Local Construction Lenders Wary of New Reserve Rules for Commercial Real Estate

Kilroy Realty Corporation, San Diego, Seattle, San Francisco, Kilroy Sabre Springs, General Atomics, Del Mar Corporate Center, Adobe, Fremont Lake Union Center, Nektar Therapeutics, West Coast, KRC


By Adam Steinhauer

A new rule meant to limit the risks that banks can take on volatile commercial real estate assets may be having some unintended consequences, with some lenders pulling on back from the commercial real estate market and some borrowers forced to accept more expensive financing on relatively safe projects.

That was the view that lenders expressed at a panel hosted recently by the Bay Area Mortgage Association at the City Club in San Francisco.

[contextly_sidebar id=”FOmZu7e9cg6lBY4A2tpGb1JszlfVpc0H”]The new rule, which took effect in January, requires banks to reserve more capital for loans on property defined as “high volatility commercial real estate,” or “HVCRE,” in real estate lenders’ jargon. The HVCRE standard was enacted by U.S. bank regulators under the Basel III international regulatory framework imposed in the wake of the financial crisis.

Among the standards that a loan has to meet to avoid HVCRE designation is a requirement that the borrower has contributed capital to the project worth at least 15 percent of its appraised as-completed value.

The “as-completed” part of the formulation is causing some relatively low-risk loans to be tagged with the HVCRE designation, the bankers said.

Martin Kearney, director of BMO Financial Group, told of a project where a sponsor had acquired a Bay Area property with environmental issues several years ago. The sponsor cleaned up the property and obtained environmental permits. Now, a prospective tenant with strong credit wants to lease the entire property.

But now, as the sponsor needs a construction loan to build for the prospective lessee, its capital contribution is likely to amount to less than 15 percent of the project’s as-completed appraised value.

“Think about this: These guys created a lot of value by cleaning it up environmentally, getting it permitted and getting a lease. They’ve taken all the risk out of the deal and created a lot of value. And now, they will get penalized on the loan because every bank is going to have to hold more capital and will charge them a higher rate,” Kearney said. “It just doesn’t really make any sense.”

Aside from the less generous borrowing terms that such projects are likely to receive, they are also said to be befuddling some bankers, who are unsure about how to apply the HVCRE standards.

“What’s going on right now is we’re sort of at an inflexion point where nobody in the commercial banking world knows exactly how to size it up or evaluate it, because it’s only recently been truly policed or enforced,” said Thomas Harp, senior vice president and relationship manager for U.S. Bank. “Nobody really knows how to make heads or tails of it. I think eventually this is all going to equalize where everyone is treating it equally. We’re just not quite there yet.”

Aside from the 15 percent capital contribution requirement, the HVCRE standard applies to loans where the lender is able to take a distribution. And since the standard is being enforced retroactively, many banks already have many HVCRE loans on their books.

“If your loan docs allow you to take any distribution whatsoever, whether it’s even a dollar, all the sudden your loan is classified as HVCRE,” Harp said. “At U.S. Bank, we have $10 billion in construction loans on the books, and I can almost guarantee you that all of them allow return on or return of capital, so our capital costs are about to get dinged in a very big way.”

Banks are likely to respond by making fewer construction loans, Harp said.

“We can certainly do [fewer] construction loans,” he said. “That seems to be the message from regulators, ‘Hey, guys. You’re overdoing the construction business. This regulation is meant to have you tap on the brakes and look elsewhere.’ And we’re doing exactly that. We’re probably going to do a lot more fully funded term lending structures going forward, versus the construction loans.”

The situation may create an opening for non-bank lenders to take a greater share of the construction loan market.
“This is an advantage for us because you have this unintended consequence where you have the guys who are creating value can’t get a bank loan,” said Adam Zoger, principal of real estate finance and investment management firm PCCP LLC.

He said that a borrower who has already invested a great deal to improve a property, and possibly run afoul of the HVCRE standard, is likely to be a better credit than a borrower who acquired a property at market rate.

“This guy is going to step up and protect his property a lot more because he has a lot of money at risk,” Zoger said.

He said that the HVCRE standard is also intimidating some bankers.

“There are a handful of banks who basically look at this and go, ‘It’s just another bucket. I just have to charge more. I’m going to do it,’” Zoger said. “And then there’s, I’d say nine percent of the banks, that say, ‘Oh my God. My clients and regulators say don’t put anything more in there because I’m just going to have to go through another audit. I don’t want to deal with it.’”

“It’s going to be interesting how this plays out. But while it plays out, debt funds like us that do construction are going to be able to take advantage of it,” concluded Zoger.

West Coast Commercial Real Estate News