Impending changes in the risk-based capital rules for banks are starting to affect the terms and pricing of some high-leverage construction loans.
The U.S. version of the "Basel 3" guidelines, which take effect Jan. 1, sharply increases the amount of capital banks must hold in reserve against "acquisition, development or construction" loans unless the leverage is 80% or less and the borrower’s up-front capital contribution is at least 15% of the project’s value.
While most bank loans would fall well under the 80% leverage limit, the equity requirement is proving to be an obstacle for some deals — largely because the 15% threshold is based on the estimated value of a project "as completed," rather than the cost of construction.
As they start negotiating loans that may close after the first of the year, banks are informing borrowers that they’ll need to put up enough cash to meet the new requirement, or pay a higher interest rate to compensate for the cost of holding additional risk-based capital, according to industry pros.
Complicating the calculations are some gray areas in the new regulations, adopted last year by the
Comptroller of the Currency, the Federal Reserve and the FDIC to conform with the Basel 3 standards set by the Bank for International Settlements. The regulators haven’t spelled out just what "as completed" means, said George Green, associate vice president of commercial/multi-family policy at the Mortgage Bankers Association.
"Is that stabilized, is it non-stabilized?" Green said. "The value of an income-producing property is based on its leased income. Significantly different values are generated if a building is substantially leased versus minimally leased."
The higher the projected value of the completed property, the more cash the borrower would have to provide upfront to reach the 15% threshold. The rules also mandate that those funds remain committed to the project until the loan is retired or converted into permanent financing meaning the developer can’t draw out leftover cash as a project nears completion.
Construction loans that don’t meet the leverage and borrower-equity requirements must be treated as "higher volatility commercial real estate" under the Basel 3 rules. Loans in that category will be subject to a risk weighting of 150%, while most other commercial mortgages will be weighted at 100% and certain multi-family loans will qualify for a 50% weighting. Banks are generally required to hold capital against 8% of the balance of their loans, but the higher risk weighting will bump that up to 12%.
While many banks have already set new lending standards in response to the rules, others are still working out the details. "It seems more banks are just waking up to this new regulatory environment," said one originator.
Some banks are starting to put language into preliminary loan agreements stating that the proposed pricing can change if the estimate of the project’s "as completed" value comes back higher than expected and the borrower’s equity doesn’t reach 15% of that figure.
One broker said he was already seeing signs that some banks are cutting back on construction lending to avoid the new capital charges.
Another industry pro said he knew of a few cases where banks walked away from potential deals when their calculations showed the loans would fall into the higher-volatility category.
