–By Scott Lynn, Director / Principal
As commercial real estate financiers, we are constantly faced with a variety of evolving banking regulations that are changing the way commercial real estate deals are financed and leveraged. Most recently, the implementation of the new lending guidelines under the Basel III rules is leaving a bad after taste in the mouths of bankers and developer alike.
Under Basel III, loans that finance the acquisition, development or construction (ADC) of property are classified as “high volatility commercial real estate” (HVCRE) loans. HVCRE loans impose more onerous capital requirements on banks because they are viewed as a more risky subset of commercial real estate loans. Banks have to reserve against 12% of the loan amount, as opposed to 8% for most commercial loans.
ADC loans must meet the following tests:
- The loan cannot exceed 80% “loan -to-value”;
- The borrower must contribute capital to the project of at least 15% of the appraised “as completed” value (not 15% of total costs); AND
- The borrower’s 15% capital must be contributed before the bank funds and must remain in the project throughout the life of the project, or until the loan is converted to a permanent loan.
These requirements create potential road blocks when trying to maximize leverage because the developer is required to contribute capital equal to 15% of the “as completed” appraised value. According to the Basel III regulations, that has to be real cash, not borrowed funds via a secured mezzanine loan.
To illustrate, assume a developer has a $10m project where he intended to borrow 85% of the project cost via a construction loan of $7m (70% LTC) and mezzanine loan of $1.5m (15% LTC). If the As-Completed value of the project is $12.5m, the developer would be required to contribute $1,875,000 or 18.75% of cost thereby limiting the potential leverage to 81.25% of cost, not the 85% that was hoped for.
The mezzanine loan won’t count as part of the equity contribution because…”proceeds constituting liabilities on the balance sheet of the borrowing development company cannot count as capital for purposes of the 15% test.” Banking regulations have been clear that supplemental debt that has a 2nd lien on a property does not count as capital contributed by the borrower; and an unrelated loan from the bank that is originating the ADC loan to a borrower cannot be counted as capital contributed by the borrower.
As a way around the Basel III limitations on the use of higher leverage loans, 2nd mortgages and/or mezzanine loans, one might ask ”if the mezzanine loan is made to a drop-down entity that is the sole member of the borrower under the senior construction loan, wouldn’t the proceeds from that mezzanine loan be considered a borrower capital contribution?” Under the new rules, the answer is likely “No.”
The better tactic is to use a Preferred Equity structure rather than a Mezzanine loan to make sure these proceeds are recognized as “contributed” equity and not an additional loan. Think of Preferred Equity as the Class A stock in an operating agreement where there’s a “First Out” to a preset Minimum Preferred Return on the A Class Stock and then, a 100% return of the capital of the Class A stockholders that has a priority on any distributable funds before any other stockholders capital is returned. The only difference is there’s no participation in property economics above the stated Preferred Return. In this structure, the Preferred Return Investment would be treated as cash equity by the Basel III rules. The issue is whether or not the construction lender will allow the Preferred Equity player to take over the control through predetermined/pre-approved control transfer rights. The Construction Lender, Subordinate Class B shareholders, and the developer have to view the Preferred Equity provider as the potential controlling party if a default occurred on the loan or within the ownership structure.
In his April 2015 HVCRE Update, Jerry Blanchard (www.bankbryancave.com/2015/04/hvcre-update-news-interagency-faq) summarized a few other Basel III issues that should be considered before you mix up the next batch of capital for your upcoming project:
- Can a borrower simply pledge unrelated real estate as collateral to the bank and have that count toward the 15% capital contribution? Again, this goes against the idea that the capital must be actually contributed to the project before it can be counted. Logically, this should also apply to cash collateral that is merely “pledged” as opposed to being injected into the project.
- Grants from non-profits, municipalities, state or federal agencies don’t count as capital. Any number of people have tried to convince the regulators that a grant of this type should be treated as capital but the regulators have decided against it. Their take on it is that because grants do not come from the borrower they would essentially disguise the borrower’s actual economic interest in the transaction.
- Does the developer get any benefit from the increased value of purchased land? This continues to be a hot button issue for banks and developers. The value of the real property contributed is measured as of the date the property was purchased, not today’s value. Lenders should be aware that examiners will be looking for evidence in the file of how the cash valuation is determined, i.e., sales contract, canceled check, etc.
- Can a developer use condo purchaser deposits as equity? This has been a hot topic in a number of states where developers are allowed by law and purchase contracts to use a buyer’s deposit in the construction of the condo project. It would not be unusual, for example, to find that a developer building a $100 million condo project had $30 million or more in the way of buyer deposits that it could use in the project.
- What about soft costs? Reasonable and customary soft costs expended by the developer such as developer fees, leasing expenses, brokerage commissions, and management fees would be considered to be contributed equity. Likewise, site preparation expenses such as engineering or permits would also be included.
To help you analyze your options for any type of commercial real estate financing or to discuss how Basel III requirements might affect your future financing goals, contact me at firstname.lastname@example.org or any one of MCA’s Senior Directors in our Dallas or Denver offices at www.metcapital.com.
The author, Scott Lynn, is the Founding Principal of Metropolitan Capital Advisors.