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The audio portion of the conference may be accessed via the telephone or by using your computer's
speakers. Please refer to the instructions emailed to registrants for additional information. If you
have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
High Volatility Commercial Real Estate Loans:
Guidance for Developers and Lenders on
HVCRE Rules and Loan Covenants Navigating Borrower Contributed Capital Rules, Maximum LTV Ratio,
Conversion to Permanent Financing and More
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
THURSDAY, MAY 5, 2016
Keith A. Mrochek, Partner, Troutman Sanders, Charlotte, N.C.
Martin W. Taylor, Partner, Troutman Sanders, Irvine, Calif.
Presenting a 90-Minute Encore Presentation of the Webinar with Live, Interactive Q&A
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FOR LIVE EVENT ONLY
High Volatility Commercial Real Estate Loans
Developer & Lender Perspectives
Keith Mrochek and Marty Taylor
May 5, 2016
• HVCRE means High Volatility Commercial Real Estate
• Source Materials
– Basel III - Created Final Rule on Risk Based and Leverage Capital
Requirements For FDIC Insured Financial Institutions
– US Mortgage Bankers Association Letter
– Joint Agency Response – Frequently Asked Questions on the
Regulatory Capital Rule dated March 31, 2015
– HVCRE Exception August 2015 Troutman Sanders Advisory
What Is HVCRE and Why Does it Matter?
6
• What Is It – a Classification Exposure for Risk
Weighting
• General Capital to Risk Rated Assets Ratios;
– Common equity Tier 1 capital to risk-weighted assets ratio of 4.5%;
– Tier 1 capital to risk-weighted assets ratio of 6%;
– Total capital to risk-weighted assets ratio of 8%.
• Risk Weighting of Loans
– General risk based capital rules for Real Estate Secured Loans –
100% Risk Weighting
– Multifamily loans – reduced risk weight of 50% for eligible MF loans
– Loan with HVCRE Exposure – 150% Risk Weighting
What Is HVCRE and Why Does it Matter?
7
• Higher the risk weight the higher the denominator for the
capital requirement ratio - the higher the Capital Required
• HVCRE = Higher Capital Requirements
• Higher Capital Requirements = Higher Cost to Lender
• Higher Cost to Lender passed on to Borrower?
– Indemnity provisions
– Higher interest rates
What Is HVCRE and Why Does it Matter?
8
• Neither the Borrower nor the Lender want HVCRE Exposure if
it can be avoided
• To best accomplish this goal, we need to understand:
– What type of loans have HVCRE Exposure
– What the exceptions are to HVCRE Exposure
– Available alternative loan provisions/solutions to minimize
impact
Shared Goal – Avoid HVCRE Exposure
9
It is Broad - General Rule
• Any Commercial Real Estate Loan that is an ADC Loan will
have HVCRE Exposure unless an exception applies
• ADC = Acquisition, Development or Construction Loan
What Loans Have HVCRE Exposure
10
What About :
• Loans Made prior to the effective date of the Rule?
– HVCRE Applies – (FAQ Response No. 2)
• Land Loans with no construction or development
component?
– HVCRE applies unless permanent financing in compliance with
Lender’s general underwriting criteria for such permanent financing
(FAQ Response 12)
• Loans where only a component of the Loan is for ADC?
What Loans Have HVCRE Exposure (cont’d)
11
What About (cont’d):
• Loans where only a component of the Loan is for ADC?
– Only that portion of the loan that is ADC is considered HVCRE (FAQ
Response 13)
• “Loans with Subsequent Advance Components?
– A loan is an ADC Loan and not a permanent loan if
• (1) the Loan is based on the “as completed” value and
• (2) There will be future advances on the Loan
(FAQ Response 9)
If Exposed, How Long Does HVCRE Exposure Last ?
