HVCRE Lending – Time to Act Now

Published on July 24, 2019 by Rajeev Hota and Venkatesh Krishnamurthy

During 2013 through 2015, the US regulators deemed certain commercial real estate loans to be riskier than other types of commercial loans and subsequently designated by the regulators as "High Volatility Commercial Real Estate Loans," or "HVCRE." The HVCRE regulation within the Basel III capital requirements came in place effective January 1, 2015.

A Loan is qualified as HVCRE provided the following conditions are met:

• The purpose of the loan is for acquisition, development or construction (ADC) of real estate

• Less than 15% of the real estate project’s "as completed" appraised value is contributed by the borrower in the form of Equity

• The loan-to-value (LTV) ratio is more than or equal to 80%

However, the above conditions are not applicable for the following criteria:

• 1-4 units multifamily properties

• Any loan which would qualify as a permissible investment for the Community Reinvestment Act

• Affordable housing (including multifamily rental housing) for low or moderate income individuals

• Community services targeted to low or moderate income individuals

• Activities that revitalize or stabilize low or moderate income geographies, designated disaster areas, or distressed or underserved nonmetropolitan middle-income geographies designated by the federal banking regulators

In May 2018, regulators increased the risk weightages for HVCRE assets to 150% from 100%, requiring banks to hold higher capital reserves against such loans. US Banks have largely embraced the proposed rules. In September 2018, the Comptroller of the Currency, Federal Reserve and FDIC proposed the regulations that rolled back or revised a number of provisions of Dodd-Frank Act. Language in the 2018 legislation pertaining to “high volatility commercial real estate” assets addressed many long-running complaints from banks and industry trade groups about the lack of clarity in the existing rules encompassing equity claw back and additional appraisal requirements during each property development stage.

A property owner could start recovering its equity capital (through cash withdrawals) from a project that starts generating revenue, provided the 15% equity level is maintained for HVCRE category. The Borrower needs to submit a new Appraisal to Banker for each stage of development as part of HVCRE rule. In January 2019, CREFC and NBA regulated a modification for preserving the exemption for construction loan on multi-phase project. Following the modification, a borrower is not required submit a new appraisal following each development stage. While the proposed changes would apply to newly originated loans starting 2019, it remains unclear if they would also apply to active loans originated after the original HVCRE rules were enacted in 2015.

In our opinion, US Regulators should give banks the option of deciding whether they need to conduct the necessary analysis before approving HVCRE Loans. We acknowledge that third party appraisal reviews increases the borrowing costs, but we believe independent third party analysis is and capital authenticity is necessary before approving HVCRE loans. Also, the factors affecting a negative equity growth should be counter mitigated by more capital hold or commitments. To ensure that the borrower’s equity interest is not capitalized at a particular transaction before the holdover period, Banks should have the liberty to maintain a springing lock box to ease working capital management for the borrower.

Though the yield curve inverted for the first time post sub-prime crisis during January 2019, a fear factor should not insist the regulator to commit more stringent actions for the HVCRE lenders/investors. This will make the construction market status quo at a steady state without making a balloon embark on the developers. In 2018 alone, the HVCRE risk factor accounted for ~19% of the total loan investments, out of which 16% is already securitized as of January 2019. This indicates that market is willing to accept risk, irrespective of the Regulator’s restrictions. We believe, the cold anchoring from the Fed would continue to remit its support towards lower economic impact because of minimal restrictions on HVCRE transactions.

At Acuity Knowledge Partners, our CRE Commercial Lending teams provide offshore support to banks through Loan Origination / Underwriting, Portfolio Monitoring and Loan Risk Grading. Our CRE analysts provide granular insight of market level trends and help banks’ underwriting team to identify potential risks in CRE lending.

Sources –

https://www.occ.treas.gov/news-issuances/bulletins/2018/bulletin-2018-34.html

https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp

https://www.fdic.gov/regulations/laws/rules/2000-8700.html

https://www.vorys.com/publications-1983.html

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