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CRE Finance World Winter 2016
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any portion of the loan is funded. Some lenders have begun to
introduce provisions requiring the borrower to contribute additional
equity as necessary to maintain the 15% capital requirement. In
the context of a non-recourse loan, some of these provisions may
not play well with borrowers and, in light of the Agencies’ response,
may be of little utility.
On a different but related topic, the Agencies indicated that an ADC
Loan, which is required to be risk-weighted as an HVCRE Loan
at closing due to a loan-to-value ratio in excess of the applicable
supervisory limits, cannot be reclassified upon the receipt of a new
appraisal or valuation reflecting a new loan-to-value ratio that no
longer exceeds the prescribed supervisory maximum. Thus an ADC
Loan which by definition has become less risky will nonetheless
continue to bear a risk weight of 150%.
The Agencies’ response to another question makes clear that cash
used to purchase land that is subsequently contributed to a project
may be counted as borrower contributed capital in satisfaction of
the 15% capital requirement, so long as the borrower has provided
satisfactory evidence of cash payment. However, while helpful,
the answer still leaves unanswered an important question — how
will appreciated value in excess of the original purchase price of
the property be treated? May a borrower who purchased property
for cash and then held it while it appreciated in value contribute
the appreciated value of the property as part of the required
15% capital requirement? To not give credit for demonstrated
appreciation in value seems an unfair outcome. A borrower who
purchased a property for $100,000 and held it (and maintained
it and paid taxes on it) long enough for it to have appreciated to
$250,000 will be worse off with a deemed capital contribution of
only $100,000 than the borrower who has just bought that same
property for $250,000 and is credited with a capital contribution
in such amount.
8
One argument for the Agencies’ response is that
cash actually paid is a clear and objective measure for purposes
of determining the amount of capital the borrower has contributed.
However, given the willingness to rely on appraisals in so many other
contexts, including for purposes of determining the “as-completed”
value of the project under the Final Rule, any reluctance to give
credit for the demonstrated appreciated value of the contributed
property contribute will be difficult to understand.
That the borrower should be required to have real skin in the game
is a recurring theme in the Agencies’ responses to the FAQs. The
required 15% capital contribution may not be satisfied through
the borrower’s pledge of unrelated and otherwise unencumbered
real property; a collateral pledge as security for an obligation
is conditional and therefore not a contribution. The 15% capital
contribution also cannot be made with (a) the proceeds of a loan from
a third party lender secured by a second lien on the project, (b) the
proceeds of a loan which is made to the borrower independent of
the ADC Loan by the banking organization funding the ADC Loan,
or (c) the proceeds of grants from non-profit organizations.
There are, however, several alternative sources of capital which
the Agencies appear either not to have considered, or if they
have considered them, have not yet determined to reject as an
acceptable means of achieving the 15% capital requirement. The
first alternative is unsecured debt or debt, secured by some other
asset completely unrelated to the project. Given the Agencies’ view
on grants and the importance of having a meaningful stake in the
project, it may be that borrower debt of any kind that is not entirely
recourse in nature will not get much traction with the Agencies.
A second alternative is mezzanine debt secured by ownership
interests (direct or indirect) in the borrower. An important distinction
from the first alternative is the identity of the borrower — typically
a mezzanine loan is not made to the developer but rather to an
entity that directly or indirectly owns the developer. The developer
receives the proceeds of the mezzanine loan as a contribution of
equity from its up tier owner and not as debt. The third option is
another common source of capital in real estate transactions —
preferred equity. The Mortgage Bankers Association is of the
view that any infusion of capital into the borrower is for the good,
although it is also quick to point out that any direct infusion of
capital ought not to have the attributes of debt — such as maturity
dates, security and payment defaults.
9
In order to avoid classification as an HVCRE Loan, an ADC Loan
must contain contractual provisions which require “the capital
contributed by the borrower, or internally generated by the project
. . . to remain in the project throughout the life of the project.”
10
In
its comment letter dated January 26, 2015, the Mortgage Bankers
Association requested guidance on permitted uses of capital.
11
In
April 2015, the Mortgage Bankers Association, perhaps sensing
where things were headed, commented that one reading of the
Final Rule would require that a borrower must be contractually
prohibited from withdrawing capital in excess of the 15% capital
requirement for the entire life of the project and urged the Agencies
to focus their guidance on permitted uses of capital rather than
on an absolute prohibition on the use of capital.
12
In response, the
Agencies seem to have adopted the less favorable reading of the
Final Rule and stated that the borrower must be prohibited from
withdrawing both its contributed capital and any internally generated
capital until the life of the project has concluded.
As further pointed out by the Mortgage Bankers Association,
some projects are capable of generating capital during the course
of development and construction (e.g. sale of pads).
13
If the Final
Rule is read to prohibit the withdrawal of any capital in excess of
Real Estate Finance in the Era Of Basel III