High Volatility Commercial Real Estate FAQs (5th and Final Installment)
The previous four blogs addressed residential subdivisions, tract developments, affordable housing and community development and small business loans and whether such loans are subject to HVCRE treatment which, if there is no exclusion, would require the bank to reserve 50% more capital for the loan and the loan pricing would, in theory, reflect the additional capital reserved through a higher interest rate.
In this installment, I am going to address the final seven questions that were posed. As stated in the prior installments, the views expressed in this blog are my opinions only and are not necessarily the opinions of Frost Brown Todd LLC. The opinions expressed herein do not constitute providing legal advice which may only arise under a formal attorney client relationship.
5) What is the guidance on grant funds as equity? How/why is this viewed differently than mezzanine debt? For example, the URA could provide a mezzanine loan to a project and have it count as equity, but not a grant? Is that correct?
According to the Interagency Regulators, grant funds do not qualify as borrower contributed capital because those funds do not come from the borrower or the borrower’s sponsor. FAQ no. 11 of the Interagency FAQs states that grant funds do not qualify as borrower contributed capital because the grant funds did not come from the borrower.
The Interagency FAQs is as follows:
“11. Projects may receive cash in the form of grants from nonprofit organizations, municipalities, state agencies, or federal agencies. Can a banking organization providing ADC funding to a project (that does not otherwise qualify as a community development investment with regard to the HVCRE exemption) consider the cash from such grants as part of the 15 percent contributed capital requirement?”
The answer provides is, “No, to the extent a project receives a grant, a banking organization may not consider the cash from the grant as a capital contribution because the cash did not come from the borrower. Although a third-party grant would increase the capital invested in the project, because it does not come from the borrower, it does not affect the borrower’s level of investment and therefore does not ensure that the borrower maintains a sufficient economic interest in the project.”
The prevailing view is that both preferred equity investments and mezzanine debt do not qualify as borrower contributed capital because both are either debt or debt like and are dependent upon the project for repayment. Some banks, however, will count mezzanine debt as borrower contributed capital in certain situations.
The Interagency FAQs and prevailing view regarding grants, mezzanine debt and preferred equity is not the end of the analysis, however. Recall that a borrower’s minimum equity investment is 15% of the appraised “as completed” value of the project. The borrower’s total equity requirement for the loan is likely a greater amount depending upon the LTV set forth in the bank’s term sheet. Say, for instance, that a bank makes a construction loan to ABC Development LLC and the loan amount will be the lesser of $10,000,000 or 70% of the total project costs (LTC). Under this loan, the borrower would have to contribute 30% of the costs to the project. In order to exclude the loan from HVCRE exposure, a portion of borrower’s total equity must be based on 15% of the as completed appraised value and would be subject to the regulations as to what does and does not qualify as borrower contributed capital. The balance of borrower’s total equity requirement could be derived from other sources, including a URA or other government grant. Using simple math under the above example, let’s assume that the borrower’s total equity requirement is $3,000,000 (30% of $10,000,000 in project costs). Let’s further assume that the as completed appraised value is $12,000,000. The sum of $1,800,000 (12,000,000 x .15) would have to be hard equity and come from sources that qualify as borrower contributed capital under the HVCRE definition. The balance of borrower’s total equity requirement, $1,200,000, could come from other sources, including government grants, mezzanine loans, preferred equity and other sources that do not qualify as borrower contributed capital for purposes of the HVCRE definition.
6) Can you walk through the guidance on the provision about no funds being able to be given back to Borrowers? What happens if the project is multiple buildings, and the first buildings are leased and operating and produce excess income above and beyond debt service requirements on the banks loan - can those additional funds be given back to the Borrower to support other expenses such as real estate taxes and insurance?
In order for an ADC loan to remain exempt from HVCRE exposure, all capital contributed by the borrower and internally generated by the project must remain “in the project” until the ADC loan converts to permanent financing, is repaid in full, or the project is sold. The purpose of borrower’s equity is to ensure that the borrower continues to retain a sufficient economic interest in the project and to provide sufficient capital to account for sales and leasing shortfalls. The issue, in the context of HVCRE regulations, does not seem to be whether excess income or other revenue is given back to the borrower because, once earned and received, such revenue and income is with the borrower, the question is whether those proceeds may be distributed up to borrower’s sponsors. Under no circumstances, during the life of the loan (e.g. conversion to permanent, repayment in full or sale of the project) should any revenues, income or equity be distributed by the borrower under its operation or partnership agreements up to its members, partners or sponsors, including for the payment of income and other taxes of the borrower’s sponsors under borrower or upper tier partnership or LLC agreements. The question becomes whether “in the project” would permit the borrower to pay project level taxes, insurance and other operating expenses. While there is no guidance on this issue, many factors point to permitting a borrower to pay taxes, insurance and other expenses from project income.