“The life of the Project”
What Loans Have HVCRE Exposure (cont’d)
12
The Four Exceptions to the General Rule
• The Loan is for One- to Four-Family Residential Properties
• Loan qualifies as an investment in community development
under applicable law
• Agricultural Loans
• Loans that Satisfy LTV Requirements and Equity
Requirements
What Loans Have HVCRE Exposure (cont’d)
13
• Exception No. 4 is broken down into 3 – okay 4 – subparts
– Clause (i) - The LTV Requirement
– Clause (ii) - The 15% Contributed Capital Requirement
– Clause (iii) –Two Part Test
• The 15% Contributed Capital Requirement is satisfied prior to any Loan
Advance
• Contractual Restriction Against Distribution of Previously Contributed
Equity or Internally Generated Equity
• Each of these Subparts are independent and each must be
satisfied for this exception to apply
HVCRE Exception 4 – Overview
14
• The LTV ratio must be less than or equal to the applicable
maximum loan-to-value ratio for the particular type of loan –
current regulations provide for the following maximum LTVs: • Raw land – 65%
• Land Development – 75%
• Construction – commercial, multi-family (“for sale”), and other non-
residential – 80%
• Construction – 1-4 family residential – 85%
• Construction – improved property – 85%
• Satisfaction of this Exception is determined at
Closing/Origination (FAQ Response 14)
HVCRE Exception 4 – Clause (i)
The LTV Requirement
15
• The Borrower has contributed capital to the project of at least
15% of the appraised “as completed” value
– As completed value is a higher standard than an “as-is appraised
value”
– As completed value is a lower standard than an “as-stabilized
standard
– [Note - This 15% jibes with the highest allowed LTV Maximum and
seems to suggest that as completed is also used as the appraised
value standard when determining whether the LTV requirement has
been satisfied – See also last paragraph of FAQ response 6]
HVCRE Exception 4 – Clause (ii)
The 15% Contributed Capital Requirement
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• What qualifies as contributed capital?
– Cash
– Unencumbered readily marketable assets
– Paid out-of-pocket development expenses (“soft costs” - FAQ No. 8
response)
– Cash paid for the land
• What does not qualify?
– Borrowed Money
• Debt of Borrower, whether secured subordinated financing of Borrower or
unsecured debt of Borrower (FAQ Response Nos. 5 and 16
– Other Collateral Pledged in Support of the Loan
(e.g., cannot pledge another asset to Lender to satisfy requirement)
HVCRE Exception 4 – Clause (ii)
The 15% Contributed Capital Requirement (cont’d)
17
• What does not qualify?
– Borrowed Money
• Debt of Borrower, whether secured subordinated financing of
Borrower or unsecured debt of Borrower
– Other collateral pledged in support of the loan
(e.g., cannot pledge another asset to Lender to satisfy requirement)
– Deposits (reservation, security, purchase, etc. deposits - FAQ
Response 4)
– Contributed Land Value (FAQ Response No. 7)
– A governmental grant (FAQ Response No. 11)
HVCRE Exception 4 – Clause (ii)
The 15% Contributed Capital Requirement (cont’d)
18
• What about the following?
– Mezzanine Financing?
– Credits (Fee credits, etc.)?
– Does the Joint Agency Response FAQ No. 4, which states the purpose
of the contributed equity requirement, provide any help?
“To ensure that the borrower maintains a sufficient economic interest
in the property and to provide a margin between the loan amount and
the value of the project to provide protection to the Lender against
loss . . .”
HVCRE Exception 4 – Clause (ii)
The 15% Contributed Capital Requirement (cont’d)
19
• First Part of Clause (iii) Test – Timing Requirement for
Satisfaction of the 15% Contributed Equity Requirement
– The 15% must be satisfied prior to advance of Loan Proceeds
(FAQ Response No. 1)
– Not Curable – Must be satisfied at loan origination
(FAQ Response No. 2)
– Note – No more nominal funding at close to ensure priority
HVCRE Exception 4 – Clause (iii) –
Part One of the Two Part Test
20
• Second Part of Clause (iii) Test – Contractual Restriction
Against Distributions
“. . . . 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”
HVCRE Exception 4 – Clause (iii) –
Part One of the Two Part Test
21
• Does this relate to only the 15% Equity or all equity?
– All Contributed Equity
• What does internally generated by the Project really mean?
– Net operating income and any other distributable funds generated by
the Project
– Note – Could a Borrower make advances to owners?
• Effect is to Trap Both Contributed and NOI in the Project • Punishment of the Conservative Borrower
• Resulting Higher Costs of Capital
HVCRE Exception 4 – Clause (iii) –
Part One of the Two Part Test
22
• What Does “Contractually Required” mean?
