The Cost of Capital- Update from NAR

BACKGROUND


As you may recall, on June 12, 2012, the Federal Reserve, OCC and FDIC proposed regulations implementing the Basel III capital accords. Basel III is an international agreement that updates capital and liquidity requirements for banks and other financial institutions. This 750 page regulation will impact the ability of non-financial businesses to raise capital and increase their costs of borrowing.
In a series of three separate but related proposals, the regulators proposed substantial revisions to the U.S. regulatory capital regimen for banking organizations that, if adopted, will have a significant impact on the entire U.S. banking industry. The U.S. rules are based on the core requirements of the 2011 international Basel III Accord and in significant part on the “standardized approach” for the weighting and calculation of risk-based capital requirements under the 2004-2006 Basel II Accord. Importantly, the proposals will extend large parts of a regulatory capital regime that was originally intended only for large, internationally active banks to all U.S. banks and their holding companies, other than the smallest bank holding companies (generally, those with under $500 million in consolidated assets).
Commercial Real Estate

Most commercial loans will continue to be risk-weighted at 100 percent. The one significant change is for “high volatility” commercial real estate loans (“HVCRE loans”), a subset of ADC loans. HVCRE loans will be risk-weighted at 150 percent. A lender may be able to return an ADC loan to the 100 percent risk weight through underwriting and the imposition of certain terms, as follows:

• The LTV ratio is less than or equal to the “applicable maximum supervisory LTV ratio.”

• The borrower has contributed at least 15 percent of the appraised “as completed” value of the property. The contribution may take the form of cash or unencumbered readily marketable assets, or the borrower may have paid development expenses out of pocket.

• The borrower has paid to the bank the capital charge that the bank will have to incur on the loan and has done so before the bank advances any funds.

• The contributed capital, which may eventually include capital generated internally by the project, must remain in place until the project is completed, the facility converts to permanent financing, or is sold or paid in full.

• Permanent financing by the bank must conform to the bank’s underwriting criteria for long-term commercial mortgage loans. An ADC loan to finance one- to four-family residential properties, however, may continue to be risk-weighted at 100 percent.

Residential Construction and Multifamily Loans

The current risk-based capital rules assign a risk weight of 50 percent to certain one-to-four family residential presold construction loans and to multifamily loans. A 100 percent risk weight applies to a presold construction loan if the purchase contract is cancelled. These risk weights are fixed by statute and cannot be changed. The proposed Standardized Approach, however, adds several new conditions to both kinds of loans in order to qualify for these risk weights.

Presold construction loans must meet several prerequisites designed to ensure that the property will, in fact, be sold on completion. Two notable new requirements are, first, that the builder incur at least the first 10 percent of the direct costs of construction (land, labor, and construction) before the builder may begin to draw down on the loan; and, second, that the loan amount may not exceed 80 percent of the sales price of the presold residence.

Loans secured by mortgages on multifamily properties will remain eligible for the 50 percent risk weight if several conditions are met. For example, a newly originated multifamily loan cannot be risk-weighted at 50 percent and must be weighted at 100 percent. If, after at least one year, the borrower has made all principal and interest payments on time, the loan will be eligible for the 50 percent risk weight, if other conditions are satisfied.

These conditions include the following: (i) the LTV ratio does not exceed 80 percent on a fixed rate loan or 75 percent on a loan where the rate may adjust; (ii) amortization of principal and interest must occur over a period of not more than 30 years, and the original maturity for repayment of principal is not less than seven years; and (iii) annual net operating income of the property must exceed annual debt service by 20 percent for a fixed-rate loan or 15 percent for a loan where the rate may vary.

Basel III Working Group

We have formed a staff level working group with various real estate groups in Washington. This group is meeting regularly to share information and develop a collective strategy on these proposed rules.

