The Economic Growth, Regulatory Relief, and Consumer Protection Act, signed into law on May 24, 2018, brings significant change and deregulation to the commercial real estate finance sector. The new law makes it easier for borrowers and lenders to avoid High Volatility Commercial Real Estate (HVCRE) exposure on loans for acquisition, development or construction (ADC). Since loans with HVCRE exposure require lenders to maintain capital reserves that are 50% greater than for non-HVCRE loans, thus increasing the cost of capital for borrowers, both borrowers and lenders benefit from avoiding HVCRE exposure.
Here is a look at the most significant changes to ADC loans under the new law:
A. Change in Terminology
The law introduces the term “HVCRE ADC loan,” which is a credit facility secured by land or improved real property, the purpose of which is to provide financing to acquire, develop or improve such real property into income-producing real property and which depends upon future income or sales for repayment. HVCRE ADC designation requires that the loan “primarily” finances, has financed, or refinanced the acquisition, development, or construction of real property.” In order to trigger heightened risk weighting and capital requirements, a loan must now meet the definition of an HVCRE ADC loan.
B. Appraised Value Can Count toward Contributed Capital
To avoid HVCRE exposure, borrowers must contribute capital of at least 15% of the real estate’s “appraised as completed” value. Under the new law, the appreciated value of real property counts toward the 15% requirement.
C. Borrowers May Withdraw and Use Contributed Capital
Previously, borrowers had to leave capital in “throughout the life of the project.” Now, borrowers may withdraw and use capital internally generated by the project above the 15% minimum that must remain.
D. Previously Classified HVCRE Loans Can Be Reclassified
The old law required that borrowers convert to permanent financing before removing HVCRE designation. Under the new law, once the construction or development is “substantially complete” and generates enough cash flow to support debt service and property expenses, the loan can be reclassified as non-HVCRE.
The new law does not address some areas of HVCRE regulation that have proved problematic. Remaining issues include complications with calculating the “as completed” appraised value for the borrower’s equity requirement, determination of when a project is substantially complete, and uncertainty as to whether mezzanine financing or other preferred equity financing qualifies as a capital contribution.
Revised SIFI Requirements May Bring More Lenders into the Market
Another important aspect of the law is the amendment to Dodd-Frank provisions relating to the designation of systemically important financial institutions (SIFI). Banks designated as SIFI are subject to increased regulations and annual stress tests. The new law changed the threshold for banks to be considered SIFI from those with greater than $50 Billion in assets to those with $250 Billion or more. This may encourage smaller banks to increase commercial real estate products.
These changes are intended to create new opportunities and promote additional investment. In fact, the section of the new law pertaining to HVCRE is labeled “Promoting construction and development on Main Street.” Contact a member of the Hirschler Fleischer real estate team to discuss how you can increase construction and development under these new, more favorable rules.