– The loan must include provisions which require that all contributed
and all internally generated capital remain in the Project for the life of
the Loan. (FAQ Response 15)
– Is there any requirement what the consequence of violation needs to
be?
• Event of Default Required
• Other Consequences ?
– Increased Interest Rate?
– Payment/Reimbursement of Lender’s Increased Costs?
HVCRE Exception 4 – Clause (iii) –
Part One of the Two Part Test
23
• What Does “Life of the Project” mean?
– Until either Converted to Permanent Financing, paid in full or sold
– What does Converted to Permanent Financing mean?
• Existing Lender can provide the permanent financing so long as it satisfies
the bank’s criteria for long term mortgage loans
• Converted to a Permanent Loan
HVCRE Exception 4 – Clause (iii) –
Part One of the Two Part Test
24
• What About Within the Loan Itself - Conversion Conditions
Within Existing Loan?
– There does not appear to be any prohibition against
– The term “converted” is used throughout and the existing Lender is
permitted to be the permanent loan lender
– Criteria seems to be only that the permanent financing satisfies the
bank’s “normal lending terms” (FAQ Response No. 17) and
“underwriting criteria”.
– Last Sentence of FAQ Response No. 17 though says “Generally, this
would involve a new credit facility in the form of a term loan replacing
the ADC Loan”
HVCRE Exception 4 – Clause (iii) –
Part One of the Two Part Test
25
• Structure – to Possibly Avoid/Minimize HVCRE Exposure
Consider Possibility of Loan being underwritten as a
Permanent Loan – Not an ADC Loan
– Consider Maximum LTV based on as-is value if possible to avoid
HVCRE
– Consider Reserve vs. Holdback (subsequent advance) structure if
small renovation/TILC component
– Consider two Loans if there is Permanent Component
• If a portion of the loan would satisfy permanent underwriting criteria,
consider providing two separate loans or loan components
Loan Provisions To Consider
26
Structure to Maximize Ability to Qualify for HVCRE Exception
• Closing Conditions
– Expressly state Maximum LTV based on Completed Value
– Expressly state required Equity Contribution of at least 15% of
Completed Value
• If not a Closing Condition, must be an initial advance condition precedent
– Create and maintain detailed records to support determination
• Bank files should contain detailed backup information as to Bank’s
determination that this condition has been satisfied(FAQ Response No. 7)
• Not just listing a number but what that number consists of for land value
(obtain a closing statement), hard and soft costs (obtain a line item
statement for all hard and soft costs), cash contributed (bank statements)
Loan Provisions To Consider
27
• Covenants
– Consider Expressly stating that no distributions are permitted,
including any contributed capital or internally generated capital
– Consider minimizing adverse impact of this Section by permitting
distributions upon the earlier of payoff or conversion of loan to a
permanent loan
– Consider more generic provision which prohibits distributions but then
permits them to the extent it is determined that such distribution
would not result in HVCRE exposure, whether as a result of:
• the loan satisfying permanent loan conditions or
• A change in law
Loan Provisions To Consider
28
• Consider Take Out Commitment for Permanent Loan
• Consider setting forth detailed conditions of conversion
within Existing Loan
– Minimum DSCR
– LTV based on actual as-is value
– General statement that Lender has determined that its general
underwriting conditions for permanent loans have been satisfied
(which likely include many of the conditions set forth for the subject
loan)
Loan Provisions To Consider
29
• Protect Against Increase Costs of HVCRE Exposure
– Consider providing for alternative consequences other than an Event
of Default for violation of the HVCRE distribution restriction covenant
• an increase in the interest rate
• payment of increased costs of lender
• Remember when drafting:
HVCRE Rules May Very Well Change During Loan Term
Loan Provisions To Consider
30
Thank you for attending
Your Presenters:
Keith Mrochek Marty Taylor Troutman Sanders LLP Troutman Sanders LLP
301 South College Street Suite 3400 5 Park Plaza, Suite 1400
Charlotte, North Carolina 28202 Irvine, California 92660
704-998-4059 949-622-2718
[email protected] [email protected]
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