High Volatility Commercial Real Estate Loans: Guidance for ...media.straffordpub.com/products/high-volatility-commercial-real-estate-loans-guidance...Mar 29, 2016 · High Volatility

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Presenting a live 90-minute webinar with interactive Q&A

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

TUESDAY, MARCH 29, 2016

Keith A. Mrochek, Partner, Troutman Sanders, Charlotte, N.C.

Martin W. Taylor, Partner, Troutman Sanders, Irvine, Calif.

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High Volatility Commercial Real Estate Loans

Developer & Lender Perspectives

Keith Mrochek and Marty Taylor

March 29, 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


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


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”


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


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

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• 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)


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)



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 . . .”



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”



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



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?



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



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”



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)


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


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)


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


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]

31

mailto:[email protected]

mailto:[email protected]

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High Volatility Commercial Real Estate Loans: Guidance for ...media.straffordpub.com/products/high-volatility-commercial-real-estate-loans-guidance...Mar 29, 2016 · High Volatility