July 17, 2016
Interviewed by: Privcap
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The New Lending Rules that Have Developers Worried

Developers could be forced to keep the net operating income of construction deals in their projects until the deals are stabilized thanks to new banking rules—a move that could dampen IRR and impact construction underwriting and lending.

Developers could be forced to keep the net operating income of construction deals in their projects until the deals are stabilized thanks to new banking rules—a move that could dampen IRR and impact construction underwriting and lending.

New Lending Rules to Force Developers to Hold NOI in Deals
With Jade Newburn of Mayer Brown

Q1: How are construction loans impacted by new rules affecting lenders of high volatility CRE?

Jade Newburn, Mayer Brown:

The high-volatility commercial real-estate loans are a classification of loans that relate to acquisition development and construction loans of U.S. banks. They came about with the U.S. regulators implementing the Basel III regulations. Fundamentally, the HVCRE regulations potentially change the amount of capital that a bank needs to hold for a loan if it’s classified as HVCRE. Of course, the issue with having to withhold more capital for any particular deal changes the economics of the loan from a lender’s perspective and, ultimately, to the borrower. That’s why it’s a pretty hot topic.

Q2: Is there mounting concern about the impact of these rules on distributions from projects?

Newburn: To avoid being a high-volatility commercial real-estate loan, one of the tests is that all the capital you put into the project—as well as all the capital internally generated from the project, which is effectively the NOI—needs to remain in the project for what the regulations say is the life of the project, which is effectively the conversion to permanent financing. What borrowers are struggling with more than anything is the test that all capital internally generated from the project may be held in the project. The reason is that there’s a period, once you complete the asset and prior to its stabilization, where you will actually have positive cash flow. And to have to keep the cash flow at the asset is a problem on a few different identifiable circumstances.

One is simply from a tax perspective. If a REIT is the borrower, the REIT must make distributions on an annual basis of virtually all of its cash. To the extent it can’t because of the HVCRE rules, that’s an actual real fundamental problem for the REIT. Another is simply for taxes. You could owe taxes on money you can’t get out of the asset. The third is fundamentally, as you think about evaluating the success of a real estate asset, owners and operators look to the internal rate of return, which is the discount rate that’s associated with receiving your capital back as well as a return on your capital. The longer it takes to get your cash flow out, it actually will depress the IRR. That has an impact both in terms of how partners look at distributing capital as between them, but also potentially the underwriting of particular assets and whether or not you do deals in the first place.

Q3: Won’t holding more equity in construction deals be a positive move for the industry?

Newburn: Yes. It’s a very technical question and I’m not sure it actually impacts a great deal how much equity is in the project. You can avoid being classified as an HVCRE loan if you satisfy three tests: if there’s at least 15% of the capital contributed as unencumbered equity and if you have a maximum loan-to-value ratio, which for land loans is 65%. Other types of development loans are between 75% and 85%. Also, there’s a requirement both to keep the capital contributed in the asset but also to maintain the NOI until the life of the project, which is subject to a lot of debate.

To answer your question, if you just look at the total amount of capital in the transaction, 15% really isn’t the market for a construction loan. The market for a construction on a loan-to-cost basis is somewhere at least in the range of 30% to 40%. In and of itself, the HVCRE regulations—in at least my experience in this cycle of real estate lending and investing—don’t have a great impact on the total amount of initial equity, at least that’s put into the project.

Q4: Will the new HVCRE rules ultimately affect returns?

Newburn: It’s certainly possible that the HVCRE rules could impact the returns, especially on an underwritten basis or potentially on an actual basis to the extent that a project is classified as HVCRE. Borrowers certainly want to avoid the situation that I described, which is to have net operating income trapped at the asset for a particular time period. And, when you’re negotiating loan documents, this comes up every day. Both borrowers and lenders are trying to come to an acceptable place.

Q5: But new rules also apply to existing loans as well as new financings.

Newburn: You’re exactly right. The loans don’t relate just to loans originated beginning in 2015. They relate across the board, and HVCRE as a general topic is changing. It hasn’t settled, I wouldn’t say. The regulations aren’t final necessarily on all the points. It would certainly be another circumstance that borrowers have to consider, and whether and how a lender would assess additional costs due to HVCRE loans when you didn’t really know to negotiate or provide for any of those things when you put together the loan in the first place.

Q6: Will this impact construction-lending volume?

Newburn: Like any potential change in costs, the effect of the HVCRE rules—just like the effect of widening spreads or the effect of lenders asking for additional recourse—is just one more element, I would think, to the underwriting decision for owners and operators in particular and their investors. So, it certainly could have an impact.

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