Defined by federal regulators, an HVCRE loan is any commercial mortgage loan used to acquire, develop, and construct (ADC) commercial real property prior to a conversion to permanent financing as HVCRE where there was not at least 15 percent cash contributed by the developer. Watch out for this requirement on commercial mortgage loans that are considered high volatility commercial real estate. It’s just one of many insane rules bankers are having to comply with today. No wonder smaller banks are selling out to larger banks.
Banks must now hold 150 percent of their capital for all HVCRE loans—typically CRE loans are 100% capital weighted. The new rule went into effect back on January 1, 2015, but for whatever reason, banks are only recently (within the past year or so) rejecting loan requests that cannot meet the HVCRE requirements. The new rule is designed to protect the lender by increasing the developer’s equity cushion above the lender’s loan amount.
This could be a big surprise if you haven’t sought a commercial mortgage loan in recent years. The new requirement for obtaining a commercial mortgage has restrictions on the use of land as equity and regulators want to see 15 percent cash contributions from borrowers.
How it impacts developers
Here’s the biggest shock that will be a challenge. Your contributed capital into the commercial property must be at least 15 percent of the “as completed” appraised value in cash or unencumbered readily marketable assets! Yep, you heard that right; dirt, land, or ground isn’t of any value to bank regulators back in Washington, D.C. It should be noted that the “as completed” value is typically lower than the “stabilized value.”
In other words, what this means is, if you land banked some property for the past 20 years and now want to develop it and build a commercial building on it, you will have to demonstrate that you have paid in 15 percent equity of the “as completed” appraised value in cash or prove that the property was recently acquired with a sales contract showing what you paid for the property.
The other scenario where this would come into effect is you buy land and it appreciates while you are getting ready to raise debt. The bank would not be able to use that appreciated equity above what you paid for it.
Remember any and all cash into the project has to be documented, such as land purchase and soft costs. If you cannot show that what you paid for the property represents 15 percent of the “as completed” appraised value, the lender is now forced to ask you to pay cash or contribute unencumbered readily marketable assets (stocks and bonds, or cold hard cash) of 15 percent into the project before they lend a dollar.
For example, let’s say you found the perfect commercial project and use of your land that you have held for the past 20 years—say it was inherited. And let’s say it is now worth $750,000. You determine your construction budget will be $5 million. You think perfect, my land is 15 percent of the total costs and I have another 10 percent in soft costs and cash—thinking a LTC of 75 percent. So you call up your local banking friend and ask for a construction loan.
He says, sorry, we cannot accept that land as equity, so you will need to deposit $750,000 in the bank as collateral instead. And then, he looks at your balance sheet and says, hmm, you won’t have enough liquidity in your balance sheet after the deposit, so I am sorry, we have to decline your construction loan request. Huh?
Land isn’t considered tangible equity… Say what???
Why? It appears the regulators do not like to see a borrower requesting a commercial mortgage from a bank without having “tangible equity” in the project. Regulators would argue that one of the factors that led to the last financial crisis was borrowers claiming they had equity in a property (because of the land’s appreciation) when really the equity or capital they contributed was really just price appreciation. When real estate prices were moving up so fast that you could buy a property and within 6 months the property increased by 20 percent or more, that inflated price they would say is not really an equity contribution by the borrower. Ok, that’s understandable. But, shouldn’t the land still be worth something? In short, the regulators are arguing that the borrower didn’t really have any of their own capital or cash in the deal—no skin in the game.
A few exceptions
There are a few exceptions if the loan is secured by:
- 1-4 family residential projects.
- Properties that qualifies as a community development project.
- Agricultural land
So basically, if you have a multifamily property that qualifies as a community development project for low to moderate income residents, then any bank that would finance the property would not be subject to this regulation. Unfortunately, this leaves out all other commercial properties that require financing. And of course, an SBA 504 loan may also be exempt from the HVCRE rule if it meets the requirements for community development and fits into the lender’s community develop act lending activities.
Therefore, real estate that does not have any tangible contributed capital is considered highly volatile commercial real estate. It is highly volatile because the borrower has not paid in enough of their own tangible cash. Apparently, there isn’t enough pain in the deal for the borrower. The borrower could theoretically walk away and not suffer a significant loss.
Of course, this is short-sighted at best. The regulators have not completely thought this through because they are not considering the value of the developed project—maybe “as completed” value but not the intangible value of creating something from raw, undeveloped land. The value of the end product as completed does provide skin in the game—not to mention the land contributed. Just ask anyone who lost their shirt during the financial crisis in 2008-2009 and they will tell you they did suffer some pain—even if they didn’t contribute 15% cash into the deal.
Banks must comply
Why do Bank’s care about this rule? First, they have to comply or be criticized by their banking regulators which can cause increased deposit insurance premiums, limit new branches, or limit any new products they might want to offer. Second, even if they made the loan, capital weight restrictions on the amount of the loan at 150 percent of the bank’s capital, reduces their already thin margins. 150 percent capital weight creates an additional cost of capital because it ties up 50 percent more capital that could otherwise be lent out to other bank customers. So, if they don’t follow all aspects of the regulation, bank examiners would likely criticize the bank for not following the regulatory guidance. Banks aren’t happy about this rule either, but it is the current regulatory environment they must operate in.
How can a borrower avoid being classified as HVCRE?
There are three conditions anyone of which triggers HVCRE:
1) The LTC is less than or equal to the maximum LTC requirements found in the Interagency Guidelines for Real Estate Lending. For construction loans, its 80 percent LTC, but most banks are lending at lower percentages.
2) The borrower contributes at least 15 percent of the “as completed” value of the property in cash or unencumbered marketable assets prior to any lender’s advance. Some banks are accepting soft costs as part of this contribution.
3) The borrower’s contributed capital and any capital generated is contractually required to remain in the project until the project is completed, stabilized, and converted to permanent financing.
If you’re looking to a bank for a construction loan and have held the property for a while, be prepared to show your skin in the game!
We have non-bank construction lenders who aren’t under such silly regulations. Give us a call if you have banked some land years ago and now want to develop it.
This article isn’t meant to be legal advice and does not answer all the questions about the HVCRE rule. So if you want to learn more here are some links to the regulation, guidance Q&A and others interpretations.