Since the 2008 financial crisis, federal financial regulators have tightened their requirements for capital and liquidity for lenders. Concerns about underwriting standards that led to the mortgage bubble and collapse led to new, stricter risk weighting levels for lenders in certain loan categories under Basel III rules. Designed to increase capital reserves at financial institutions, the long term effect has actually dampened liquidity in the Commercial Real Estate sector, especially for new development loans.
Current Basel III rules expanded from only the largest banks to all banks on January 1, 2015. Now all federally regulated institutions must identify which of its Acquisition, Development and Construction (ADC) loans qualify as High Volatility Commercial Real Estate (HVCRE) loans. These HVCRE loans require the bank to risk weight those loans at 150% (compared to 100% for non-HVCRE loans).
A higher risk weighting means the bank must hold more capital in reserve for this subsection of loans. That, and the higher cost to administer reporting for HVCRE loans have led to many banks re-examining their lending allocations for development and construction. With more banks effected since 2015, the result on the overall CRE loan market include:
- Less lending capacity for new construction loans, even as existing construction loans convert to permanent financing.
- Increased costs in compliance reporting for banks, estimated to translate into between 50 and 100 basis points per loan.
- Lenders tightening underwriting criteria to avoid HVCRE designation by either requiring a minimum of 15% capital (paid in with cash not necessary land contributions) by the sponsor at origination or lower loan to value ratios.
- Lenders strive to move construction loans into permanent financing sooner after completion, decreasing the amount of time developers are allowed to achieve stabilization.
After a year of heightened enforcement on all financial institutions regardless of size, 2016 has seen movement towards correction in the industry. This spring, an Independent Community Bankers of America petition gathered almost 15,000 signatures in support of removing community banks from the Basel III requirements. H.R. 3791 passed in the House of Representatives in April approving that relief. In June the Senate Banking Committee held hearings on bank capital and liquidity, but the Senate has yet to take formal action on the matter.
Several members of Congress recently wrote Fed Board Chair Janet Yellen, Comptroller Thomas Curry and Fed Chair Martin Gruenberg citing the “overly broad and complex” definition of HVCRE, and its disproportional effect on both community banking and the commercial real estate industry in general, noting the CRE segment generates more than 20% of our nation’s GDP. A link to the letter is here: June 8, 2016 Congressional Letter to Yellen, Curry and Gruenberg.
President Obama was elected two months after the collapse of Lehman Brothers and the subsequent melt down on Wall Street. That has no doubt effected the Administrations’ tighter regulation of the entire financial industry over the past 8 years. With the changing attitude in Congress this summer, the upcoming election may offer relief from the Basel III HVCRE requirements to our community bank and development clients. Davis & Kuelthau, s.c. will continue to monitor this issue and share any updates as they become available.