CREFW-Winter2016

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Winter issue 2016 sponsored by CRE Finance World Winter 2016
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T
Real Estate Finance in the
Era Of Basel III
he Basel III regulations adopted by U.S. regulators last
year directly impact commercial real estate in a number
of important ways: It changes the risk weighting of
various real estate credit exposures, including increasing
the risk weight assigned to delinquent loans and altering
the landscape of mortgage servicing. However, while all changes have
the potential to dramatically change the commercial mortgage market,
the biggest potential impact comes from the introduction of so-called
the High Volatility Commercial Real Estate (HVCRE) loans.
US Basel III has received attention and interest from numerous
financial specialists within the banking industry and has been
greeted with varying levels of enthusiasm. In particular, US Basel
III directly impacts commercial real estate in a number of important
ways including by (i) changing the risk weighting of various
real estate credit exposures, including so-called high volatility
commercial real estate loans, (ii) automatically increasing the risk
weight assigned to loans that are more than 90 days past due
or in non-accrual, and (iii) imposing new limits on the amount of
mortgage servicing rights that may be included in the calculation
of Tier 1 Capital as well as changing the risk weighting for those
mortgage servicing rights.
High Volatility Commercial Real Estate Loans
HVCRE loans are deemed to be riskier than other credit exposures
and, effective January 2015, all acquisition, development or
construction loans, whenever made, that can be classified as HVCRE
loans will be assigned a risk weighting of 150%.3 This new risk
weighting represents a significant departure from the risk weighting
approach to real estate assets in Basel I and II, both of which
charged a risk weight of 100% to some real estate loan assets
and 50% to others. The net effect is a substantial increase (by half)
in the capital required to be reserved in respect of certain real
estate loans by banking organizations subject to the final rule.
An HVCRE loan is defined under the Final Rule4 as a loan that
is not a “permanent” loan and which finances the acquisition,
development, or construction of real property (ADC) unless the
Loan finances:
1. One- to four-family residential properties,
2. Real property that qualifies as an “investment in community
development” or a “qualified investment”
3. Agricultural land, or
4. Commercial real estate properties in which
a. the loan to value ratio is less than or equal to the applicable
regulator’s supervisory limit on loan to value ratios; 5
b. the borrower has contributed capital, in the form of cash,
unencumbered readily marketable assets or out-pocket-expenses (incurred and paid by the borrower), of at least
15% of the real estate’s appraised “as completed” value; and
c. the borrower has contributed such capital prior to the lender
making any advances and such capital contributed by the
borrower, or internally generated by the project, is contractually
required to remain in the project for the “life of the project”.
Per the Final Rule, the “life of the project” ends only when the
project is sold or the loan is converted to “permanent” financing
or is paid in full. The banking organization providing the ADC Loan
may also provide permanent financing provided such permanent
financing is subject to the banking organization’s underwriting
criteria for long-term mortgage loans.
The provisions of the Final Rule pertaining to HVCRE loans went
into effect in January 2015, and all banking organizations subject
to risk based capital reporting requirements were required to
determine by March 31, 2015, the status under the Final Rule of
each of their ADC Loans.
Unfortunately, the Final Rule does not provide much guidance on
how to apply the exemption criteria, which has left those banking
organizations subject to the Final Rule in a state of uncertainty as
to how and when the HVCRE designation may be avoided. Both
banks and other interested parties6 have sought clarifications
on the rule and have raised a number of questions and issues
including (i) whether an HVCRE Loan can be “rehabilitated” after
closing; (ii) whether the cash paid for raw land at purchase may
count towards the borrower’s required capital contribution; (iii)
whether the borrower may include appreciated land value as part
its required capital contribution; and (iv) whether the required
capital contribution may be made with borrowed funds, and the
point at which the developer may withdraw capital from the project.
In April 2015, the Agencies published a set of “frequently asked
questions” (FAQs)7 and responses. Their responses covered many,
but not all, of the issues raised by interested parties and with
varying degrees of clarity.
In response to FAQ #1, the Agencies stated in no uncertain terms
that a loan which at the time of funding is an HVCRE Loan cannot
be rehabilitated by subsequent injections of capital from the borrower.
The borrower’s required capital contribution must be made before
By Sarah V.J. Spyksma12.
Capital Markets Counsel
Wells Fargo Bank, N.A