By April Pyatt and Aaron Aft, both of Ice Miller LLP
If you represent commercial real estate developers, you are most likely familiar with the term High Volatility Commercial Real Estate (HVCRE) loans. The HVCRE loan classification was established by the Basel III rules that went into effect on January 1, 2015 (HVCRE rules) as part of the Dodd-Frank Bank Reform Act. A loan is classified as an HVCRE loan if, “prior to conversion to permanent financing, [the loan] finances or has financed the acquisition, development or construction (ADC) of real property” – otherwise known as ADC loans. Commercial banks are required to hold increased capital reserves against HVCRE loans. In turn, banks impose higher equity requirements on borrowers who obtain HVCRE loans and borrowers incur higher borrowing costs in connection with such loans.
Under the HVCRE rules, in order for a construction loan for commercial, multifamily and other nonresidential developments to be exempt from the HVCRE classification, such construction loan must meet all of the following criteria: (1) loan-to-value ratio is less than or equal to the applicable maximum ratio prescribed by bank regulators, which is 80 percent; (2) the borrower has contributed cash equity equal to 15 percent of the real estate’s appraised “as completed” value; and (3) the borrower has contributed its capital prior to bank funding, and said capital remains in the project until the construction loan is either converted to permanent financing or paid in full. There have been several issues and concerns raised by real estate developers and banks with respect to these HVCRE rules and the requirements necessary to avoid HVCRE loan exposure. One such issue was the fact that a borrower could only include the original cost of the land that it contributed towards the 15 percent equity requirement and not the appreciated value of the land. Another issue, was that banks could not remove the HCVRE designation from a construction loan once the real estate development was substantially complete and stabilized. Instead, banks had to wait until the loan was converted to a permanent loan or paid in full.
In May of this year, the Economic Growth, Regulatory Relief, and Consumer Protection Act (the Act) was enacted. The Act, among other things, addresses some of the issues and concerns noted above with respect to the HVCRE rules and HVCRE exemption criteria. The Act modifies the Federal Deposit Insurance Act to revise how ADC loans are classified as HVCRE loans. The text of the relevant amendment can be found here. In summary, the law requires banking regulators to revise elements of the current HVCRE designation by, inter alia:
- Allowing borrowers to include the appreciated value of contributed land, rather than the original cost as under the prior rule, in establishing the 15 percent borrower equity requirement to avoid HVCRE classification.
- Limiting the application of the HVCRE classification by clarifying that loans made to acquire existing income-producing property would not be subject to higher capital requirements.
- Allowing banks to remove the HVCRE designation prior to the end of the loan upon substantial completion and stabilization.
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