High Volatility Commercial Real Estate (HVCRE) loans represented a potential problem for the banking industry. Under the Basel III international banking accord and the Dodd-Frank Wall Street Reform Act, HVCRE loans are new construction and development financing loans so classified if their loan-to-value (LTV) ratio is in excess of the Supervisory Loan-To-Value (SLTV) ratio set by the relevant commercial banking authority in the U.S. (or respective country in the case of Basel III). The issue is the loss severity risk exposure that has habitually attended loans for commercial real estate development projects (called “ADC” – as in “Acquisition, Development & Construction” loans). ADC loans represent a special class of risk due to the nature of the operations taking place – development and construction being the issue, as these are complex operations that have the potential for loss due to cost overruns and delays caused by a variety of risks that have been heretofore difficult to manage.
The reality is, that with the exception of weather related delays, we have found there are fewer uncertainties with commercial real estate development and construction programs than there is for developing new technology in our own business (Internet Technology and Internet Information Services). At least in CRE projects budgets and schedules have a real meaning, while in IT we have found that development schedules and budgets are nice reference tools only. Levity aside, the key to HVCRE loan risk management comes down to the following issues that require forecasting, monitoring and mitigation management:
- Execution Risk Management & Mitigation. The key issues here are the risks that are associated with second dollar change order costs and the transference of the risk associated with execution by contractors and sub-contractors for completion of all related contract activities during the construction process itself, and the execution risk that comes with pre-opening operations and post-construction start-up and lease-up (pre-stabilization) operations; and
- Investment Fraud Risk Management & Mitigation. The key issues here are fraud risks associated with conflicts-of-interest that result in the sponsor/borrower entity enriching itself at the potential cost of the lender, fraud due to third-parties such as contractors and sub-contractors intentionally defrauding the borrower/sponsor on the terms of delivery of required assets, and fraud committed by third-parties and employees during the pre-opening and post-construction lease-up phase that create the potential for loss or launch failure; and
- Market Risk Management & Mitigation. The key issues here are the risks associated with introduction of the proposed operations of the CRE property operating business into the market and the attending risk that comes with attempting to penetrate the market with the new business, as well as the risks that attend those operations that extend beyond market risk in and of itself; and
- Maturity Risk Management & Mitigation. The key issues here are the risks for the take-out financing not showing up when the lender needs to exit the deal due to the fact the project fails in its construction process (over budget or past schedule) or fails on market launch to attain sufficient market penetration to induce the permanent financing take-out source to close because the permanent financing source won’t take the deal because it hasn’t reached stabilized operating capacity.
In today’s world the LTV ratio isn’t the real issue. The real issue is the due diligence process that has failed to mitigate the loss severity risk these issues have created in the past. The focus has been the underwriting analysis and review process that comes prior to funding, yet the real solution lies in an end-to-end solution that starts with pre-funding underwriting and continues throughout the entire construction process and into operations for the life of the property to prevent or mitigate these issues to an extent the loss severity risk associated with these risks is no longer materially-significant.
The approach we are now utilizing focuses on these approaches and renders the issue less of a risk than a management reporting and ongoing verification and vetting process to optimize the opportunity for a successful outcome for all the parties at-interest.