Basel III rocks construction lending foundations in US

Lenders and developers decry big capital charge for construction loans

New Basel III capital regime regulations are discouraging US banks from financing development.

The Basel III ‘super-capital’ charge for so-called high-volatility commercial real estate (HVCRE) loans came into effect at the start of the year, intended to curb the sort of excessive construction lending that created big losses during the recession.

But since the creation of the HVCRE category, under which many construction loans often fall, even non-bank lenders that could otherwise benefit from Basel III fear the regulations will hurt the commercial real estate market by impeding development.

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

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

In a note on the change to clients, law firm Gibson Dunn said the 50% more capital that banking entities must maintain against HVCRE exposure was significant, as it comes “at a time when banks are struggling to achieve desired returns on equity due to 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, and passing on a range of requirements to borrowers: lower loan-to-
value levels, increased up-front cash equity requirements, tougher scrutiny of construction deadlines and shorter loan durations.

The rules may seem like a blessing to speciality 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.

Bad news for borrowers

The rules are also bad news for borrowers, because as banks retreat from this area or pass on costs, the alternative lenders that step in to make senior loans will be able to charge more. The CRE Finance Council has said the new requirements add up to 80bps to average construction loan costs.

“Banks are more aware of the rules and have factored this into pricing, which opens a window of opportunity for unregulated lenders like [us],” Baydala says. But, he adds: “To have the more efficient capital driven out will make deals more expensive.”

Onerous borrower requirements have also stymied developers. To avoid 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, even after the 15% capital contribution is met, owners could be prohibited from withdrawing internally generated capital from the project.

Stevens: seems punitive “not to recognise appreciated land value as part of the 15% equity requirement”

In a letter to lawmakers, responding to guidance released at the end of March by US regulators on the HVCRE designation, David Stevens, CEO and president of the Mortgage Bankers Association, wrote: “The retention requirement for internally generated capital could result in capital above 15% being retained in the project.

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

In addition, appreciated land value does not contribute to the 15%, essentially penalising developers that 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 recognise appreciated land value as part of the 15% equity requirement,” Stevens wrote. “It seems a punitive result not to [do so], particularly, if the land has been held for a substantial period.”

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 a 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  once it meets the underwriting standards for a bank’s permanent financing, “to remove the construction risk capital requirement”.