Banking Regulations Could Mean Trouble For Construction Financing

Fall 2015

New regulations have made lending to commercial real estate development more costly for financial institutions. 

THE BASEL III BANKING regulations could have an important impact on a developer’s bottom line — and on whether a planned development project even goes forward.  

Basel III is the regulatory framework promulgated by the Basel Committee on Bank Supervision, an international body composed of banking regulators from around the world. Banks utilize the framework established by the Basel Committee to calculate the amount of capital they must hold against specific types of loans on their books. Since the financial crisis of 2008, the Basel Committee has aimed to issue standards that will strengthen the international banking system’s ability to withstand a similar shock. These include the imposition of stricter capital requirements for banks on some loans.  

The Basel III standards impose increased capital requirements on banks for acquisition, development and construction (ADC) loans for commercial real estate projects. These commercial construction loans are now designated as “high-volatility commercial real estate” (HVCRE) loans, and banks are required to assign these a “risk weight” of 150 percent, compared to other business loans, for purposes of calculating the capital they must hold against these riskier loans. In other words, for a HVCRE loan, the bank now has to keep capital in the amount of 150 percent of the capital it would keep for other loans. This makes lending to commercial real estate development more costly for the financial institution. Banks therefore can be expected to either reduce their construction lending or, more likely, increase the amount they charge borrowers for these loans. 

To avoid being designated as a HVCRE loan, the loan-to-value ratio must be less than 80 percent, and the borrower must contribute capital — in the form of cash or unencumbered marketable assets — equivalent to 15 percent of the “as completed” value of the property before any funds are advanced by the bank. Funds generated by the project — capital generated by operations — must be kept in the project until the construction loan is converted to permanent financing, the project is sold or the loan is paid off in full. 

What makes these new requirements particularly problematic is that when the borrower’s equity contribution is determined, land contributions must be valued by the bank at the property’s cost, not at its current market value, which may have appreciated significantly. This has a big impact on those who have held land for longer periods of time. Those seeking to develop projects on land they had acquired years or decades ago therefore may need to contribute more money to avoid HVCRE designation and a higher-cost loan. This leads to certain illogical outcomes. For example, a developer who bought a parcel of land 10 years ago and held onto it while it appreciated would be in a worse position — in terms of having to come up with its equity contribution for a loan — than someone who more recently purchased an adjacent parcel of equal value. 

Loans in existence before the effective date of the regulation are not grandfathered, meaning that banks have to review their portfolios, determine which loans are HVCRE, and then reserve additional capital against these loans. It is unclear at this point what overall effect the new approach will have on commercial construction lending, and the costs may be difficult to quantify until banks have had more experience with the new standards. But banks likely will increase origination fees or the interest rate they charge for commercial construction loans in order to offset their lower returns and decreased profitability. Smaller banks could be forced to shift a large part of their focus away from construction lending. 

When these proposals were first floated in 2012 by the banking regulators, NAIOP and a coalition of real estate organizations strongly opposed them, warning of the problems they might cause for commercial real estate. In April 2015, the banking regulators issued long-awaited “clarifications” that many believed would soften the impact of the new rules, but the new guidance did nothing to resolve the many problems identified by the CRE industry. While the regulators had signaled some desire to possibly change the rules regarding internally generated capital, there was less agreement on addressing the appreciated land value issue. As a consequence, we will continue to work with the banking industry and our real estate allies to ensure that banking regulators understand the impact on the industry, as well as educate our elected officials about needed changes.