Impact of Basel III norms on US CRE capital adequacy

Published on June 20, 2019 by Hitesh Acharya

Basel III norms impact the US commercial real estate (CRE) sector in many ways, especially by changing the risk weighting of various loans, such as the High Volatility CRE (“HVCRE”) facilities. Previously, risk-based capital-adequacy rules applied a risk weight of 100% to most CRE projects. However, under Basel III norms, the risk weights applicable to CRE loans vary between 50% and 150%, depending on several factors, as listed below:

1. Multifamily property loans – These are mortgages for residential properties with more than four units

Risk weight – 50-100%

Qualifying criteria – Multifamily loans with a risk weight of 100% at origination will be eligible for a 50% risk weighting after one year of origination if all the following criteria are met:

1. History of timely interest and principal repayments

2. LTV <= 80% (for fixed-rate loans) and <=75% (for adjustable-rate loans)

3. Amortization period <=30 years with principal repayment => 7 years

4. Annual net operating income > debt service by 20% (for fixed-rate loans) and >15% (for adjustable-rate loans)

2. Non-multifamily and non-HVCRE loans – CRE loans that cater neither to multifamily use nor to HVCRE projects

Risk weight – 100%

3. HVCRE loans – These are loans made for the Acquisition, Development, or Construction (“ADC”), of real property, and are deemed to be inherently more risky

Risk weight – 100-150%

Qualifying criteria – Previously, under Basel III, a risk weight of 150% was to be applied to all such ADC loans, the only exceptions (with a risk weighting of 100%) being

• Loans to one- to four-family residential projects

• Loans to certain community development projects

• Loans to businesses or farms with gross revenue => USD1m

• CRE loans meeting all the following three conditions:

  • LTV <= 80%

  • Borrower’s capital contribution => 15% of appraised “as complete” project value, through cash or unencumbered marketable securities

  • Borrower’s capital must be invested prior to bank funding, and the capital must remain in the project until the loan is fully repaid, or sold, or converted into equity

Of the three criteria for HVCRE exemption mentioned above under point iv), sub-points a. and c. are generally met because the lenders already grant loans to the CRE sector on similar conditions. Borrowers are generally not able to fulfil sub-point b. (i.e., a minimum 15% capital contribution), as only the cash amount originally used to purchase the collateral land is considered as capital, whereas earlier, even the appreciated value of the land was considered as capital contributed to the project. Such rules are onerous not only to borrowers, but also to banks that struggle to interpret and apply them and their associated exceptions.

To simplify the regulations, US federal banking regulators in May 2018 replaced the HVCRE category with the HVCRE ADC (HVADC) category. Under the HVADC regulations (not applicable to loans already outstanding or committed to prior to the date of the final HVADC rules), the following clauses have been modified:

• Loans made prior to January 1, 2015, are exempt from the HVCRE/ADC rules

• The scope of HVADC loans is expanded to include other loans primarily financing ADC projects, such as mezzanine loans and bridge facilities

• The HVCRE/ADC process is changed from a purpose-oriented approach to a collateral-oriented one. Thus, a loan must be secured by land or property for it to be classified as an HVADC loan

• Consideration is also given to the collateral property’s cash flow. Loans availed for acquisition or refinancing of, or improvements to an income-producing property are not classified as HVADC loans if the property’s cash flow is sufficient to support the debt service and property expenses. Thus, loans with tenant-improvement holdbacks may attract a risk weight of only 100%

• To meet the criterion of a minimum 15% capital contribution by the borrower, banks can also include the current value of the collateral property as appraised by the bank’s valuer at the time of loan origination

• The rule of maintaining the borrower’s contribution until the end of the project’s life is scrapped. Now, a loan may become non-HVADC, and the borrowers may pull out their capital, if the collateral property is “substantially completed”, and the resultant cash flow has stabilized and is sufficient to meet the minimum debt service requirement and property expenses

Despite the revisions, some uncertainty remains in the new HVADC rules. For instance, matters such as the funding of condos and co-op ADC loans, the definition of “substantial completion” of collateral property, provisions for change in loan classification due to a change in the collateral property’s value are not completely addressed.

These new rules may prompt banks to reduce exposure to the CRE sector due to higher capital costs and increased regulatory complexity. This may lead to higher funding costs for CRE developers, a lack of capital availability to develop or refinance CRE projects, and a downward spiral in property prices. Acuity Knowledge Partners’ team of real estate experts helps lenders to accurately interpret and adhere to the new Basel regulations, safeguarding their CRE credit exposures.

Source:

• Reports from www.fdic.gov

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