During construction, a borrower’s construction budget generally includes payment of taxes and insurance which means that such costs are paid from project sources, i.e. loan proceeds and equity.
A borrower has an unqualified obligation to procure and maintain insurance for the project, pay taxes and keep the project free of tax and other liens which are paid, during construction, from either loan proceeds, equity or cash flow, to the extent the property cash flows prior to the “end of the life of the project.”
If the property cash flows before construction is completed, such cash flow would be a preferred source of payment of taxes, insurance and other expenses because the 15% equity initially invested in the project would remain in the project and loan proceeds would be available for hard costs rather than soft costs.
As such, to the extent that property level revenue is available for the payment of project taxes and insurance, such payment would be permitted without violating the HVCRE rule. Using generated capital in the project for the maintenance of the property by paying ad valorem real property taxes and insurance would be considered to be “in the project” within the requirements of the HVCRE rule.
In sum, Payment of project real property taxes and insurance from cash flow would be permitted and the loan would remain within the commercial real estate exception so long as the other elements of the exception continue to be satisfied. This view is supported by the Federal Reserve Bank of Atlanta which, in its FAQ, stated that the payment of developer fees, for example, would be permitted to be paid from loan proceeds so long as the borrower’s equity contribution does not fall below the 15% threshold.
7) If a Borrower initially contributes in excess of 15% of the "As-Completed" Value in equity, are any of the funds above 15% allowed to be returned to the Borrower if they do not exceed the 15% number? For example, if the 15% requirement was $2 Million, but a Borrower put in $2.5 Million, could they get $500,000 back through project income and not trigger HVCRE?
The prevailing view and a strict reading of the definition leads to the conclusion that all internally generated capital must remain in the project for the life of the loan. Presumably, income generated by the project during the life of the loan is internally generated capital and must remain in the project for the life of the loan. As a result, the conservative and prevailing interpretation is that, under the circumstances described in the question, no internally generated capital may be distributed out of the borrower to its sponsors, members or partners until the loan converts to permanent, is repaid or the project is sold, even if the capital in the project at the time exceeds 15% of the as completed value of the project.
On the other hand, according to the Federal Reserve Bank of Atlanta, as long as the borrower maintains a minimum 15 percent capital position in the project, assuming all other exception factors are complied with, the exception would remain if, for example, developer fees were paid from loan proceeds. While developer fees are a project budget line item, and distributions to partners and sponsors is not, the distinction seems to be without a difference.
It may be that the Interagency regulators would extrapolate from the statement made by the Atlanta Fed to conclude that so long as the borrower’s capital position in the project is at least 15% of the as completed appraised value, that income generated by the project may be distributed the borrower’s sponsors and partners. Until the Interagency Regulators provide guidance on this issue, the more conservative approach is recommended.
8) How does a third party play into the ability to receive operating cash back from a project before it goes permanent?
If income is derived from third party source, such as rental income under a lease, the receipt of such income before the loan converts to permanent financing or is refinanced does not violate the HVCRE commercial real estate exclusion that requires all internally generated equity to remain in the project for the life of the loan. If, however, those funds are distributed out of the borrower entity to the sponsor and/or other partners or members of the borrower, that would violate the HVCRE rules.
The Atlanta Fed addressed this question, although not completely. The Atlanta Fed Q&A are:
“Question: Assuming a borrower has a construction loan that is interest only for an extended period to allow for stabilization, would the bank violate the exception if the borrower were allowed to receive cash from the operation of a lease prior to the loan converting to permanent? This would be typical for a single-entity building where the tenant moves in and begins paying rent prior to conversion to permanent financing or payoff from a nonrecourse lender?
Answer: The interest only feature has no relevance to HVCRE designation. As long as the cash is coming from a third party under a property rental agreement, it would not violate the exception.”
9) Is the expectation that all income generated from properties before they flip to a permanent phase be put into an account at the Bank and the Bank manage the payment of expenses? Otherwise, how can anyone be sure that funds are not going back to the Borrower?
Generally, the loan documents should include a covenant that prohibits distributions to members, partners and/or sponsors during the life of the loan which would be tied into an event of default. Financial and other reporting requirements required by the loan documents should disclose all cash flow and the use and/or distribution thereof. The bank and also its counsel should review the limited partnership agreement or operating agreement if the borrower is a LLC and require that the borrower’s governing documents prohibit distributions by the borrower to its partners or members during the life of the loan. Loan documents often require the borrower to establish certain accounts with the bank. If the loan requires that he borrower maintain operating accounts with the bank, the bank does not necessarily have to manage payment of expenses, but the bank will have access to information as to whether capital internally generated by the project is being used by the borrower in a manner that would result in the loan being an HVCRE exposure.
