A bill that would ease Basel III capital requirements on commercial real estate loans could level the playing field between depository and nonbank lenders and spur more construction lending.
The Clarifying Commercial Real Estate Loans Act, H.R. 2148, codifies and clarifies exemptions to the requirement that high-volatility commercial real estate loans carry a 150% risk weight for capital retention purposes. The bill passed the House on Nov. 7 and now heads to the Senate.
HVCRE lending is a subset of acquisition, development and construction loans that applies to commercial properties being built. The current Basel III requirements forces banks to keep more capital on their books for these loans, resulting in higher borrowing costs compared to other lenders not subject to Basel III.
"Many of these changes are just very practical adjustments to conform the rule better to the way real estate development is conducted," said Gregg Loubier, a partner in Alston & Bird's Finance Group. Some banks were cautious and automatically classified construction loans as HVCRE to avoid regulatory problems. Others, typically smaller banks, only made loans that qualify for the exemption to avoid the capital hit.
It also benefits the bridge lending space by removing from HVCRE status loans for improving income-producing properties under certain conditions, such as long as cash flow is sufficient to support the debt service and the expenses, Loubier added.
The current exemptions include a loan-to-value test and a separate prerequisite that the borrower has contributed 15% in cash equal to the property's as-completed valuation. If the borrower has those in place, the risk weighting drops to 100%.
The bipartisan bill redefines the valuation standard to stabilized value. It also creates an exit ramp that should move loans out of the HVCRE category when they reach certain milestones, allowing them to be reclassified permanent financing. Permanent commercial loans have a 100% risk weighting.
If passed, banks should be used more often as a capital source for construction loans, said Bruce Oliver, the Mortgage Bankers Association's associate vice president for policy in the commercial and multifamily group.
"What it does is it helps level the playing field, making banks a more competitive source because some of the requirements under the HVCRE rule are not well aligned with risk. It sometimes made it difficult for banks to be competitive with other capital sources for projects," he said.
That higher capital charge is reflected in the loan pricing and "it unlevels the playing field in a way that doesn't seem quite right," Oliver said.
In other words, it makes it less attractive for a borrower to get an AD&C loan from a bank when other commercial real estate lenders could offer a lower interest rate, including life insurance companies, commercial mortgage-backed securities issuers and debt funds, none of which are subject to Basel III capital requirements, added Ashley Gunn, associate director of the MBA's Commercial/Multifamily Group.
Exactly half of the 136 banks surveyed by the American Bankers Association in 2016 had HVCRE loans on their books. Just over seven out of 10 were still originating these loans after Basel III was implemented.
While only 37% said they increased pricing to cover the increased capital cost, 55% declared they lost deals to a competitor not covered by the regulations or had the borrower decline the loan after structuring the terms so the loan would not be classified as HVCRE.
Proper rule interpretation and remaining competitive given the additional cost were the biggest challenges associated with the HVCRE classification, most respondents commented.
But banking regulators have not been idle even as this bill has been working its way through Congress. A proposed regulation by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp. and the Federal Reserve is not as friendly an approach to the subject as the bill is.
The regulation would rename this category as high-volatility acquisition, development and construction loans. While it reduces the risk weighting to 130%, the proposal vastly increases the kind of loans that would qualify for that designation.
"It would expand the ability to lend because it would reduce the capital that would have to be held," said Joseph Pigg, the senior vice president of mortgage finance at the ABA. "It should spur lending in the construction space."
The ABA is still vetting the regulatory proposal, but even with the lower risk weighting, H.R. 2148 is more in line with what the banks are looking for.
"We would like to see something to address this, either regulatory or legislatively, so we'll work towards that end," Pigg said.
The bill doesn't change "the fundamental structure of the capital regime for HVCRE," Oliver said, but it provides bank lenders with more flexibility for the deal to be crafted in such a way that it's eligible for 100% risk weighting.
"It affects behavior and when you respond to the incentives, then good things happen," he said. "It makes it easier for banks to lend in that space with those changes."
On the other hand, Oliver continued, the OCC/FDIC/Fed proposal "in effect they take away the incentive to structure the deal in ways to reduce the risk."