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COMMERCIAL FINANCE 701 — Real estate loans – HVCRE revisited

MOLLY MOODY & BEN WILLIAMS

In the midst of all the recent investigations, pardons, Supreme Court rulings, and incessant breaking news, you might have missed a favorable change in federal banking law.  On May 22, Congress amended the Dodd–Frank Wall Street Reform and Consumer Protection Act (enacted in 2010), which revisions included significant tweaks to the High Volatility Commercial Real Estate (HVCRE) regulations governing commercial acquisition, development and construction (ADC) real estate loans.  President Trump signed the legislation and the long overdue changes took effect immediately.

Pain for all

The introduction of HVCRE on Jan. 1, 2015, into the commercial real estate industry inflicted considerable pain on both banks and borrowers.  See http://msbusiness.com/2015/05/commercial-finance-701-basel-iii-high-volatility-realty-loans/.  For select ADC real estate loans, borrowers were stuck with Morton’s fork: contribute 15 percent upfront equity on the “as completed” value of the project or face a higher interest rate due to a 150 percent capital requirement imposed on the lender.  Additional nuances limited the value of contributed real estate and restricted distributions during the life of the loan.  Apart from the underwriting challenges, merely understanding and following the regulations proved expensive and arduous.  The federal banking regulators provided blurry “guidance” in the form of equivocal responses to just 17 of the thousands of “Frequently Asked Questions.”  Lenders, borrowers and regulators alike detested the regulations.

Race for Change

The ill-conceived HVCRE regulations spurred a flood of complaints and a bureaucracy-laden endeavor to find a workable restructure.  On Oct. 27, 2017, the federal banking regulators proposed (and published) regulations substantially modifying HVCRE.  The tentative amendments sought to eliminate the differing capital requirements imposed on banks for HVCRE (to be called “HVADC”) loans and non-HVCRE loans.  The 15 percent front-end equity requirement would have been eliminated, though pre-existing supervisory loan-to-value lending limits would remain.

Even as the banking agencies took comments on the proposed HVADC, the Republican-controlled Congress was scrutinizing the Dodd-Frank Act, and the progeny of related regulations.  Trumping the pending HVADC regulatory mend, the House tendered H.R. 2148 to the Senate in November. The Senate responded with S. 2155 in March 2018, which was passed on May 22 and was signed by the president two days later.   Among other changes to Dodd-Frank, the law legislatively amended HVCRE regulations and significantly gutted the proposed HVADC regulations.

HVCRE II

As enacted by Congress, the revised HVCRE is a friendlier attempt to address the inherent risk of ADC real estate loans. First, the universe of ADC loans subject to HVCRE classification was shrunk. Now wholesale excluded from HVCRE consideration are loans that:

1. finance certain small residential projects, community developments or agricultural land

2. finance acquisition of performing projects

3. finance rehabilitation of adequately cash-flowing existing projects

4. do not “primarily” finance or refinance a project

5. do not depend on future income or sales for repayment

6. are not secured by real estate

7. were closed prior to January 1, 2015.

Second, as for the loans subject to HVCRE, the rules changed.  The 15 percent equity contribution safe harbor provision is easier to meet, as now the borrower receives credit for the current appraised value of contributed property (rather than historic cost).  Post-closing withdrawal of capital (contributed and/or earned) is permitted so long as the 15 percent  initial equity contribution remains in the project.  HVCRE application ends once the project is substantially completed and financial performance underwrites to the bank’s permanent loan criteria.

The 150 percent  capital requirement was not amended and still applies for ADC loans which are not excluded or fail to meet the 15 percent  equity safe harbor provision.

A summary of the modified HVCRE rules is included in the accompanying chart.

Status quo?  

Effective May 24, 2018, the HVCRE regulatory burdens dating to Jan. 1, 2015, have been legislatively softened.  Fewer loans are subject to the rules.  Confirmation of equity injection and negative covenants on distributions will continue to be included in loan documents.

Somewhat confusingly, the federal banking regulators may move forward with some modified version of the stymied HVADC proposal, including discarding the 15 percent  equity contribution provision in favor of an across the board 130 percent capital requirement.

Heraclitus of Ephesus, a Greek philosopher, perceptively observed, “Nothing endures but change.”  At least this most recent change is positive.

» BEN WILLIAMS and MOLLY JEFFCOAT MOODY are attorneys at Watkins & Eager PLLC, and are both recognized by Chambers USA and Best Lawyers in America. Molly and Ben were selected as Best Lawyer’s 2018 Lawyer of the Year (Jackson, Mississippi) in, respectively, Commercial Transactions /UCC Law and Project Finance Law. Additional information is available at www.watkinseager.com.

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