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New HVCRE Capital Requirements and the Commercial Real Estate Sector
Following the financial and banking crisis from 2008 to 2013, almost 500 banks failed. The cost to the FDIC fund came in around $73 billion including $12 billion from the failure of IndyMac, the most expensive failure in FDIC history. One of the outcomes of the crisis was an overhaul of banking regulations, including higher capital requirements for High Volatility Commercial Real Estate (HVCRE). The regulators deemed certain commercial construction loans to be riskier than others and the new requirements were designed to protect financial institutions in the event of a loss from failed construction loans. The 2015 regulations required that HVCRE loans carry a 150% risk weight for loans that finance the acquisition, development or construction of real property. That means covered lending institutions must reserve $1.50 per $1.00 of capital compared to non-HVCRE loans. This, of course, adds costs and limits to credit availability for commercial real estate borrowers.
Nearly three years later, a new law amends multiple provisions of Dodd-Frank, including the capital requirements for construction loans secured by HVCRE.
The Economic Growth, Regulatory Relief, and Consumer Protection Act was recently made into law to relieve some of the stipulations for lenders and borrowers brought about by the post-crisis reforms. The overarching goal of the Act was to bring some regulatory relief to community banks across the U.S.
The new law includes changes to the HVCRE requirements, including:
- HVCRE loans now have a narrower focus that doesn’t require in-place income
- A newly defined, High Volatility Commercial Real Estate Acquisition, Development or Construction loan (HVCRE ADC Loan), means that the loan must now “primarily” finance the acquisition, development or construction of real property. It must also intend to finance the conversion of the project to income-producing real property that’s dependent on “future” income or proceeds.
- Improvements to existing income-producing real property won’t be covered if the prior income generated by the existing property can cover debt service and related expenses
- Borrowers can now get credit for the appreciation of contributed land above the purchase price paid
- The loans will now be reclassified as non-HVCRE when cash flow from the property is substantial enough to cover the debt, or upon significant completion of the project.
What does this mean for commercial real estate sector?
HVCRE maintains demanding lending requirements, but the Act introduced a more limited scope and new options to alleviate the duration of the heightened capital requirements for HVCRE.
The lower capital requirements free up credit availability for borrowers, which will drive new real estate development. In addition, financial institutions have a greater incentive to lend with the potential for a lower price tag for borrowers on construction loans.