Basell III and Dodd-Frank Update

The Federal Reserve Board of Governors met on June 7th to publicly discuss proposals for implementing the Basel III capital requirements and Dodd-Frank capital requirements in a simplified manner, as well as to vote on a final market risk capital rule (Basel 2.5).
The Board unanimously approved the release of three Notices of Proposed Rulemaking (NPRs) for Basel III and the final rule for Basel 2.5. Basel III requires that a bank hold 4.5% of its risk-weighted assets (RWA) as common equity (up from 2% in Basel II) and 6% as Tier 1 capital (up from 4% in Basel II). Total capital (Tier 1 plus Tier 2) must be at least 8% of RWA. Additionally, Basel III requires that banks hold another 2.5% capital buffer, made up of common equity. Restrictions are also to be imposed on what assets can be counted toward Tier 1 capital.
The Board is under the impression that most banks already meet these requirements at the present time (especially those under $10 B). The approach for calculating risk weighted assets would also change the treatment of residential mortgages, making it more risk-sensitive. Under the NPR, residential mortgages are divided into two categories and the risk weights would depend heavily on LTV and would range from 35%-200%, while High Volatility Commercial Real Estate Exposure (HVCRE) risk weights would jump to 150% from 100%. Governor Elizabeth Duke raised concerns about this portion of the proposed rule reducing the willingness of banks to make mortgage loans.
While the new capital rules won’t take effect until 2019, concerns have been expressed by both industry and some Fed governors, that such an increase in capital requirements would have negative economic effects, as there would be less capital available to lend. The Fed’s rule-writing staff said that these effects were likely to be modest and would largely be mitigated by having a long phase-in period. Furthermore, the staff said that banks could largely meet requirements via retained earnings, and would probably not have to issue more equity.

The Federal Reserve surprised the banking industry by forcing even the smallest lenders to comply with Basel III -- all 7,307 U.S. banks. Many bankers had expected regulators to exempt smaller, community bank lenders. While the core Basel III rules will apply to all banks, other aspects of the new regime single out the biggest, most complex banks for tougher treatment than their smaller peers. The banks will have more than six years to fully comply with the new rules, with the phase-in period starting next year.
Potential Impact on Credit Capacity

While the goal of the new regime is commendable, requiring banks to hold far more capital to prevent financial disaster could further exacerbate credit challenges for real estate and broader credit capacity. There is grave concern among many in the banking community that stricter capital rules may curb economic growth by making it more expensive to lend.
As proposed, there is concern that the measure is not appropriately calibrated and could lead to disproportionately higher borrowing costs for commercial real estate borrowers. Setting excessive capital requirements will limit the availability of funds that support new investments and job creation – particularly for commercial real estate.
The current risk weight under Basel II for commercial real estate loans, including acquisition, development and construction (ADC) loans, is generally 100%. However, the Accord permits regulators the discretion to assign mortgages on office and multi-purpose commercial properties, as well as multi-family residential properties, in the 50% basket subject to certain prudential limits. Under Basel I, commercial real estate was assigned to the 100% basket. The proposed Basel III measure would increase the risk weighting to 150% for High Volatility Commercial Real Estate Exposure (HVCRE) and, which could also deter banks from making real estate loans and reduce credit capacity.
Importantly, however, the NPR specifically permits regulators the discretion to exempt certain commercial real estate collateral from HVCRE treatment that fall under certain guidelines. Such collateral would generally be treated as corporate debt position, with a 100% risk weighting. These CRE exemptions would apply to:

(1) One- to four-family residential property; or

(2) Commercial real estate projects in which:

(i) The LTV ratio is less than or equal to the applicable maximum supervisory LTV ratio in the agencies’ real estate lending standards;

(ii) The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15 percent of the real estate's appraised “as completed” value; and

(iii) The borrower contributed the amount of capital required under paragraph 2(ii) of this definition before the banking organization advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project. The life of a project concludes only when the credit facility is converted to permanent financing or is sold or paid in full. Permanent financing may be provided by the banking organization that provided the ADC facility as long as the permanent financing is subject to the banking organization's underwriting criteria for long-term mortgage loans.

Next Steps

The Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC) must also review the proposed Basel rules before they take effect, and are expected to do so on June 12th. Comments on the three NPRs' will be due on September 7, 2012.
NAR is currently reviewing the measure and its potential impact on commercial and residential real estate credit capacity. We are already working with a number of industry groups to develop consensus viewpoints in an effort to begin raising concerns about the economic consequences of proposed rules in advance of the comment deadline.


The documents may be found at CLICK HERE

Midland States Bank is on the Grow!

