On September 18, 2018, the federal banking agencies issued a release with a proposed rule to implement the changes made to the capital treatment of certain high-volatility commercial real estate (“HVCRE”) loans by section 214 of the Economic Growth, Regulatory Reform, and Consumer Protection Act (“EGRRCPA”). The deadline for comments on the proposal is 60 days after publication of the proposal in the Federal Register and thus will likely fall in late November.
Before turning to the substance of section 214 and the proposed rule, two features of the implementation of section 214 are worth noting. First, because section 214 took effect immediately upon enactment, the agencies provided initial guidance more than two months ago on how to report loans subject to section 214 in the call report. This guidance remains in effect, even though the proposed rule is unlikely to be finalized for several months. Second, section 214 by its terms applies only to capital treatment at the bank level, but under the proposed rule, the Federal Reserve Board would apply section 214’s changes to holding companies as well.
Background on Section 214. The Basel III-based capital standards, which took effect in 2015, apply a risk weight of 150 percent (rather than the standard 100 percent) to HVCRE loans – commercial real estate (“CRE”) loans that do not satisfy certain conditions, among them a requirement that a borrower make a capital contribution to the financed project of at least 15 percent of the project’s value. Responding to concerns that the scope of the definition of an HVCRE loan and the higher risk weight may depress CRE lending, Congress in section 214 limited the enhanced risk weight to a smaller group of acquisition, development, and construction loans that are termed “HVCRE ADC” loans. In addition to reducing the types of loans potentially subject to the 150 percent risk weight, section 214 permits a borrower to make the required capital contribution in forms other than cash or marketable securities, and allows a bank to reclassify an HVCRE ADC loan as a non-HVCRE ADC loan before the loan is paid off or replaced by permanent financing.
The Proposed Rule. Under section 214, an HVCRE ADC loan is “a credit facility secured by land or improved real property.” The proposed rule would define such a facility consistently with the Call Report definition of “a loan secured by real estate.” Such a loan is one where the estimated value of the real estate collateral at origination (after deducting senior liens) is greater than 50 percent of the principal amount of the loan at origination.
A loan that meets this definition of a credit facility is not automatically subject to the higher risk weight. Section 214 limits the scope of HVCRE ADC loans to loans that meet three standards – the loan must primarily finance or refinance the acquisition, development, or construction of real property; the purpose of the loan must be to turn the property into income-producing property; and the repayment must depend upon the future income or sales proceeds from (or the refinancing of) the property. The proposed rule would incorporate these conditions, noting that these determinations are made only once, at the time of the loan’s origination.
Additionally, loans that otherwise have the elements of an HVCRE ADC loan may fall into one or more of the exclusions in the definition. The capital rules already contain four exclusions for one- to four-family residential properties, community development investments, agricultural land, and CRE projects that meet certain prerequisites. The proposed rule would refine the application of these existing exclusions as follows:
- Commercial real property projects. The current capital rules exempt an HVCRE loan from the 150 percent risk weight if it satisfies several criteria, among them: (i) a capital contribution by the borrower in the form of cash or readily marketable assets to the project of at least 15 percent of the real property’s appraised “as completed” value; and (ii) a provision in the loan agreement that requires the 15 percent contribution to remain in the project until the loan is paid off or replaced by permanent financing. Section 214 eases these requirements in certain respects. Real property or improvements are acceptable forms of the capital contribution. Additionally, the project may return the contribution to the borrower while the loan is still outstanding if the loan is re-classified as a non-HVCRE ADC loan. The proposal rule would implement the requirements for this exclusion as follows:
- Contributed capital. The proposed rule would offer further explanation of the new types of eligible contributions. A contribution in the form of paid development expenses out-of-pocket (a type of contribution already recognized in the current capital rules) would include costs incurred by the project and paid by the borrower before the advance of funds. For a contribution in the form of real property (a new provision in section 214), the value of this property would be determined under the appraisal standards. The value of such a contribution would be reduced by the aggregate amount of any liens on the property that secures the loan.
- “As completed” value appraisal. The proposal would modify the requirement (already contained in the current capital rules) that contributed real property be appraised on an “as completed” basis. This type of appraisal may not be available for certain loans, in which case the proposal would permit an “as is” value appraisal. In addition, consistent with the appraisal regulations (including amendments elsewhere in EGRRCPA), the proposed rule would permit a bank to use an evaluation, rather than an appraisal, for a commercial real estate transaction under $500,000 that is not secured by a single one- to four-family residential property and for certain transactions with values of less than $400,000 involving real property or an interest in real property that is located in a rural area.
- Project. The necessary amount of a contribution depends on the value of the financed project. The proposal recognizes that some projects may be part of multiple phases or stages of a larger project. In such a case, a loan financing a particular phase or stage would be eligible for the contributed capital exclusion only if the phase or stage has its own appraised “as completed” value (or an appropriate evaluation).
- One- to four-family residential properties. The proposed rule would align this exclusion with the definition of a one- to four-family residential property in the interagency real estate lending standards. Notably, two categories of loans would not be eligible for this exclusion: loans to finance the construction of condominiums and cooperatives and loans used solely to acquire undeveloped land regardless of how the land is zoned.
- Community development investment. This exclusion would cover any loan that would qualify as a community development investment under the Community Reinvestment Act regulations.
- Agricultural land. This kind of loan would be synonymous with a loan reported as a loan secured by “farmland” in the Call Report. This term includes all land known to be used or usable for agricultural purposes but not farm property construction or land development.
Section 214 also adds two more exclusions that cover loans on certain income-producing property and reclassified loans, which the proposal would implement as follows:
- Loans on existing income-producing properties that qualify as permanent financings. For this exclusion, which has been added by section 214, the proposed rule would largely adopt the language of the statute. The exclusion covers a loan secured by a mortgage on the property, where the cash flow generated by the real property covers the debt service and expenses of the property, in accordance with the lending bank’s underwriting criteria for permanent loans. The agencies would review the underwriting criteria as part of the regular supervisory process.
- Reclassification as a non-HVCRE loan. The proposed rule would adopt the language of the statute as to a reclassification: a loan initially classified as an HVCRE ADC loan ceases to be one when development of or construction on the property is substantially complete, and the cash flow generated by the property covers debt service and expenses.