New restrictions stand to make a big impact on construction lending, and both commercial real estate developers and lenders are up in arms about it. Experts in the field are arguing that these new restrictions might hurt credit availability and encourage the creation of loans in risky sectors.

The Basics

Basel III requirements that went into effect this year established a new acquisition category known as High Volatility Commercial Real Estate. These loans have a 150% capital requirement, which means that construction loans are far more expensive than in the past.

This higher cost is causing developers to look elsewhere for the funds they need, meaning that nonbank lenders are picking up the bulk of the responsibility. According to Thomas Biscacquino, who helps lobby on behalf of the commercial real estate market, this move to take some of the best loans out of the banking system doesn’t really makes sense for the industry’s needs.

The new and higher capital charge was applied to these loans as a result of events in the recent financial crisis. Regulators discovered that many of the banks who failed during that period had high numbers of acquisition, construction, and development loans. One of the most common challenges surrounding this market had to do with the fact that once construction on new properties was finished, there was very little demand for this kind of loan.

The ultimate purpose for these loans is to force borrowers to meet a 15 percent equity requirement in order to skirt the High Volatility classification. In addition, another stringent requirement for these loans is that the leverage on the loan is not allowed to exceed more than 80 percent of the total estimated completion value for the project.

According to lenders, though, these requirements don’t take the unique factors of the construction industry into account. Lenders argue that these new regulations don’t consider land’s appreciated value in the process of determining what equity the developer has brought forward.

Lenders also believe that some of the new stipulations just aren’t necessary. If a loan is taken out for four years, for example, but the construction work is completed in half that time, the loan still has to be held for the entire four year duration.

The lending industry is already pushing for changes, such as allowing appreciated land value to count towards the equity requirement and allowing reclassification earlier than currently permitted. According to those in the lending industry, the changes at this time simply put banks at a big disadvantage when compared with nonbank lenders. When borrowers are able to score lower costs elsewhere, there is little reason for them to use the banking system for funds. Lending experts believe that these changes force banks to focus specifically on lower grade projects where they can cover capital costs with a higher interest rate.