loan origination exceeds 80% based on the "as completed" appraised value;
- whether the borrower's capital contribution meets or exceeds the 15% requirement (again, based on "as complete" appraised values); and
- whether the loan documentation adequately obligates the borrower to maintain the capital contribution in the project.