In 2015 US Basel 3 final rules replaced the existing general risk-based capital rules, affecting more than 8,000 US banking organizations. Covered organizations include all national banks, state member banks, state nonmember banks, state and federal savings associations, and top-tier holding companies, and top-tier savings and loan holding companies domiciled in the United States.
Basel 3 forces banks to assign higher risk weights for acquisition, development, and construction loans: now defined as High Volatility Commercial Real Estate (“HVCRE”) loans. HVCRE loans are given a risk weight of 150 percent as compared to other loans, forcing banks to hold more capital against their real estate lending. For commercial loans, in order to avoid the HVCRE designation, a borrower must fulfill certain requirements in addition to meeting applicable loan-to-value requirements:
The borrower must contribute cash, unencumbered marketable assets, or paid development expenses, equal to 15% or more of the appraised completed or stabilized value of the project.
The borrower must contribute the 15% before the bank advances any funds.
Capital contributed by the borrower, and internally generated fund, must be kept in the project until converted to permanent financing, sold or paid in full.
Under the new rules, the land contribution must be valued by the bank at the property’s original cost, not at its current market value. Loans in existence before the effective date of the regulation are not exempted from the new capital requirements, creating the possibility that some banks may try to require additional equity from the borrower to avoid the increased capital charge.
Most loans are unlikely to fall into the HVCRE definition due to these exemptions:
Most lenders are more conservative than the 80% threshold required.
The second exemption is that the borrower contributes equity to the project before the bank. Most banks require their money is only released after sponsor equity has been fully invested.
The third exemption is that the borrower provides 15% cash equity to the project value. This is a departure from traditional bank credit practices. Normally equity is 15% or more of the project’s cost and banks traditionally considered the current value of developable land to count as part or all of the borrower’s equity contribution.
For developers who want to build on land previously invested and held for the right market circumstances these new rules may create significant challenges. These borrowers will not only find capital harder to source from banks, they amount have a direct impact on the project’s projected return and feasibility. Alternative construction capital from nontraditional lenders may eliminate the equity issue, but the cost of capital from private equity and other non-bank lenders is typically more expensive than bank loans.
Multifamily loans will have lower capital requirements with a potential risk weight of 50% relative to a weight of 150% for HVCRE loans. Banks therefore will likely be motivated to originate loans secured by existing multifamily properties under Basel 3. This reallocation of capital toward the multifamily sector benefits apartment owners by increasing liquidity and potentially lowering their cost of capital. The lower risk weighting does not apply to multifamily construction loans.
This redirection of funds toward the multifamily sector reduces the capital available to other property types. The real estate industry relies on the banking sector for capital. Banks can increase their profitability by passing the higher capital costs through to borrowers. A higher cost of capital puts upward pressure on cap rates, which drive the value of stabilized properties, which drive the value of new and transitional properties. Conversely, higher mortgage rates negatively impact both the profitability and asset values of property owners. The resulting lower collateral values raises LTV ratios and reduces loan proceeds to real estate borrowers.
When a commercial mortgage is originated, the process also creates the right to service the loan. The servicing fees are embedded in the interest rate of the loan. The bank has the choice of retaining the servicing function or selling the servicing to third party. Many banks prefer retaining servicing on order to maintain a relationship with the borrower, and also to be in a better position to control the workout of the loan in the event of a delinquency. The borrower benefits from the flexibility of working within a relationship if circumstances change, or problems arise during the loan’s term.
By increasing capital charges for which a bank does not retain the associated loan, banks may be more likely to sell servicing. However, selling the MSRs may be more difficult since the typical buyers are often other banks. The unintended outcome of the new requirements under Basel 3 is that commercial mortgage servicing is moving to third-party, non-bank servicers who are not subject to these regulations. If a bank decides to retain servicing, servicing fees will likely be greater, creating higher loan rates. Non-bank servicers are likely to take advantage of the situation by raising their servicing costs.
The above changes will likely move more commercial mortgage lending out of the banking system to the CMBS market, and in the case of construction, to non bank lenders.