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How HVCRE Will Impact Commercial Real Estate Construction Lending

Wednesday, September 21, 2016

Real estate indicators from HFF Director Jennifer Keller and Senior Real Estate Analyst Martha Nay in HFF's Boston office.

What is HVCREAny borrower seeking a construction loan in the last 12 months has likely encountered a five-letter abbreviation that has the potential to present new and considerable challenges on the path to the closing table: HVCRE. HVCRE (Highly Volatile Commercial Real Estate) is a classification that today’s construction loan borrower must be aware of, as its impact could be very costly. Before we can understand the impact to commercial real estate borrowers, we must first understand what HVCRE is, how it is classified and what banks must do to accommodate it.

What constitutes an HVCRE loan?

HVCRE is derived from the Basel III regulatory framework that took effect January 1, 2015, although its implementation by the banking community has been staggered since its introduction. It should be noted that the regulation applies to all commercial real estate loans meeting certain criteria; however, we will focus on the regulation’s specific impact on construction loans.

According to the regulation, a loan is classified as HVCRE if, “prior to conversion to permanent financing, [the loan] finances or has financed the acquisition, development or construction (ADC) of real property” – otherwise known as ADC loans. While there are a few groups of exempted ADC loans (agricultural land, one- to four-family residences) from the HVCRE classification, the most applicable exemption relates to loans that meet all of the following criteria:

      1.  LTV ratio is less than or equal to the applicable maximum ratio prescribed by bank regulators. The ratio for raw land is 65 percent; land development is 75 percent and construction of commercial, multifamily and other non-residential is 80 percent.
      2.  The borrower has contributed cash equity equal to 15 percent of the loan’s “as completed” value.
      3.  The borrower contributed its capital prior to bank funding, and said capital remains in the project until the construction loan is extinguished by either converting to permanent, construction loan repayment in full or property sale.

Impact on the Construction Loan Borrower

At its core, Basel III’s rules require banks to hold increased capital reserves against their outstanding commercial mortgage balances. The reserve amount is directly correlated to the perceived risk profile of the mortgage. Because these reserves are not being put to work, banks will seek to offset the lost opportunity cost of that reserved capital with increased interest rates. This requirement is likely to make less capital available for construction lending and to increase borrowing costs.

Following the implementation of HVCRE, larger banks were generally quicker to modify underwriting and credit policy to adhere to the new HVCRE regulations, with adoption from the smaller, local banking community lagging behind. Today, more than 18 months after its enactment, nearly all of the banking community has implemented modified underwriting and/or legal documentation to account for the HVCRE regulations.

The second of the three criteria above – requiring cash equity equal to 15 percent of the loan’s “as completed” value – when not anticipated, has the potential to cause the most heartburn for construction loan borrowers.

The most obvious solution is to resize the capital stack and reduce the construction loan such that the required debt-to-equity at stabilization ratio is in balance. What is HVCREThis approach would require the borrower to contribute enough equity such that the loan does not exceed 85 percent of the “as completed” value. This has a pronounced impact on projects with a land contribution at an implied market value, rather than actual cost.

In case the capital stack includes a highly-levered mezzanine piece, another potential solution would be to replace the mezzanine slug with preferred equity that otherwise walks and talks like mezzanine debt, as some lenders do not consider preferred equity debt and would allow it to be contributed toward the required equity.

Another potential solution for this requirement is for the bank to charge a higher interest rate. As the Basel III requirement demands the need for increased capital reserves for HVCRE loans, the bank effectively ties up capital and loses the earning potential of those dollars. As such, the bank can charge a higher interest rate, potentially increasing the spread by as many as 75 or 100 basis points, in order to avoid resizing the loan.


The world is changing; there is no doubt about that. It is likely that different interpretations and implementations of the HVCRE regulation could pose challenges for borrowers. Some of the effects of a loan being classified as HVCRE could include reduced loan proceeds, additional equity infusions, or an increase in interest rate spread by as much as 75 basis points. Construction loan borrowers must be aware of the regulation and its potential implications when preparing initial construction budgets and investment returns analysis, so having sound guidance and advice during the course of any financing is now more important than ever.

About Jennifer Keller

HFF Director Jennifer Keller

Jennifer Keller is a Director in the Boston office of HFF. She is primarily responsible for originating and executing financing transactions. During the course of her career at HFF, Ms. Keller has been involved in nearly $10 billion of commercial real estate transactions.

Ms. Keller joined HFF’s New York office in January 2008 and later moved to the firm’s Boston location in July 2015. Prior to HFF, she was an Analyst for Cushman & Wakefield.


About MarthA Nay

Martha Nay is a Senior Real Estate Analyst in HFF's Boston office with more than six years of experience in commercial real estate finance and property sales. Ms. Nay primarily focuses on debt and equity placement transactions for all property types and throughout the course of her career with HFF, has been involved in the underwriting and marketing of more than $1.3 billion in closed commercial real estate transactions.

Ms. Nay joined the firm in 2013. Prior to HFF, she was a Portfolio Manager/Assistant Vice President transacting on real estate loan and equity investments at Citizens Bank. Before joining Citizens Bank, Ms. Nay was Teach For America corps member, teaching high school Spanish in inner-city Baltimore, Maryland.

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