In Washington, you often have instances of what some term regulatory overreach, occurring when agencies charged with ensuring the proper functioning of certain sectors of our economy are caught sleeping at the wheel – and subsequently overreact in an effort to prevent future failures. In what has become one of the many partisan fronts on Capitol Hill, many have said the Dodd-Frank legislation passed in the wake of the financial meltdown of 2008 missed its target, and has resulted in ineffective over-regulation that harms our economy. Unfortunately, when things become so politicized, even technical or modest changes that are clearly needed are seen as attempts to rollback reforms, and take on an outsized symbolic importance which makes it almost impossible to move forward with common-sense changes.
The commercial real estate industry may be facing such a scenario regarding banking regulations that went into effect at the beginning of this year. These impose increased capital requirements on banks for acquisition, development and construction (“ADC”) loans for commercial real estate projects. The new requirements could increase the cost of capital, or decrease its availability, for commercial real estate construction loans.
The standards, promulgated by the Federal Reserve, Federal Deposit Insurance Corporation, and other bank regulatory agencies, were developed as part of the Basel III Capital Accords, which were a response to the lax underwriting and other problems associated with bank lending (or over-lending) in the housing market. They were issued for public comment in 2012, and went into effect last year for large banks. However, for the smaller banks (those with assets over $500 million), including many community banks that provide lending to commercial real estate, the new standards went into effect on January 1, 2015. As a result, some real estate developers are only now noticing their impact.
The new capital standards created a new class of loans defined as High Volatility Commercial Real Estate (“HVCRE”) loans, which were given a risk weight of 150 percent as compared to other loans, forcing banks to hold more capital against their real estate lending. For commercial loans, in order to avoid the HVCRE designation, a borrower would have to fulfill certain requirements in addition to meeting applicable loan-to-value requirements:
- The borrower must contribute cash (or unencumbered marketable assets), or has paid development expenses, equal to 15% or more of the appraised “as completed” value of the project;
- The borrower must contribute the 15% before any funds are advanced by the bank;
- Capital contributed by the borrower, and any internally-generated funds by the project, must be kept in the project until converted to permanent financing, sold or paid in full.
Importantly, land contributions must be valued by the bank at what the property original cost, not at the current market value of property. Obviously, this has a big impact on those who have held on to their land for longer periods of time. Another problem: loans in existence before the effective date of the regulation are not grandfathered, leaving one to wonder what measure the banks can legally take (depending on what their loan documents say) regarding those existing loans.
The bottom line is that, because these HVCRE require the bank to hold back more capital in reserve, they are less profitable for the banks. They will either reduce their lending to commercial real estate unless the borrower can fulfill their more onerous requirements, or they will have to charge the borrower more for the loan.
When these proposals were first floated in 2012 by the banking regulators, NAIOP and a coalition of real estate organizations strongly opposed them, submitting a comment letter to the regulatory bodies warning of the problems these might cause for commercial real estate. We also weighed in with the relevant committees in the House and Senate warning of their potential impact. Regulators, however, had grown concerned that too many banks had too much commercial real estate lending on their books, and pushed forward with the rules.
In response to concerns the advocacy community continued to present, the federal banking agencies recently issued a “Frequently Asked Questions” document intended to clarify confusion regarding the new requirements. This new guidance did nothing to resolve the many problems identified by the commercial real estate industry. As a result, we will continue to work with Congress to monitor the effect of the new regulations. The challenge is that attempts to force legislative changes, despite being reasonable, can degenerate into partisan warfare, much as proposed changes to Dodd-Frank have done.
As one congressional staffer for a Democratic congressman noted, even the name used by the regulators – “High Volatility” – is scary enough for some in Congress to want to keep away from the issue.