By the Numbers

Capital rules may shape CRE lending, trading, securitization

Mary Beth Fisher, PhD | August 11, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The newly proposed capital rule for banks includes a modest shift in the treatment of commercial real estate loans and securitizations that could have significant downstream impact on the market. Commercial real estate lending looks likely to require marginally less capital, leading to a slight easing of lending standards for loans on stabilized properties. But securitization and trading of CRE loans would require marginally more capital. This could direct more CRE lending into both agency and non-bank channels, and possibly impact CMBS and CRE CLOs differently.

Lighter capital for most CRE loans

The FDIC, Federal Reserve and the Office of the Comptroller of the Currency (OCC) released their 1,089-page proposed rule implementing the Basel III revised bank capital standards. My colleague, Tom O’Hara published a broad overview of the proposed new capital requirements. The markets are still assessing the potential impact on the residential and commercial real estate markets, but it’s fair to say that the impact could differ.

The proposal includes a flow chart (Exhibit 1) for how a bank should determine the capital charge for residential and commercial real estate exposures (Exhibit 1). The proposed rule includes some new definitions of CRE loans that assign the risk weight to use when determining the appropriate capital charge. There is also a new stratification applied for regulatory CRE loans depending on their loan-to-value (LTV) ratio.

Exhibit 1: Flow chart for determining capital charges for real estate loans

Note: For definitions of relevant terms, see the appendix to this note.
Source: Basel III Endgame Proposal (page 61 of 1,087)

Change in risk weights to determine capital charges for low LTV loans

Under the current capital rules, most standard CRE loans—that is, not acquisition, development or construction (ADC) loans, or high volatility commercial real estate (HVCRE) loans—have a 100% risk weighting. Under the proposed rule, those weighting will be stratified depending on the LTV ratio (Exhibit 2). For loans with LTV ratios of 80% or below, the risk weight would go down from 100% to 70% or 90%, respectively, while loans with LTVs above 80% would have their risk weight rise to 110%. The risk weight for most ADC and HVCRE loans remains at 100% and 150%, respectively, in the proposed rule.

Exhibit 2: Proposed change in risk weights for some CRE exposures

Source: Santander US Capital Markets

The proposed rule also requires the bank to stratify standard, or regulatory CRE loans, based on whether or not repayment of the loan depends on the cash flows generated by the real estate. This appears to be a method for discriminating among CRE loans based on property type. Multifamily loans and office loans, for example, would depend on the cash flows generated by the real estate itself to repay the loan; while property for a manufacturing plant or a retail store would use the business proceeds to repay the loan.

In cases where the repayment is not based on the real estate cash flows, banks apply the risk weight applicable to the borrower or 60%, also based on the LTV of the loan (Exhibit 3). This would also marginally lower risk weights for CRE exposures of high-quality borrowers. For example, an investment grade borrower with debt outstanding typically has a risk weight of 65%. If there is not enough information to determine the risk weight applicable to the borrower, then a risk weight of 100% would be assigned to the regulatory CRE exposure, which is likely equivalent to what it is under the current system.

Exhibit 3: Risk weights for regulatory CRE not dependent on real estate cash flows

Note: If the LTV is greater than 60% and the banking organization does not have sufficient information about the exposure to determine what the risk weight applicable to the borrower would be, the banking organization would be required to assign a 100% risk weight to the exposure.
Source: Proposed rule.

Increased capital charges for securitization and trading

The proposed rules surrounding changes in risk weights for securitization and trading activities of real estate loans are complex, and beyond the scope of the current analysis. An excellent summary of Basel III Endgame by law firm Sullivan & Cromwell includes the following overview:

For trading activities, the agencies estimate that capital requirements would “increase substantially, though the specific outcome will depend on banking organizations’ implementation of internal models.” More specifically, the Federal Reserve staff memorandum accompanying the proposal estimates that capital requirements for trading activities would “more than doubl[e] for some firms.” The extent of the proposed increase in capital requirements for trading activities was another area of focus in a number of statements accompanying the proposal. Chair Powell, for example, cautioned that “the proposed very large increase in risk-weighted assets for market risk overall requires us to assess the risk that large U.S. banks could reduce their activities in this area, threatening a decline in liquidity in critical markets and a movement of some of these activities into the shadow banking sector.”

