How HVCRE will impact commercial real estate construction lending

Any borrower seeking a construction loan in the last 12 months has likely encountered a five-letter abbreviation that has the potential to present new and considerable challenges on the path to the closing table: HVCRE. HVCRE (Highly Volatile Commercial Real Estate) is a classification that today’s construction loan borrower must be aware of, as its impact could be very costly. Before we can understand the impact to commercial real estate borrowers, we must first understand what HVCRE is, how it is classified and what banks must do to accommodate it.

What constitutes an HVCRE loan?

HVCRE is derived from the Basel III regulatory framework that took effect January 1, 2015, although its implementation by the banking community has been staggered since its introduction. It should be noted that the regulation applies to all commercial real estate loans meeting certain criteria; however, we will focus on the regulation’s specific impact on construction loans.

According to the regulation, a loan is classified as HVCRE if, “prior to conversion to permanent financing, [the loan] finances or has financed the acquisition, development or construction (ADC) of real property” – otherwise known as ADC loans. While there are a few groups of exempted ADC loans (agricultural land, one- to four-family residences) from the HVCRE classification, the most applicable exemption relates to loans that meet all of the following criteria:

1. LTV ratio is less than or equal to the applicable maximum ratio prescribed by bank regulators. The ratio for raw land is 65 percent; land development is 75 percent and construction of commercial, multifamily and other nonresidential is 80 percent. 
2. The borrower has contributed cash equity equal to 15 percent of the loan’s “as completed” value.
3. The borrower contributed its capital prior to bank funding, and said capital remains in the project until the construction loan is extinguished by either converting to permanent, construction loan repayment in full or property sale.

Impact on the Construction Loan Borrower

At its core, Basel III’s rules require banks to hold increased capital reserves against their outstanding commercial mortgage balances. The reserve amount is directly correlated to the perceived risk profile of the mortgage. Because these reserves are not being put to work, banks will seek to offset the lost opportunity cost of that reserved capital with increased interest rates. This requirement is likely to make less capital available for construction lending and to increase borrowing costs.

Following the implementation of HVCRE, larger banks were generally quicker to modify underwriting and credit policy to adhere to the new HVCRE regulations, with adoption from the smaller, local banking community lagging behind. Today, more than 18 months after its enactment, nearly all of the banking community has implemented modified underwriting and/or legal documentation to account for the HVCRE regulations.

The second of the three criteria above – requiring cash equity equal to 15 percent of the loan’s “as completed” value – when not anticipated, has the potential to cause the most What is HVCRE heartburn for construction loan borrowers.

The most obvious solution is to resize the capital stack and reduce the construction loan such that the required debt-to-equity at stabilization ratio is in balance. This approach would require the borrower to contribute enough equity such that the loan does not exceed 85 percent of the “as completed” value. This has a pronounced impact on projects with a land contribution at an implied market value, rather than actual cost.

In case the capital stack includes a highly-levered mezzanine piece, another potential solution would be to replace the mezzanine slug with preferred equity that otherwise walks and talks like mezzanine debt, as some lenders do not consider preferred equity debt and would allow it to be contributed toward the required equity.

Another potential solution for this requirement is for the bank to charge a higher interest rate. As the Basel III requirement demands the need for increased capital reserves for HVCRE loans, the bank effectively ties up capital and loses the earning potential of those dollars. As such, the bank can charge a higher interest rate, potentially increasing the spread by as many as 75 or 100 basis points, in order to avoid resizing the loan.

The world is changing; there is no doubt about that. It is likely that different interpretations and implementations of the HVCRE regulation could pose challenges for borrowers. Some of the effects of a loan being classified as HVCRE could include reduced loan proceeds, additional equity infusions, or an increase in interest rate spread by as much as 75 basis points. Construction loan borrowers must be aware of the regulation and its potential implications when preparing initial construction budgets and investment returns analysis, so having sound guidance and advice during the course of any financing is now more important than ever.