The banking industry celebrated a small victory in early November with the approval of H.R. 2148—a bill that aims to cut through some of the confusion that the Basel III high volatility commercial real estate (HVCRE) rule created for construction loans. Although it is a step in the right direction, it may be a bit premature to start popping champagne corks.
Banks are keeping close tabs on two key initiatives that could change the current HVCRE rule that was first introduced in January 2015. First there is the H.R. 2148 legislation that aims to clarify the HVCRE regulations. “It does provide clarity on key issues and it better aligns the rule with the economics and the risks of these types of projects,” says Bruce Oliver, associate vice president for commercial/multifamily policy at the Mortgage Bankers Association (MBA), an industry association.
Second, and concurrent to H.R. 2148, is a new proposal that would replace the HVCRE rule with an amended rule that is being billed as HVADC (high volatility acquisition, development, construction). The current HVCRE rule was jointly issued by the Federal Reserve, the OCC and the FDIC. It is those same regulators who are behind the new proposal, which was introduced in late September.
Theoretically, both the legislation and the amended rule proposal are working towards a common goal—to address concerns raised by bankers that these rules are confusing, put an added burden on banks and create an unintended consequence of restricting lending. However, each initiative takes a different approach to accomplishing that objective.
Generally, bankers seem to be leaning more in favor of H.R. 2148, and the MBA is cautiously optimistic that the legislation has good momentum and bipartisan support that could help it move through the Senate. In addition, if the legislation moves forward and does become law, it would supersede the HVADC proposal.
“I think a lot of banks are excited by the possibility of H.R. 2148,” says Ashley Gunn, associate director, commercial/multifamily, at the MBA. “It creates a lot of clarity and simplification of the rule, while still incentivizing a certain amount of risk reduction based off of your capital requirements.”
Currently, the bill is in the Senate’s Committee on Banking, Housing and Urban Affairs.
Bill addresses industry concerns
The original rule is often viewed as ambiguous, not very advantageous for borrowers and, in some cases, has caused more loans to be classified as HVCRE because of the way the rules were structured, notes Gregg Loubier is a partner in the finance group of law firm Alston & Bird in the Los Angeles office. “The bill takes aim at many of those problems and attempts to correct them,” he says.
One of the key components of H.R. 2148 is that it more clearly defines what qualifies as a high volatility ADC loan. The trouble with the current rule is that banks are unsure whether a loan on a project that has some amount of construction, but is not a construction loan, would be included in the HVCRE loan bucket, says Oliver. “Some banks just throw up their hands and say, ‘we don’t want to be wrong. Let’s just throw everything into the most conservative bucket and live with it,’” he says.
A second important component to the legislation is that it makes some clarifications and modifications to specific requirements under the capital contribution exemption. The HVCRE rule creates an incentive where if a deal is structured to meet certain requirements, namely meeting an 80 percent loan-to-value (LTV) or lower, a 15 percent minimum capital contribution and restrictions on withdrawal of capital during the life of the project, the bank gets the benefit of a lower capital requirement. Instead of a 150 percent risk weight, the reward is a lower risk weight of 100 percent.
Under the current rule, banks have jumped through hoops to structure deals to get the lower capital requirement, says Oliver. “The bill would clarify the front-end definition of an HVCRE loan, and it would make a few changes to the capital contribution exemption in ways that are easier to administer, simplifies it and better aligns it with the economics and risk of the deal,” he says.
Still some uncertainty ahead
Generally, the industry is happy with the bill, notes Loubier. In addition to improving the definition of what an HVCRE loan is, it excludes from the definition the acquisition or refinancing of an existing income property secured by a mortgage so long as the cash flow generated is sufficient to pay expenses and debt service. It also excludes loans made for improvements of existing income-producing properties, which tends to be beneficial for bridge financing, he says. That should help level the playing field between regulated banks and non-regulated lenders, he adds.
As it relates to contributed capital by the borrower, another important change is that land can now be contributed at its appraised value as opposed to the existing rule, which says that land can only be contributed at the acquisition value. One concern is that the bill still doesn’t specify exactly when a project would be deemed complete for the purposes of no longer being classified as HVCRE, notes Loubier. In addition, there was always a question of whether the borrower could use the proceeds of mezzanine financing or preferred equity investment as contributed capital. The bill does nothing to clarify that, he says.
H.R. 2148 does appear to have some good traction. However, it is very difficult to predict what will happen in Congress these days, or how long it might take to move the bill forward. That is likely one reason why the industry is continuing to follow the progress of the HVADC rule being proposed by bank regulators. Comments on the HVADC proposal are due at the end of December.
The biggest difference between H.R. 2148 and the proposed HVADC replacement rule is that HVADC completely eliminates the capital contribution exemption and the incentives that it creates. Some of the feedback from MBA bank members on the HVADC proposal is that they don’t think it will be good for their bank and they think that regulators missed the mark, largely because it did take out the capital contribution exemption, notes Gunn. “It would be a shame to eliminate an incentive that is working rather than trying to make better,” she says.