The Playbook Is Changing For High-Volatility Loans

By Robert Brunswick, CEO of Buchanan Street Partners

Last year, the Federal Deposit Insurance Corp. (FDIC) implemented its Regulatory Capital Rules, a new set of directives intended to address regulatory deficiencies that contributed to the 2008 banking collapse. The regulations impose significant limits on bank acquisition, development and construction (ADC) loans, and create an opportunity for loan originators, specifically nonbank lenders, to expand their ADC offerings.

The most notable change requires banks to increase the amount of capital set aside for ADC loans that exceed loan-to-completed value standards or do not comply with minimum real-cash equity investments. The nonconforming loans affected by these regulations are characterized as High Volatility Commercial Real Estate (HVCRE) loans. The new laws were first released in October 2013 and implemented at the start of 2015.

The new reality

Banks that were major players before the recession have returned to the market, but on a limited and inconsistent basis. Lenders have been producing ADC loans at a significantly lower volume than the peak in 2007, causing a decline in the market share of ADC loans originated by regional and community banks.

Under the Regulatory Capital Rules, banks must categorize an ADC loan as HVCRE if it fails to meet several conditions. Chief among them are the following: The borrower has contributed at least 15 percent of the appraised-as-completed value of the asset before receiving bank financing; and the loan-to-value ratio of the financing does not exceed 80 percent. Also, loans for land development must not exceed 75 percent LTV.

This new ruling affects bank offerings on HVCRE loans nationwide, limiting borrowers’ access to capital — and leaves the door open for private lenders to swoop in, especially those able to serve unmet demand with flexible loan structures and efficiency.

Clarifying the rules

The FDIC has issued clarifications of the law over the past year. First, if a loan is initially classified as HVCRE financing, it remains so until the acquisition, development and construction loan is refinanced with a permanent loan. Nonetheless, a loan cannot be classified as permanent if it is based on the “as completed” value of the project. Furthermore, these clarifications included a distinction between the “as completed” and “as stabilized” values, so that the latter value cannot be used to determine whether a loan meets the definition of HVCRE financing.

Clarifications also established that borrowers may not withdraw capital generated internally by a property during the term of an HVCRE loan. Neither unrelated real estate assets nor grants from state, federal or municipal governments, or nonprofits can be included as part of the borrower’s 15 percent equity contribution; and preconstruction deposits on condominiums cannot be counted as a borrower-equity contribution.

Also, junior liens collateralized by the property, cannot be considered part of the 15 percent contribution. It is not clear yet whether mezzanine loans secured by partnership interests and originated by a lender unrelated to the bank will circumvent this rule. Borrowers are, however, permitted to include land contributed to a development project as a part of the required capital. The value of this contribution must correspond to the borrower’s real-cash equity in the land. For example, if a borrower purchased a site in 1980 and since entitled it, the cost basis is the original land purchase price plus the entitlement expenses. This is a major shift in bank regulations, creating a void that can only be filled by nonbank construction lenders.

A borrower’s contributed capital can include soft costs, such as brokerage fees, marketing expenses or costs of feasibility studies. Project costs paid to related parties for developer’s fees, leasing expenses and brokerage commissions, and management fees may be included in the soft costs — provided they are reasonable in comparison to fees paid to third parties for similar services.

The new regulations do not preclude banks from originating HVCRE loans. In the wake of their implementation, however, some banks may determine that HVCRE loans will not generate sufficient returns as compared to alternative investment options because of the additional costs associated with higher reserve requirements. This situation presents greater opportunities for flexible, nonbank lenders to move into the space.

Impact on Lending

The regulations have created a competitive advantage for private lenders in funding high-leverage construction loans, construction mezzanine loans, and highly structured bridge and land-acquisition financing.

A study by Joseph Rubin, Stephan Giczewski and Matt Olson of Ernst & Young LLP pointed to several significant effects of the new regulations:

  • Higher capital requirements from the borrower could result in banks shifting assets away from the commercial real estate sector;
  • Interest rates could increase to account for the increased costs; and
  • Borrowers may be forced to shift to higher-cost private lending sources.

Capital advantage

Although the new capital regulations impose limits on bank lending, banks are not out of the picture. According to the Ernst & Young study, a minority of commercial real estate loans are likely to fall into the definition of HVCRE because banks already avoid loans with LTVs of 80 percent or above, and most borrowers acquire development sites simultaneously with, or just prior to, the closing of the acquisition, development and construction loans.

Even among nonbank institutions, there are relatively few lenders that specialize in loans with LTVs above 80 percent. But there is demand for such loans, as well as opportunities for nonbank lenders. Their biggest advantage is the ability to structure flexible debt more quickly than banks, and commit to deals while banks are still evaluating them.

Some other situations where nonbank financing is a good fit include:

  • A borrower has owned the land for a significant period of time, but has a very low real-cash basis;
  • An asset has increased in value because of rezoning, or the entitlement process;
  • A borrower seeks more than 80 percent of cost-construction financing for a preleased, investment-grade, credit-tenant building;
  • A borrower requires cash out from unit sales to fund unrelated projects — for example, a situation in which a condominium developer previously arranged an 80-20 percent split of unit-sale proceeds to pay a principal or dividends; and
  • A bank rejects a borrower’s assertion that developer’s fees included as part of the contributed equity are justified by the market (a standard that has yet to be defined by regulators).