April 4, 2016 HVCRE Explained

The increased risk weight for banks as it relates to high volatility commercial real estate (HVCRE) went into effect at the beginning of this year. The result is that all acquisition, development and construction (ADC) CRE loans must be reported separately from other CRE loans and are to be assigned a risk weighting of 150% for risk-based capital purposes – above the typical requirement of 100%. This will have a significant impact on banks’ capital ratios and ability to lend at historic pricing levels. It is important to note that these restrictions are related to real estate, specifically construction, and not the macro-economy.

However, there are some exceptions for qualifying commercial ADC loans allowing a risk weighting of 100% if the following requirements are met:

  1. LTV ratio does not exceed regulator maximum LTV ratio for particular loan
  2. Borrower has contributed at least 15% of the appraised as completed value (can structure mezz as preferred equity which will count towards the 15% minimum requirement)
  3. The 15% contribution was met before the funding of the ADC loan and the capital remains in the project until the loan is paid in full or converted to permanent financing (meaning no distributions of excess cash flow to borrowers while the construction loan is in effect)

The HVCRE requirements are changing the way lenders reserve for construction lending and impacting availability and pricing, including becoming more conservative in terms of leverage or asking for partial recourse. Lenders are more focused on leverage and execution. Many lenders are now topping out at 60% LTC for construction, with a heavy focus on pre-leasing. Other lenders are also pulling back on specific property types – like hospitality, spec office, retail – and have decided to pause construction loans altogether, unless the deal is highly compelling or a repeat borrower.

We have arrived at an inflection point in which lenders are becoming more sensitive to construction and more focused on clean deals to avoid scrutiny by internal credit committee and regulators.