High Volatility CRE, Revisited

Avison Young Principal Jay Maddox discusses how the implementation of HVCRE rules has negatively impacted borrowers and created uncertainty for lenders, as well as the current efforts to soften the regulation.

jay maddoxTwo years ago, the real estate industry was dealing with the pending implementation impact of the High Volatility Commercial Real Estate (HVCRE) rules for both borrowers and banks. It seemed appropriate to revisit the topic to see what has actually occurred, and highlight current efforts that are aimed at softening this burdensome rule.

HVCRE was part of a suite of rules designed under Basel III after the 2008 financial crisis to help ensure that banks have an adequate capital cushion to withstand market volatility. It was adopted by the Federal Reserve Board in 2013 and became effective in 2015. The HVCRE rule requires U.S. banks to hold 50 percent more capital reserves against loans that finance commercial and multifamily acquisition, development and construction (ADC) projects (with a few exceptions), and has greatly affected the availability of ADC loans from banks.

Borrower impact

To avoid HVCRE classification, the borrower must have contributed cash equity of at least 15 percent of the “as completed” value before the bank advances loan funds. Also, the 15 percent equity requirement translates to a much higher up-front cash equity requirement as a percentage of the project’s costs, since by definition the “as completed” value exceeds project costs. Consequently, yesterday’s 65 percent loan-to-cost is 55 percent today.

Further impacting borrowers, the common practice of counting appreciated market equity in the property toward the equity requirement was discontinued. A pledge of unrelated real estate could no longer be treated as collateral for the purposes of the minimum loan-to-value test, and a new, updated appraisal obtained after the loan closed wouldn’t change the analysis. Finally, profits or other funds generated by the project could no longer be distributed to the owners for the life of the ADC loan. 

The rules are problematic for banks.  They do not:

  • “Grandfather” loans made prior to the 2015 introduction of the HVCRE regulations;
  • Define when a project is deemed “completed”; or
  • State the conditions under which an HVCRE loan could be declassified, and therefore no longer subject to the higher capital standards.

Finally, it is unclear whether mezzanine loans or preferred equity would be treated as equity for HVCRE purposes. These and other factors led to increased uncertainty and costs for bank ADC loans.

As I predicted in 2015, the HVCRE rules have contributed to a pullback from ADC lending by banks, and those that remain are increasingly conservative in their underwriting and loan sizing. This pullback has spawned a cottage industry of alternate ADC lenders, including private equity funds, family offices, offshore investors and REITs. Some of these lenders offer “HVCRE compliant” mezzanine debt or preferred equity that is structured to qualify as equity under HVCRE rules, thereby providing borrowers with increased leverage for new construction and value-added projects. 

Fortunately, help is on the way. A new bipartisan bill (H.R. 2148) has recently been introduced in the House of Representatives that addresses some of the problems created by the original HVCRE rules, and specifically exempts loans funded prior to 2015. New acquisition financings for existing income-producing commercial properties would potentially be excluded, as well as loans for improvements to such properties if the property meets the bank’s debt coverage requirements for permanent financing. The bill does not address the treatment of mezzanine debt and preferred equity, and there are several other problems areas that aren’t covered, but it appears to be a good start.  To be sure, changes are inevitable as the bill winds its way through the legislative process. Until it becomes law, both borrowers and lenders will continue to face speedbumps.