Leon J. Holschbach serves as President and Chief Executive Officer of the bank and its holding company Midland States Bancorp, Inc. and is Vice Chairman of both the bank and holding company boards. He serves on the bank’s Asset / Liability Committee, Trust, and Loan Committees. Mr. Holschbach shares his vision and values in this unique and interesting interview. Since taking the helm at Midland he has overseen the growth of the bank from assest of just under 400 million to aproximately 1.7 Billion. Not a bad record considering that it all happened in less than three years! Prior to joining Midland States Bank in August 2007, Mr. Holschbach held the positions of: Regional Market President, Community Bank Group at AMCORE Bank from 2000-2007; President/CEO/Director AMCORE Bank North Central N.A. from 1997-2000; and President/Director Citizen’s State Bank from 1979-1997. He received his B.A. in Economics from University of Wisconsin in 1975. To watch the entire TV interview with Leon J. Holschbach CLICK HERE

Jim Schultz Founder of Open Prairie ventures

I really enjoyed the chance to interview Jim Schultz. Jim’s passion for entrepreneurship and building businesses was born of lessons learned within a family of global entrepreneurs dating back to the creation of the family seed company in 1903. He has carried those lessons throughout his twenty year career as an advisor and investor.

Jim has played an active role in a multitude of agriculture businesses, including operating experience with the Brazilian-unit of the family soybean business and a farmland syndication business which he co-founded. Today, he is Founder and Managing Partner of Open Prairie Ventures and invests in ag-tech businesses with disruptive technologies.

Open Prairie Ventures is a venture capital firm focused on investing in early and growth-stage Midwest-based companies in the ag-tech and life science sectors.

Today Open Prairie ventures is a dynamic force in supporting start up activity in the Mid-West and is engaged in transactions that are on par with any VC in the country. To watch the entire interview with Jim Schultz CLICK HERE

NEW SBA INITIATIVES POISED TO HELP CRE INDUSTRY

WASHINGTON, D.C. — President Obama unveiled several proposals this week aimed at helping small business owners. The proposals will expand two critical Small Business Administration (SBA) lending programs, one of which could help some in the commercial real estate industry.

One of the new SBA initiatives will temporarily allow for the refinancing of owner-occupied properties under the SBA 504 program, which provides guarantees on loans for the development of real estate and other fixed assets but could not be used to refinance maturing debt up until this point. Under the new initiative, businesses with a loan maturing in the next year, and who are current on their loan payments, will be able to refinance up to 70 percent of the current property value, with the SBA helping with the remainder. For less established lenders, the SBA will take on up to 40 percent of the property's value for the refinancing.

The program will be funded through additional fees for refinancing projects instead of through a Congressional appropriation. The refinancing proposal will help refinance up to $18.7 billion a year in commercial real estate that would otherwise be foreclosed on or liquidated.

In a statement, SBA Administrator Karen Mills said, "Thousands of good, creditworthy businesses find themselves caught by declining real estate values as a result of the recession. With many of them now facing mortgages coming due in the next few years, the ability to refinance into SBA's 504 loan will give them the chance to lock in long-term, stable financing, as well as protect jobs by protecting small businesses from foreclosure."

One of our lenders put together a great overview on the capital markets

Economic and Interest Rate Outlook

The market has shown strength the first two weeks of the year. A combination of factors including softer than expected Payrolls last Friday, better than expected treasury auctions, and dovish talk from the Fed have driven a sharp move lower in 2010 after a 60 basis point run up into the year-end of 2009.

We continue to see the 10 Year Treasury trade within the range of the 2nd half of 2009—unable to break 3.85% on the high side and 3.20% on the low end. The economic data has improved but not to the point where it is evident that the Fed is prepared to start hiking its target rate. New Treasury supply continues to come, but there is obvious demand for it as evidenced by the solid auctions this week. Every time the 10-Year Treasury rate starts to head toward the high end of the range, buyers emerge and the market rallies. Lack of an imminent move higher in inflation, combined with employment weakness are the key catalysts for fixed income buying at these levels. There are no auctions scheduled for next week, so corporate earning and equity prices will be the primary drivers of the bond market.

The Consumer Price Index excluding the volatile Food and Energy Components showed prices rising 0.1% in December (as expected) and the Fed’s Beige Book characterized the economic conditions as improving modestly. Capacity Utilization inched up higher than expected in December to 72%, the highest level of the past year. Tempering the bullish news this week was a higher than expected initial jobless claims number.

