These are notes I took on an interview regarding Basel III regulations and its impact on lenders and borrowers of construction financing;
High Volatility Commercial Real Estate (HVCRE) Loans – A designation primarily for construction loans provided by banks. Proposed Basel III regulations will require higher reserves for loans with a HVCRE designation. Another implication of the HVCRE is that internal returns generated by the project must be kept within the project. For instance, after completion of the asset but before stabilization of the asset, there will likely be a period of positive cash flow. This provision will have onerous tax consequences on REITs, which are required by their tax designation to distribute a substantial portion (approximately 90%) of their taxable income to shareholders.
Additionally, Basel III regulations will a have dampening effect on IRRs which impacts how cash flow is distributed among investors, and may dissuade investors from taking on certain construction projects altogether.
A construction loan will avoid the HVCRE designation provided it meets the following criteria:
- 15% of the capital is contributed as unencumbered equity;
- Maximum of 65% LTV; and
- Keep capital contributed in the asset, including equity and NOI.
The new rules apply to loans new and old, however these regulations are still being negotiated.
