Basel III's Impact on Construction Lending

At least one of the proposed rules under Basel III will affect real estate finance markets, specifically construction lending.

In early June, the Federal Reserve and other banking agencies issued three notices of proposed rulemaking that would, in large measure, implement new international banking standards known as “Basel III.” The new standards are anticipated to be adopted and would become effective in 2015.

At least one of the proposed rules will affect real estate finance markets. The regulatory agencies are specifically focused on construction lending and will impose greater balance-sheet scrutiny on construction loans by imposing a higher risk weighting on construction loans than other loans. The higher capital ratios will apply with respect to so-called “high volatility commercial real estate exposures.” HVCREs are loans that finance or financed the acquisition, development or construction of real property.

A commercial real estate loan that is not an HVCRE exposure will be treated as a corporate exposure on the bank’s balance sheet (receiving a 100 percent risk weighting, as opposed to 150 percent). One would, therefore, expect certain changes to construction lending practices in an attempt by banks to avoid a loan being characterized as HVCRE. In this regard, we should expect the following:

■  lower going-in LTV ratios;

■  increased upfront equity (a minimum of 15 percent) before any loan proceeds are disbursed, and the calculation of that equity will be based not on construction costs, or some other reference, but on as-completed value (and perhaps stabilized value for purposes of ensuring take-out financing);

■  cash equity as opposed to equity attributable to a property’s appraised value;

■  financial covenants to maintain a minimum amount of equity in the project during the term of the loan (with more limited rights to make distributions even upon completion, lease-up, et cetera);

■  increased emphasis on take-out commitments, with deadlines to achieve take-out
financing preceding maturity by many months (so as to reclassify the loan as
non-HVCRE as soon as possible);

■  increased scrutiny of construction deadlines and lease-up thresholds (to ensure greater certainty with respect to take-out financing);

■  shorter durations and fewer mini-perm loans (due to the methodology for determining when the minimum equity requirements burn off);

■  more frequent syndication of construction loans (such that the originating bank is able to remove portions of the HVCRE loans from its balance sheet), with a likely corresponding increase in loan administration and other fees to counteract the lost profits from the syndication;

■  implementation of the foregoing in any loan modifications on construction loans;

■  increased activity in loan sale markets to non-regulated entities during the initial implementation of these new standards, as regulated institutions adjust to the new capital requirements; and/or

■  increased origination by non-regulated entities, and possible resurgence of securitization markets for construction loans (though new rules about risk retention in the securitization markets under Dodd-Frank, among other new requirements, may counteract any such resurgence).

This article is excerpted from a column that appeared in the August 2012 issue of Commercial Property News and is titled “Construction Warning: Changes Ahead.”