10) What level of renovation triggers a project to be considered HVCRE unless it meets all of the other requirements for equity, etc.?
There is not specific threshold under the regulations that trigger HVCRE. The issue is not how much the renovations cost or how the renovations take to complete, but rather how the loan is underwritten. If the loan is underwritten as a short term ADC loan, then the whole of the loan may well be treated as a HVCRE exposure. On the other hand, if the loan is underwritten under the bank’s long term mortgage financing guidelines, the loan may be exempt from HVCRE exposure. Assuming that the loan in question finances both the acquisition of the property in question and certain renovations to either reposition the property or provide for tenant improvements, an approach to consider is to underwrite the entire loan under the bank’s underwriting criteria for long term mortgage financing with two buckets or tranches. The first would cover all acquisition costs and would be fully funded and disbursed at closing. The balance would be fully funded as well, but disbursed into a reserve account and disbursed in a manner substantially similar to disbursement of construction loans. The downside for the borrower may be that it pays interest on the whole loan, from day one, but the structure keeps the entire loan from being deemed a HVCRE exposure.
11) What are you seeing in the market as far as appetite to do HVCRE loans by Banks? Are you seeing a premium in pricing on these loans?
Below is an excerpt from an article I authored that was published in the International Journal of Banking Law and Regulation.
HVCRE is a risk weighting that both borrowers and lenders want to avoid. Basel III revised risk weightings for many credit exposures, including ADC loans. Prior to Basel III, commercial real estate loans, including ADC loans, generally enjoyed a 100% risk weighting which meant that a bank required to retain a total capital ratio of 8% would have to reserve $800,000 for a $10,000,000 loan. Basel III created a new 150% risk weighting for HVCRE loans which means for the same $10,000,000 loan and 8% capital ratio, the bank is required to retain $1,200,000 in capital. The additional capital that a bank must retain for a HVCRE exposure is capital that cannot be deployed in the market which presumably reduces available credit. From the borrower’s perspective, HVCRE exposures may increase loan pricing by 80 to 100 basis points. One bank reported that an ADC loan with an interest rate of LIBOR plus a 200 bps spread would, if it was required to be underwritten as a HVCRE loan, require an additional 94 to 100 bps in order for the bank to realize the same return. Empirical studies reveal that if the ratio of common equity is increased by 2% for a given loan, banks would need add 39 basis points to maintain a 15% return on equity. As a result, both borrowers and lenders are incentivized to avoid HVCRE classification by satisfying the elements in the regulation for exclusion from HVCRE treatment.
It was predicted that Basel III’s increased capital requirements would result in a sharp decrease in commercial real estate and construction lending, some estimating that with every percentage point increase in capital requirements, banks would reduce commercial real estate loan growth by around four percentage points after one quarter and that HVCRE regulations would drive construction lending to non-banks. Thus far, the doomsday predictions have not been reflected in the market. Construction lending continues to grow on bank balance sheets. In 2014, banks added almost $15 billion in construction and development loans to their balance sheets. That trend increased through the first five months of 2015 as construction and development loans increased by 5.8% or 12.7 billion and that trend continued unabated throughout 2015. In all of 2015, banks had $1.54 trillion in CRE loans on their books, up 9.2% from 2014. Non-owner-occupied CRE loans increased 10.6%, year over year from 2014 to 2015 to $751.5 billion. With the increased volume of CRE loans and easing of underwriting standards, comes increased risk. As a result of banks near insatiable appetite for CRE loans, there are now more than 1,400 banks with less than $10 trillion in assets with CRE Loan to total risk-based capital ratios in excess of 300%. Non-performing CRE loans increased in the first quarter of 2016 by 4.8% or $4.8 billion.
While both borrowers and lenders are incentivized to avoid HVCRE classification, because of the competitiveness among banks and other lenders in the market and how well some financial institutions are capitalized, the well capitalized lenders are not reluctant to underwrite and hold an ADC loan as a HVCRE exposure without increasing pricing for the loan. In most instances, a HVCRE exposure will increase pricing, but thus far the regulations have not decreased the availability of construction loan mortgage capital. Increased competition among lenders for traditional commercial real estate and ADC loans, and easing of underwriting standards have seen banks increase commercial real estate and construction lending.
As always, if anyone has any questions, please feel free to contact me at 412.513.4330 or sregan@fbtlaw.com.