If you work in the world of commercial real estate, chances are you have heard about High Volatility Commercial Real Estate (HVCRE) loans. Subject to a few exceptions, any bank loan that provides financing for the acquisition, development, or construction of real property will be considered an HVCRE loan.
Under recent bank regulatory reforms, loans with HVCRE exposure are given a risk weighting of 150% (compared to a risk weighting of 100% for non-HVCRE loans). Due to the higher risk weighting, lenders are required to maintain higher capital reserves for HVCRE loans – a cost that presumably would be passed on to the borrower in some form. Accordingly, it is often in the best interest of the borrower to avoid HVCRE exposure.
For most projects, the only way to avoid HVCRE exposure when utilizing bank financing is to satisfy certain Loan to Value (LTV) and Equity Requirements.
A. Loan to Value
The LTV ratio must be less than or equal to the applicable regulatory maximum LTV for the particular class of loan (e.g. 80% commercial/multifamily; 75% land development, etc.). The LTV is to be determined at origination/closing and a subsequent appraisal obtained post-closing cannot move the loan into the exemption. The commentary from Federal banking agencies suggests the “as completed” value is to be used for determining the LTV.
B. 15% Contributed Capital
The borrower must have contributed to the project, in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket – certain soft costs count) of at least 15% of the real estate’s appraised “as completed” value. Cash paid for the land counts (but not the current fair market value of the land).
Certain items do not qualify:
Borrowed money (secured subordinated debt or unsecured debt)
Other collateral pledged (other assets of the borrower)
There is still uncertainty as to whether mezzanine financing or other preferred equity financing provided by a third party will qualify as capital contributed by the borrower.
C. Two-Part Test
1. The 15% contributed capital requirement must be satisfied prior to any loan advance.
2. There must be contractual restrictions against distribution of previously contributed equity or internally generated equity throughout the life of the project.
“Internally Generated” captures net operating income and other distributable funds generated by the project.
“Contractually Required” means that the loan documents must include provisions that require the contributed equity to remain in the project for the life of the loan.
“Life of the Project” means until the loan is converted to a permanent loan or paid in full.
It is important to keep these requirements in mind when discussing project financing with your lender and weighing your financing options. For more information on how you may be impacted by these new rules, contact a member of the Hirschler Fleischer real estate team.
Kristen M. Chatterton