Basel III - The Impact on Cash Equity for Construction Loans and a Major Unintended Consequence
Basel III went into effect on January 1, 2014 for banks with more than $50 billion in assets and went into effect on January 1, 2015 for smaller institutions. The component of Basel III describing High-Volatility Commercial Real Estate Loans (HVCRE Loans) is of interest to commercial real estate developers because it defines an HVCRE Loan as an acquisition, development or construction loan (ADC Loan). ADC Loans are assumed to have high risk; Basel III requires banks to set aside 150% of the regulatory capital required for non-HVCRE Loans. The need to set aside more capital has an impact on whether a bank will make an ADC Loan and at what pricing. By way of comparison, the only other loans subject to 150% of regulatory capital are those that are over 90 days past due.
In order to avoid the categorization of a commercial construction loan as an HVCRE Loan, banks will require a 15% minimum cash contribution by the borrower. The 15% minimum cash contribution is based on the “as-complete” appraised value of the project being developed, not on the development cost or the development budget (the development budget differs from the development cost as it includes land at market value and a development fee). As a result, the developer will not know the amount of the minimum cash contribution until the bank has engaged an appraiser and accepted the completed appraisal.
Under the HVCRE rule, no ADC Loans were grandfathered – this poses a particularly thorny issue for banks where ADC Loans were booked without “as-complete” values in the appraisals and where loan documents failed to include prohibitions against distributions of “internally generated capital”. Without the appraisal data and the corresponding language in the loan documents, all ADC Loans would have to be categorized as HVCRE unless they were secured by 1-4 family dwellings, agricultural land or loans for “qualified investments” involving projects that provide community benefit.
While this regulation increases uncertainty for all developers, it penalizes developers who expected to use imputed land value as most of their equity contribution. Although the original cost of land is considered cash equity, carrying costs on that land since purchase and the difference between cost and market value are specifically excluded from cash equity calculations.
Additionally, the cash equity must be invested by the borrower prior to the disbursement of any loan funds by a bank and must remain in the project during the term of the loan. For an income producing property, the term of the loan ends when the construction loan is converted to a permanent loan. In addition, an ADC Loan that starts out as a non-HVCRE Loan may be converted to HVCRE if “internally generated capital” is distributed prior to repayment or conversion to a permanent loan. The prohibition against distributing “internally generated capital” is puzzling since it represents a return on capital as opposed to a return of capital – at least that is how the IRS would require a borrower to categorize it.
Some construction lenders are willing to make HVCRE loans but the pricing will increase due to the higher level of capital required by regulators; the usual premium is 50 to 75 basis points. The willingness of a bank to make an HVCRE loan is likely contingent on a particular bank’s capital adequacy, the term of the loan and the perceived risk profile of a particular transaction.It is important for developers to be aware of these Basel III requirements sooner rather than later so that alternative forms of financing can be investigated. This falls under the “no surprises” rule.
New regulations often produce unintended consequences; in the case of Basel III, more cash equity is required for construction loans that have the least speculative risk:
Project A is a build-to-suit office building for a credit tenant that signed a 20-year lease; the “as-complete” and “as-stabilized” values are identical since the tenant will move in and commence contractual rental payments as soon as the building is complete. Project B is a 100% speculative office building with a three-year lease-up; the “as-complete” value is significantly less than the “as-stabilized” value. Since the required 15% cash equity is dependent on the “as-complete” value, the 100% preleased project requires more cash equity than the speculative project. This situation is exacerbated when Project A is valued using a lower vacancy rate, a lower management fee and a lower capitalization rate due to the long-term credit tenant.
As illustrated above, the increased cash equity requirement for Project A with a credit tenant is significant. The result is the opposite of what should be expected; the riskier project should require more cash equity.
In order to assist clients, U.S. Realty Capital estimates the “as-complete” value of to-be-developed projects and structures debt packages submitted to construction lenders to conform to the general guidelines of Basel III using proprietary Excel templates. In addition, U.S. Realty Capital offers access to alternative capital sources to meet the guidelines set by Basel III.
Special thanks to Christophe P. Terlizzi, senior vice president & regional manager CRE First Niagara Bank for his valuable contributions to this article. Mr. Terlizzi is a member of an American Bankers Association Real Estate Committee proposing changes in HVCRE Loans to federal regulators, chaired a two-day conference on HVCRE Loans for the Global Financial Markets Institute and recently gave a presentation to the Boston Real Estate Finance Association on the topic.
*This article does not constitute legal advice and should not be construed as such. In addition, it is not intended to be a comprehensive review of Basel III. Individual banks will decide exactly how to respond to Basel III guidelines.
David L. Church, CCIM is managing director of U.S. Realty Capital, LLC and chief investment officer of American Pathway Regional Center, LLC.