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COMMERCIAL FINANCE 701: Basel III, HVCRE & real estate loans

EDITOR’S NOTE: Commercial Finance 701 is a continuing series on commercial loans written exclusively for the Mississippi Business Journal. This series is geared to lenders, developers, investors and transactional attorneys.

 

Molly Jeffcoat Moody and Ben Williams

Molly Jeffcoat Moody and Ben Williams

Sitting atop the Alps, Switzerland managed to eschew both World Wars, flout the fluctuating Euro, and fleece wide-eyed tourists with opened arms.  Of late, however, the multilingual country has exported more than chocolate: from Lausanne, the controversial Iranian nuclear treaty negotiations, and, more on point for us, from Basel, Switzerland, a series of confounding financial regulations innocuously referred to as Basel I, II and III.  Our focus today is on Basel III and its impact on commercial real estate (CRE) projects.

What is “Basel III” and do I care? 

It would be reasonable to wonder if Basel III has affected or will affect you.  The short, simple answer is “yes.” Basel III is a regulatory framework adopted by the Basel Committee on Bank Supervision, an international committee composed of over 25 member countries.  In proposing the guidelines, the committee’s stated goal was to help the banking world better withstand “shocks” of another economic crisis by, inter alia, imposing stringent capital requirements on certain type loans.  This imperious edict has now crossed the Atlantic and, via the U.S. Code of Federal Regulations, made it to your already heavily-regulated bank.

If you are a CRE lender, you have learned of Basel III from recent memos and flummoxing new lending policies, as many portions of Basel III with the most pronounced effects on CRE development became effective January 1, 2015. If you are a developer, you may not have heard about it by name, but you have likely seen its progeny in commitment letters.  For purchasers and users of CRE – office buildings, shopping centers, assisted living facilities, apartments — you may never hear the name “Basel III,” but unfortunately, you will pay.

How will Basel III affect a commercial real estate project? 

Under U.S. federal regulations implementing Basel III, a bank must maintain higher capital requirements for certain CRE loans. Specifically, CRE loans for acquisition, development and construction  of high-volatility commercial real estate (HVCRE) now require an initial capital weighting of 150 percent (up from a previous maximum of 100 percent). This means, using regulatory math, the bank has taken risk tantamount to 150 percent of the amount of the loan. This higher risk rating translates directly into greater capital requirements and reserves for the bank.

You might think your conservative CRE project couldn’t possibly be HVCRE (a term not previously used in describing real estate projects).  Counterintuitively, the high volatility classification is NOT based on an objective credit evaluation of a specific project’s or borrower’s risk criteria.  Instead, there are prejudicial assumptions built into the 275 pages of involute regulations. To avoid a fairly typical CRE construction project being bureaucratically classified as high volatility, a borrower must (1) inject and maintain project cash equity of at least 15 percent of the “as complete” value of the project BEFORE the bank funds a penny, and (2) satisfy loan-to-value ratios required by regulatory agencies (e.g., 80 percent maximum for commercial and multifamily projects).

At first blush, the exemptions might seem like standard practice.  But a 15 percent equity requirement calculated on the “as complete” value is different from most banks’ existing practice.  Under Basel III, the appraisal works against the developer. The higher the appraisal the more equity required — regardless of cost.  The developer’s efficiencies in keeping costs low – perhaps through integration of a captured construction company — are snubbed.  The “cash” requirement impairs the common practice of counting a builder’s deferred fee as equity.  Further, to avoid a subsequent HVCRE classification, the capital invested in the project, along with any capital generated from operations, must stay in the project until the loan is paid off. So much for distributions.

What is Basel III’s cost?

The true cost of the HVCRE designation is difficult to quantify.  A November 2014 Bank of America Merrill Lynch white paper reckoned a “50 percent increase in the cost of capital for a bank at a 35 percent taxable rate would equate to a need to increase loan spreads in excess of 60 basis points.”  On a traditional mini-perm five-year, $10,000,000 loan, a 60 basis point increase in the interest rate equates to a net present value of, roughly, $261,503.

In most instances, once a loan is closed and classified as high volatility, the damage is done. The HVCRE designation will stand until the project is complete, and the loan converted to a permanent loan or otherwise repaid in full. There is some wiggle room for the bank’s capital requirements to be reduced after completion and stabilization, but the mechanics are problematic.

The Exemptions.

Naturally, there are some exemptions — albeit written in federal-ese.   The equity injection exemption is described above.  Additional exemptions exist for (a) one-to-four family residential properties, (b) certain agricultural land, and (c) community development projects.

The Implications?

A pre-implementation paper by a Big Four accounting firm predicted Basel III “may influence banks’ willingness to finance commercial real estate loans due to lower returns and decreased profitability.”  More specifically, we believe that smaller banks may simply throw their proverbial hands in the air and avoid anything that remotely resembles HVCRE.  Larger banks will quantify the cost of compliance (in terms of capital and administration) and factor these financial burdens into an increased origination fee and/or interest rate.

In our biased legal opinion, the U.S. should limit imports from Switzerland to army knives and chocolates.

Merde!

» Ben Williams and Molly Jeffcoat Moody are attorneys in a commercial law practice at Watkins & Eager PLLC (watkinseager.com).   Ben is recognized by Chambers USA and Best Lawyers in America and was selected as Best Lawyer’s 2014 Commercial Finance Lawyer of the Year in Jackson.   Molly is recognized by Chambers USA in the area of Real Estate Law. 

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