In this webinar from Sageworks we cover the definition of High Volatility Commercial Real Estate (HVCRE) and best practices for mitigating concentration risk at banks and credit unions. Access this and other webinars at https://www.sageworks.com/banking/resources/bank-webinars/ In a recent poll, 42% of bankers indicated that commercial real estate is the primary focus for growth in the loan portfolio. At the same time, regulators are concerned that CRE may be overheating as lending standards have eased and CRE portfolios have experienced significant growth.

1. Robert Ashbaugh
Executive Risk Management Consultant
Sageworks
P R E S E N T E D B Y

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• Founded in 1998

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Robert Ashbaugh
Executive Risk Management Consultant
Sageworks

6. HVCRE: a primer
• Why do the regulators care about HVCRE loans in the first place?
• HVCRE Loans: How did we get here?
• HVCRE Loans: All loans except for what?
• The Equity Contribution
Challenges
• HVCRE Risk Management
• How much HVCRE is there?
• HVCRE Capital Requirements
Relief on the horizon?
• HR 2148 to the rescue
• FFIEC EGRPRA Section 2222
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12. HVCRE is the result of the Basel III (2010) response to the impact of significant
losses banks took on commercial real estate loans during the last recession
During the 1990s and 2000s CRE grew using CMBS and a regulatory environment
that permitted lower capital requirements and did not place lending caps, merely
supervisory limits
• Demand for product to feed CMBS boosted lending across the banking industry
• Limits were 100% of capital (construction) and 300% (all investor CRE)
» In 2006 31% of US banks exceed at least one limit
• 23% that exceed both limits failed
• 13% that exceed the construction limit failed
• Accounted for 80% of the losses to the FDIC insurance fund
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13. "a credit facility that, prior to conversion to permanent financing, finances or has financed the
acquisition, development, or construction (ADC) of real property," with certain exclusions that
MUST be all met:
1. LTV must be less than or equal to the maximum LTV ratio for certain types of loans
» Raw land 65%
» Land development 75%
» Non residential construction 80%
» Residential construction 85%
» Construction for improved properties 85%
2. Borrower capital contribution of 15% of the “as completed” value for the “life of the project”
3. The borrower capital contribution must be in place before bank funds are advanced and must
remain in place until the loan is converted to permanent financing
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14. Other exclusions:
• 1-4 Family Residential properties and the residential portion of mixed use properties
• Agricultural land loans
• Loans for
» Community development
» Public welfare
» Economic development
Be sure to have a testing process to identify potential HVCRE loans during the prospecting process
• Bankers should be familiar with the guidelines
• HVCRE loans should be specifically identified during both the pre-screen and final approval
process
• Outline expectations and requirements with borrowers in advance
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15. • Distributions cannot be made until the project is completed, or converted to perm
• The 15% equity contribution may take the form of cash or land, as long as the land is being used for
the project
» Cash cannot come from 2nd lien financing, grants or leasing deposits
• The contribution cannot be borrowed from the bank giving the loan
» But it may be contributed from a non-bank financial or borrowed on an unsecured basis from
another bank
• The contribution is based on the “as completed” value, or the expected value of the property at the
time the project is completed
• Certain expenses paid by the borrower can count towards equity
» Site development
» Leasing and brokerage expenses
» Reasonable soft costs tied to the development
“Borrower needs to show skin in the game”
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17. Loan Structuring considerations
• Try to avoid HVCRE in the first place
» Simultaneous permanent loan in conjunction with the ADC loan
» Be creative and know the definitions
• Define the conversion process to permanent
• Equity contribution as a condition precedent
» Define and detail provisions
Define in commitment letter and loan documents:
• Minimum DSCR
• Define as-is LTV
• Defining equity contribution
» Distributions only upon conversion to permanent financing
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86 87
93
100
108 109
113
117
115
0
20
40
60
80
100
120
140
3/31/2015 6/30/2015 9/30/2015 12/31/2015 3/31/2016 6/30/2016 9/30/2016 12/31/2016 3/31/2017
Billions
Total HVCRE Lending

19. HVCRE loans have a 150% risk weighting when calculating regulatory capital
Basel III identified methods to calculate capital
• Standardized approach
» General risk weighted assets, plus
» Market risk
• Advanced approach
» Banks greater than $250 billion
• Banks must run both methods and apply the most stringent result
» Uses bank internal models to determine risk weights
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20. What is the practical effect of higher capital costs?
• HVCRE loans become more expensive to hold
» Fewer construction loans?
• Portfolio limits
» Creative structures to avoid HVCRE classification
• HVCRE loans are higher risk. Borrowers should pay for that risk.
» HVCRE loans should carry a higher interest rate
» Mitigate the risk through structure and covenants/indemnity clauses
» A pricing model should include capital cost allocation
• ROE/ROA hurdles
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22. HR 2148
• Bipartisan bill passed by the House on November 7 (Senate is reviewing)
• Applies to only new HVCRE loans and exempts loans originated before 2015
• HVCRE loans include loans that
» Finance or re-finances the acquisition or construction of real property
» Purpose is to develop property into income producing real property
» Will be dependent on future income proceeds
• Equity built up beyond the 15% threshold can be withdrawn
• Equity contribution is based on recent appraisal rather than purchase price
• ADC loans whose project is completed and are sufficiently cash flowing to cover
debt service and expenses would become non-HVCRE loans
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23. OCC, FDIC and the Federal Reserve have proposed HVADC
• Proposed September 27 (60 day comment period just ended)
• Includes new loans that primarily (more than 50% used for the..) finance or
refinance:
» The construction or improvement of existing buildings
» The development of land for new structures
» The purchase of vacant or developed land
• Capital charge is reduced from 150% to 130%
• Includes more loans under the rule as 15% equity contribution is eliminated
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What is HVADC What is NOT HVADC
Raw land loans and loans for apartment and
condominiums
Lot development loans for townhomes and row
homes
Bridge Loans Owner occupied projects with sufficient existing
cash flow to repay
Project where more than 50% of the proceeds
would be used for ADC purposes
Interest only loans could be considered
permanent financing
Loans to finance activities that promote
economic development by financing businesses
or farms that meet SBA standards, or have $mm
in gross revenues or less and meet the public
purpose test

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Robert Ashbaugh
Executive Risk Management Consultant
robert.ashbaugh@sageworks.com
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