Critics say Basel III rules will impede CRE development

New regulations under the Basel III capital regime will stall new development in the US by discouraging banks from financing construction, according to critics of the rules.

New regulations under the Basel III capital regime will stall new development in the US by discouraging banks from financing construction, critics argue.

Six months after the ‘super-capital’ charge for so-called High-Volatility Commercial Real Estate (HVCRE) loans became effective, even non-bank lenders who could stand to benefit from Basel III fear that the current regulations will hurt commercial real estate by impeding development.

Baydala
Baydala

“They are discouraging the banks from participating in the construction loan market,” Terence Baydala, managing director, originations, at Pembrook Capital Management, told Real Estate Capital. “That’s not a good thing for commercial real estate finance and development in general.”

The change under the new Basel III regime is meant to curb the sort of excessive construction lending that created major losses during the recession, by creating a category of loans deemed HVCRE, under which many construction loans often fall.

Loans judged as meeting the HVCRE criteria receive a heightened 150 percent risk weighting for regulatory capital purposes on a bank’s balance sheet, versus the 100 percent requirement for other CRE loans.

In a recent note on the change to clients, law firm Gibson Dunn said the 50 percent more capital that banking entities must maintain against HVCRE exposures had come at a time when banks are already “struggling to achieve desired returns on equity due to the new heightened capital requirements.” 

As a result, banks with heavy exposure to these loans are either pulling back or taking measures to mitigate the increased capital requirements, leading to a range of requirements they pass on to borrowers: lower LTVs, increased upfront cash equity requirements, heightened scrutiny of construction deadlines and shorter loan durations.

At face value the rules may seem like a blessing to specialty finance lenders who could step in to fill the gap. But firms like Pembrook, targeting higher yields via mezzanine debt and preferred equity investments, are often happy to lend atop the stability offered by a senior loan from an established, major bank.

The rules are also bad news for borrowers because big banks are either pulling out of construction financing or accordingly passing costs onto borrowers, while alternative lenders who swoop in to make senior loans will have more leverage to charge more, critics argue. The CRE Finance Council has said the new requirements add up to 80 basis points to the cost of the average construction loan.

“The banks are much more aware of the rules and have factored this into pricing, and that opens up a window of opportunity for unregulated lenders like [us],” Baydala said. But, he added, “To have the more efficient capital driven out will certainly make deals more expensive.”

Onerous borrower requirements in the regulations have also stymied developers. In order to avoid the HVCRE designation, borrowers must meet a 15% equity requirement and leverage cannot exceed 80%. But, critics have noted, the HVCRE rule is unclear on various points — for instance, that even after the 15 percent capital contribution is met, owners could be prohibited from withdrawing internally generated capital from the project

Stevens
Stevens

“The ongoing retention requirement for internally generated capital could result in capital in excess of 15 percent being retained within the project,” wrote David Stevens, CEO and president of the Mortgage Bankers Association, in an April letter to lawmakers, including Janet Yellen, chair of the Board of Governors of the Federal Reserve System, and Martin Gruenberg, chairman of the Federal Deposit Insurance Corporation.

Stevens was writing in response to guidance released on 31 March 2015 by US regulators on the HVCRE designation.

“We are strongly concerned that this requirement could result in differing amounts of contributed capital being required based upon differences in internally generated capital,” Stevens said.

In addition, appreciated land value does not contribute to the 15 percent, essentially penalizing developers who may have purchased a site many years ago, improved it and/or watched its value appreciate.

“We strongly recommend that a bank be permitted to recognize appreciated land value as part of the 15 percent equity requirement,” Stevens wrote. “It seems a punitive result not to recognize appreciated land value as part of the 15 percent capital contribution requirement, particularly, if the land has been held for a substantial period of time.”

HVCRE loans also must be held for the full term, according to the March guidance. For example, if construction is completed in two years on a loan with an original five-year term, the loan must be held for the full period.

MBA argued that a loan should be reclassified as income-producing real estate (IPRE) once it meets the underwriting standards for a bank’s permanent financing, “in order to remove the construction risk (HVCRE) capital requirement.”

While Stevens was not able to comment on the his progress with lawmakers, Yellen last week did signal that more regulatory changes could be underway — but this time for the so-called “shadow banking system,” which would include non-bank entities that are increasingly making commercial real estate loans.

“We are thinking about regulations… like minimum margin requirements that would apply not only to banking organizations but more broadly [would] address some potential risks in the shadow banking system,” she said Wednesday in testimony to Congress.

 

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