Client Alert: Basel III Impact on Commercial ADC Loans

January 14, 2015

Basel III (updated capital rule) requires banks to maintain capital based in part on the riskiness of the assets in their portfolios. To the extent more capital is required to support a transaction, that transaction is likely to be priced at a higher interest rate. Alternatively, the bank may work with the borrower to reduce the risk in the loan. That is particularly true when it comes to “high volatility commercial real estate” (HVCRE). This category includes acquisition, development and construction (ADC) loans excluding 1-4 family residential properties, certain community development investments and ag land. These HVCRE loans require a risk weighting of 150%. The HVCRE category doesn’t apply if the commercial ADC loan is less than the supervisory loan to value ratio (LTV), which is 75% for development and 80% for construction, and the borrower meets certain equity requirements.

Here is the whole text from the regulation as to the requirements for excluding a commercial ADC loan from the HVCRE category:

(i) The loan-to-value ratio is less than or equal to the applicable maximum supervisory loan-to-value ratio in the OCC's real estate lending standards at 12 CFR part 34, subpart D (national banks) and 12 CFR part 160, subparts A and B (Federal savings associations);

(ii) The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15 percent of the real estate's appraised “as completed” value; and

(iii) The borrower contributed the amount of capital required by paragraph (4)(ii) of this definition before the national bank or Federal savings association advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project. The life of a project concludes only when the credit facility is converted to permanent financing or is sold or paid in full. Permanent financing may be provided by the national bank or Federal savings association that provided the ADC facility as long as the permanent financing is subject to the national bank's or Federal savings association's underwriting criteria for long-term mortgage loans.

ADC loan agreements should be modified to include something like the following:

Borrower represents that it has contributed cash or unencumbered readily marketable assets or has paid development expenses out of pocket in an amount equal to at least 15% of the appraised “as completed” value of the project (“Initial Capital”). The appraised “as completed” value shall be determined by an appraisal prepared for the Bank in accordance with the loan commitment.

Through the life of the interim construction loan, Borrower agrees that it will continuously maintain the Initial Capital and retain such Initial Capital until this interim construction loan is converted to permanent financing, the project is sold, or this facility is paid in full.

Typical underwriting processes require “skin in the game.” However, the Basel III rules add a bit more. Therefore, cautious banks who are concerned about increased capital costs will need to amend their loan agreements to cover this issue or consider this additional capital cost in pricing such loans. The rule has already been applied to the mega banks. However, this became applicable to community banks as of January 1, 2015.

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