As you might expect, the Fed Funds Futures market lowered its expectations for Fed rate hikes over the course of the week as rates fell. The market still sees about a 30% chance that the Fed will raise it Target rate to 0.50% in August but will certainly move the probability after we see 4th quarter earnings from the Fortune 500

A big thank you to Eric Better of Better Capital for providing this report!

Can USDA Help You Get Your Deal Done?

The answer may be a resounding YES if you are looking to do a transaction in a rural community. I recently interviewed Dave Chestnut and Matt Harris from the local USDA/Rural Development office in Champaign, Il. Wow! All I can say is that they blew my socks off when it came to the shear number of programs that they have in the USDA playbook to help you get a deal done. Oh and another important point THEY HAVE MONEY! and THEY HAVE A MANDATE TO LEND! That's right in addition to their normal adequately funded budget they have been given an additional $45,000,000.00 to help spur economic development, facilitate the purchase or sale of a business, help a farmer or agribusiness expand or even just help you sell that gas station on the corner! No kidding they have what one might might be tempted to call a "best kept secret" type of thing going if it weren't for the fact that they are doing everything they can to get the word out. Besides all of this they are easy to work with. You start by talking to your banker. That's right your personal neighborhood banker can help you navigate the paperwork and process. The program works best that way simply because there is some paperwork involved which is about the only downside to working with USDA. So if you can handle that (which your banker will help you do) and your deal is not in a community with a population over 50,000 people then USDA may just be the answer to getting your deal done! The entire interview with Dave Chestnut and Matt Harris can be heard on the radio show Central Illinois Business in January. The program airs Saturday mornings at 11:00a on 1400A.M.

Banks are still making loans

by Ken Pirok
Business Consultant
www.kenpirok.com

Banks are still making loans. It may be a bit tougher to get approved these days, but low property values and low interest rates are creating opportunities in real estate. It is, perhaps, more important than ever to understand how banks approve commercial loans and to be savvy when it comes to applying for a mortgage.

Contrary to popular belief, the collateral value of your property is not the primary concern of the bank. Liquidation of collateral only happens when loans go bad. The primary source of repayment and the most important factor to your bank is cash flow. Most banks measure cash flow using the Debt Service Coverage Ratio.

Debt Service Coverage Ratio = Net Operating Income ÷ Annual Debt Service

Net operating income or "NOI" includes all cash income, expenses, and taxes, and it is presented on an annual basis. NOI excludes non-cash expenses such as depreciation, and it also excludes interest expense, since interest is included in the denominator of the ratio. For prior years, you will provide the bank with your actual numbers. For future periods, you should assume some reasonable amount of vacancy and bad debt in your calculations.

The annual debt service requirement includes all scheduled principal and interest payments on any mortgages for a property. Banks usually prefer to see debt service coverage of at least 125% as a cushion in case times get tough.

The secondary source of repayment is collateral, which is a backup to the bank. Banks measure the collateral value of properties using the loan to value ratio or "LTV".

Loan to Value = Mortgage Principal Balance ÷ Appraised Value of Property

Obviously, banks like to see loan to values of at least seventy-five or eighty percent, but sometimes if the cash flow looks good, and the property is marketable, a bank might loan even an even greater amount.

Here are a few hints to help you maximize the debt service coverage ratio or appraised value of your property. Tell your banker or your appraiser about any discretionary or unusual expenses. Maybe you paid your brother-in-law a lot more than the going rate to paint your property, or you provided extra landscaping and a garden at your apartment building, or maybe you donated money to charity. You can create "pro forma" financial statements showing what your cash flow would look like if you had not incurred such hefty expenses. You don't want to be penalized for going the extra mile.

Watch your depreciation too. If you have assets with accelerated depreciation schedules or if the IRS allows you a big write-off when you purchase a piece of equipment or remodel a unit, then tell your banker or your appraiser. They may add back some of the depreciation or expense to your NOI.

A third and final source of repayment to the bank is your personal assets and resources, which the bank ties up using a personal guarantee or by requiring your signature on the mortgage as an individual.

When you apply for a mortgage, the bank will ask you to fill out a personal financial statement, which they will use to measure your personal wherewithal. Before you turn this form in to them, be sure to double check your math. You would be surprised how many people submit numbers that just don't add up.

If you would like to learn more about commercial borrowing, visit www.kenpirok.com or call us at 217.840.7726.