LOS ANGELES—In January, new high volatility commercial real estate legislation came into effect, which has been a challenge for lenders and borrowers across the country who have been struggling to understand and apply the new regulations. Adding more confusion, some local and regional banks haven't been complying with the regulations. Jonathan Lee, a principal at George Smith Partners, has run into this issue on a few of the construction loans that he has secured on behalf of his clients. We sat down with Lee for an exclusive interview to find out about this issue. Here is what he tells us:

GlobeSt.com: For the unfamiliar, tell us a little bit about the new HVCRE legislation that came into effect in January.

Jonathan Lee: HVCRE came out of Basel III. It is a new banking regulation that is meant to slow down speculative loans done by banks from the past cycle. It passed in 2013, but it went into full effect in January of this year.

GlobeSt.com: How has this regulation been a challenge in the Los Angeles market specifically?

Lee: I have seen it applied differently in that some banks aren't aware of it or aren't implementing it, while others area. So, we have to talk to the banks up front to see if they use it as a constraint. Money centered banks, which are more national in presence, have done it more consistently. However, it is definitely the regional banks that are either not aware of it or are not adhering to it.

GlobeSt.com: So, is there a larger issue here about the enforceability of these regulations?

Lee: We know this is a mandate for banks, and we know the FDIC will oversee it. Bank regulators are already doing regular audits, and this will be one more item they will likely be examining. I think a very real world question for the auditors is if they have the manpower to drill down into local and regional banks. And for the larger banks, if they don't comply, will there be a grace or cure period if they are not HVCRE compliant across their portfolio? So we know there is an extra layer of oversight coming, but we don't know the ramifications of that yet for the lenders.

GlobeSt.com: How has this dichotomy created a challenge for you?

Lee: The money center banks have cheaper capital; so in order to maintain their competitive advantage and to get the best pricing, we have to ensure that the loans we do conform to HVCRE. The competitive advantage of the more local banks is that we know from the beginning what their cost of capital is going to be, so we have to present that to the borrowers to weigh the pros and cons before they move forward on a term sheet. Banks run three tests typically on a construction loan. They run a loan-to-cost, loan-to-value and a debt yield test on stabilized NOI. Now, at the same time, they have this HVCRE constraint, which requires at least 15% equity. So, you have these counter goals. You are trying to get a high NOI in order to meet the debt yield test, but show that there is not too much value being created to keep the HVCRE test in check. We have to argue both sides at the same time.

GlobeSt.com: Have borrowers been forced to adjust their business plans to meet these new requirements?

Lee: Borrowers haven't really had to adjust their business plan. You are not going to stop building apartments if you have an apartment project because of HVCRE. What it has done is given them one more hurdle to get over and one more uncertainty or one more unknown that they have to solve for. You don't know going in. For example, if your term sheet is 80%, it might get cut back to 75% because of HVCRE. Or your cost of capital could jump 60 to 100 basis points.

GlobeSt.com: Other than disclosing these new regulations to clients in advance, have you had to do anything to mitigate potential challenges?

Lee: At the onset, we just have to continue to sharpen our underwriting and make sure that the NOI that we are projecting at the beginning can survive heavy scrutiny. It is an extra layer of positioning on the deal level that we have to prove out before we go to market for the loan. And then of course you have the extra layer of appraisal review.

GlobeSt.com: I have heard so many different explanations of this regulation. Is that because it is new or is it because there is confusion of the regulation itself?

Lee: There is some hesitancy because the rule itself doesn't make sense, to banks or to borrowers. By that I mean that real estate entrepreneurs are incentivized to create as much value as possible, and you are asking the bank to hold back reserves in excess of what they normally would do if the project outperforms. So, it is sort of an inverted way of looking at real estate from how we traditionally have viewed it. If you asked five different bank heads how they would interpret it, you would get five different answers. I think ultimately, everyone is going to do this. But I also believe the industry itself is going to push back and say, 'wait, we have overcorrected for past mistakes' and use that as jumping point to make changes legislatively.