New Proposed Simplified Capital Rules Will Affect Small Banks’ Commercial Real Estate Lending
The federal banking agencies recently issued a notice of proposed rulemaking with the goal of simplifying banks’ capital rule calculations. The new capital rules will apply only to those banks following the standardized approach to calculating the banks’ capital and not to those that use the advanced approaches. One of the regulators’ proposed changes is to the capital treatment of commercial acquisition, development and construction loans or refinances of such loans (ADC loans) from 150% risk weight to 130% risk weight. While on its face this seems to be an improvement, the proposed rule would eliminate an exemption to the current HVCRE rules that banks have been using to assign a 100% risk weight to certain commercial construction loans. With the elimination of this exemption more construction loans will be assigned a 130% risk weight rather than 100% risk weight.
When do the new rules go into effect? These new rules are still in the discussion stage and may be revised before they become final. The regulators are receiving comments for the next 60 days, after which they will issue final rules affecting ADC loans.
What’s the existing treatment of commercial construction loans? Under the existing HVCRE rule, if a commercial construction loan meets certain criteria then the risk weighting for that loan is 100% rather than 150%. That criteria includes an 80% LTV ratio, requiring the borrower to contribute at least 15% of the as completed appraised value of the property to the project in cash or readily marketable assets, which cash has to be used before loan proceeds are disbursed and requiring the borrower to maintain internally generated equity in the project (the so-called contributed capital exemption). If it fails to include all of the previous restrictions then it is assigned a 150% risk weight. As you can imagine, interpretation of the requirements varies widely among banks.
What’s the new rule? The agencies tried to simplify the contributed capital exemption but in the end decided to eliminate the contributed capital exemption altogether. If a loan is an ADC loan (including a refinance of a loan that was an ADC loan), as defined by the agencies, then that loan is assigned a risk weight of 130% and there is no contributed capital exemption to the new capital rule. So, if your bank was relying on the contributed capital exemption to assign a 100% risk weight to your commercial construction loan then the risk weighting of that commercial construction loan will increase under the new rules.
What about existing loans? If the final rules don’t change, the agencies will not require (or allow) the risk weighting of HVCRE loans made before the effective date of the new rule to be calculated under the new capital rules. You will be living with the existing risk weighting of the existing loan for the term of the loan.
What loans are HVADC loans? Under the proposed rule, if the commercial loan is primarily for acquisition, development or construction of buildings or dwellings, including addition to or alterations of existing structures, and including any refinance of a loan that was originally for acquisition, development or construction of a building or dwelling, then it will be subject to the new rule, which the regulators call the HVADC rule, unless a specific exception applies. The regulators define “primarily” as 50% or more of the loan proceeds are used for the ADC activities. For example, if a loan is going to be used to purchase equipment and to develop land then the part of the loan that is to purchase the equipment has to exceed 50% of the entire loan proceeds and your records should back up that conclusion.
What ADC loans are not HVADC loans?
1. One-to-four family residential properties loans. Townhouses or row houses are also excepted but condo and cooperative loans are HVADC loans unless the total number of condos or cooperatives are five or fewer.
2. Agricultural loans.
3. Permanent loans. What’s a permanent loan? The regulators say a permanent loan is a prudently underwritten loan that has a clearly identified ongoing source of repayment to service repayment of the loan aside from the sale of the property. So, vacant land loans are always subject to the new HVADC rules. Loans that can be repaid from a borrower’s other sources of revenue would be excepted. Bridge loans are not excepted unless the borrower can otherwise make the payments from sources outside of the proceeds of the bridge loan. Interestingly, the loan can be an interest only loan but the lender will still need to prove that the borrower had a clearly identified source of repayment other than the sale of the property.
4. Community Development loans.
What should you do before the final rules go into effect? If you have a commercial ADC loan that would qualify for a 100% risk weight treatment under the existing HVCRE rules you might want to consider making the loan before the new HVADC rules go into effect. Unfortunately, since the final rules haven’t been announced yet, we don’t know when they will go into effect.
DISCLAIMER: The information provided is for general informational purposes only. This post is not updated to account for changes in the law and should not be considered tax or legal advice. This article is not intended to create an attorney-client relationship. You should consult with legal and/or financial advisors for legal and tax advice tailored to your specific circumstances.