Economic impact of changing risk weights

The federal agencies undertook an economic analysis of the impact of the proposed changes in capital requirements and disclosed the results as part of the proposed rule. They analyzed the impact across asset classes of the shift in funding costs as well as the likelihood that banks may redistribute capital to different lending activities. The results included the following (excerpts beginning on page 498 of 1087, edited for brevity):

From section C: Economic impact on lending activity

The agencies estimate that the proposal would slightly decrease marginal risk-weighted assets attributable to retail and commercial real estate exposures and slightly increase marginal risk-weighted assets attributable to corporate, residential real estate and securitization exposures.

The proposal may have second-order effects on other banking organizations, as a result of potential changes in large banking organizations’ lending decisions. Large banking organizations may shift asset allocation toward assets that are assigned lower risk weights under the proposal relative to current capital rule, which would affect other lenders that compete in the same lending markets.

Further reading

CREFC published a preliminary overview of the proposed rule and its potential impact on the CRE market, Proposed Rules Would Raise Capital Charges on Large Banks, with a more detailed conference call scheduled for September.

Appendix: Definition of regulatory terms

In general, a statutory multifamily mortgage is a loan secured by a first lien on a multifamily residential property that meets the following criteria:

Made in accordance with prudent underwriting standards
Amortization must occur over not more than 30 years
Minimum original maturity for repayment of principal must not be less than 7 years
Loan to value (LTV) ratio, calculated using a property value that is the lower of acquisition cost or appraised value, does not exceed:
- 80% for a fixed rate loan
- 75% for a variable rate loan
Property’s annual debt service coverage ratio (DSCR) must not be less than:
- 1.20 for a fixed rate loan
- 1.15 for a variable rate loan
All principal and interest payments have been made on a timely basis in accordance with the loan terms for at least one year prior to applying a 50% risk weight
The loan is not more than 90 days past due or on nonaccrual

The above definition is excerpted and lightly edited from a Federal Financial Institutions Examination Council (FFIEC) presentation on reporting regulatory capital data in call reports.

Statutory real estate exposure – a pre-sold construction loan, a statutory multifamily mortgage or a high volatility commercial real estate (HVCRE) exposure.

An acquisition, development or construction (ADC) exposure means a loan secured by real estate for the purpose of acquiring, developing or constructing residential or commercial real estate properties, as well as all land development loans and all other land loans.

A high volatility commercial real estate (HVCRE) exposure means any loan secured by real estate (improved or unimproved) that:

Primarily finances or refinances the acquisition, development or construction of real property
Depends on future income or sales proceeds from, or refinancing of, the real property for repayment of the loan

HVCRE exposure does not include the following:

Any loan financing the acquisition, development or construction of
- one-to-four family residential properties
- real property that would qualify as an investment in community development, or
- agricultural land
Any loan financing the acquisition or refinance of existing income-producing real property if the cash flow from the property is sufficient to support debt service and expenses of the property

Please see the full, revised definition of an HVCRE exposure for regulatory capital rules for complete terms and conditions.

A regulatory commercial real estate exposure is a real estate exposure that is not a regulatory residential real estate exposure, a defaulted real estate exposure, an ADC exposure, a pre-sold construction loan, a statutory multifamily mortgage or an HVCRE exposure, provided the exposure meets several prudential criteria (edited for brevity, please see proposed rule for complete definition):

The exposure must be primarily secured by fully completed real estate
The banking organization must hold a first priority security interest in the property that is legally enforceable in all relevant jurisdictions
The exposure must be made in accordance with prudent underwriting standards, including standards relating to the LTV ratio.

The underwriting must evaluate the borrowers ability to repay in a timely manner

Mary Beth Fisher, PhD
marybeth.fisher@santander.us
1 (646) 776-7872

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