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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   June 2015

Look Into a High-Volatility Future

New regulatory capital rule highlights ‘upon completion’ appraisal values

Look Into a High-Volatility Future

If you work for a bank that makes commercial real estate loans, chances are you’ve become familiar with High Volatility Commercial Real Estate (HVCRE) — either in 2014 if you’re in a larger bank or already this year if you’re in a bank with more than $500 million in assets. HVCRE is an important section of a new regulatory capital rule published by the federal financial institution regulatory agencies that implement the Basel III Accord, among other things.

Most importantly to commercial real estate, this new rule impacts the amount of capital a bank must set aside for certain commercial real estate loans. It also impacts the amount of capital developers may need to have in a project for the bank to avoid having to set aside additional funds to comply with HVCRE requirements.

Obviously, banks and developers prefer not to set aside additional funding for reserves. This has led to many questions from banks and developers about HVCRE as they try to peer into the future of regulatory capital.

When Basel III was first sent out for comment, the federal agencies proposed a 150 percent risk weighting (RWA) for HVCRE, a significant increase over the previous 100 percent risk weight. In the final rule, the agencies retained the 150 percent risk weight, but included several exemptions that could bypass this additional reserve amount, including:

  • Loans for acquisition, development and construction (ADC) of one- to four-family residential properties;
  • Loans to businesses or farms with gross revenues of $1 million or more; and
  • Loans that qualify as community development investments (i.e., affordable housing, including multifamily rental).

Other ADC loans may also qualify for this exemption. They must, however, meet three specific criteria. First, the loan must have a loan-to-value (LTV) ratio less than or equal to 80 percent. Second, the borrower must contribute capital to the project in the form of cash or unencumbered marketable assets of at least 15 percent of the appraised prospective market value upon completion.

Finally, the borrower’s capital must be contributed before bank funding and must remain in the project throughout the life of the project. A project is “concluded” once the credit facility is converted to permanent financing, sold or repaid in full. Some observers have predicted this final rule may make ADC loans less accessible as a result of lower LTV ratios, increased upfront cash equity by developers, stricter financial covenants, more scrutiny of construction deadlines and lease-up thresholds and shorter durations.

The need for capital and support

The third exemption also deviates from traditional bank credit practice. Typically, the equity provided is 15 percent or more of the project’s costs. Banks have generally considered the current market value of developable land to count as the borrower’s equity contribution — its “skin in the game.”

Banks facing potential loans that fall under HVCRE rules should use
professional appraisers who hold the MAI designation.

In a recent “Ask the Fed” webinar, respondents from the Federal Reserve confirmed that the agencies would treat land at the original purchase price — not its current market value — toward the 15 percent capital requirement. This means that, to comply with the HVCRE rule, developers who want to build on land previously acquired and held for development may need to bring more money to the table to prevent the lending institution from being forced to assign the higher risk weight.

Further, several commercial real estate lenders have said that appraisers are analyzing and handling entrepreneurial incentive, or the developer’s profit component, within appraisals that include opinions for the prospective market value upon completion. Some lenders have shared concern about overreliance on rules of thumb and have expressed a need for more support for where profit is earned along the development cycle continuum.

A familiar concept

The prospective market value upon completion concept is nothing new to the realm of appraisal. In fact, interagency appraisal and evaluation guidelines include a definition for the concept, and it is taught in appraisal courses because it is commonly requested in construction loan appraisals.

Essentially, the concept means determining what the market value of the project will be when construction is completed. This value is different from the prospective market value upon stabilization, illustrating that profit can be earned on a development incrementally. Typically profits can be realized in three periods in the development process:

  1. Entitlement (permitting/approval process);
  2. Construction; and
  3. Absorption/marketing (lease up/sell-out).

The market value upon completion includes the portion of entrepreneurial incentive attributable to entitlement and construction periods, but not the portion attributable to the marketing and absorption period.

Controlling the situation

Several methods are available to appraisers to analyze the treatment of entrepreneurial incentive in a development project, and they are taught in valuation-related courses. There are also steps banks can take to avoid complications that arise when using rules of thumb or analysis of the issue of entrepreneurial incentive.

Primarily, banks facing potential loans that fall under HVCRE rules should use professional appraisers who hold the MAI designation, as well as review appraisers who hold the AI-GRS (General Review Specialist) designation. They should also request that the entrepreneurial-incentive and lease-up adjustment methods are considered and correctly used in the development of the property’s prospective market value upon completion estimate.

Following these steps can help banks increase the credibility of appraisals used in construction projects. That, in turn, should assist in alleviating any confusion and additional scrutiny in response to HVCRE and the new regulatory capital rule.

Further elaboration from the agencies on HVCRE issues is likely to come in the months ahead. The acceptance of developable land is one issue, as is the application of the rule to certain development project types, such as condominiums. As always, banks should be sure to talk with the primary regulator, and managers can get ahead of these issues by ensuring that those preparing upon-completion appraisals have experience analyzing the issue of entrepreneurial incentive. 


 


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