RBI/2009-10/487, UBD. (PCB) BPD. Cir.No. 69 /09.22.010/2009-10,
June 9, 2010
The Chief Executive Officer
All Primary (Urban) Cooperative Banks
Exposure to Real Estate and Commercial Real Estate sector – UCBs
Please refer to paragraph 2.3.1 of our Master circular UBD. PCB. MC. No.1/13.05.000 / 2009-10 dated July 1, 2009 on Exposure Norms and Statutory / Other restrictions. In terms of the circular, the total exposure of UCBs to real estate including individual housing loans and commercial real estate is restricted to 15% of the total deposit resources of a bank. In view of the requests made by a few banks and the federation, it is clarified as under:
2. Finance extended to the eligible category of borrowers mentioned in paragraph 2 of the Master circular UBD.PCB.MC.No.2/09.22.010 / 2009-10 dated July 1, 2009 will be eligible to be categorised as housing finance..
3. While the purpose of the loan shall determine whether the loans granted against the security of immovable property need to be classified as real estate loans, the source of repayment will determine whether the exposure is against commercial real estate. For this purpose, UCBs may be guided by the instructions in Annex 2 of circular UBD.PCB.Cir.No. 59 / 09.14.000 / 2009-10 dated April 23, 2010 (copy enclosed).
4. The ceiling of 15% may be reckoned on the total deposits of a bank based on the audited balance sheet as on March 31 of the previous financial year. The exposure for the purpose of computing the prescribed limit of 15% should take into account both fund based and non fund based facilities.
5. We advise that the existing paragraph 4.7.1 of Master circular on Housing Schemes UBD.PCB.MC.No. 2 / 09.22.010 / 2009-10 dated July 1, 2009 stands modified as under: “ UCBs may utilize up to 15% of their total deposit resources to provide housing, real estate and CRE loans ”. It is further advised that the working capital loans against hypothecation of construction materials provided to the contractors who undertake comparatively small construction on their own without receiving advance payments, as provided for in paragraph 7 of the the Master Circular is exempted from the prescribed limit of 15%.
6. The above clarifications may be placed before the Board for their information.
Chief General Manager
Encl: As above
Definition of Commercial Real Estate Exposure (CRE)
Real Estate is generally defined as an immovable asset – land (earth space) and the permanently attached improvements to it. Income-producing real estate (IPRE) is defined in para 226 of the Basel II Framework as under :
“Income-producing real estate (IPRE) refers to a method of providing funding to real estate (such as, office buildings to let, retail space, multifamily residential buildings, industrial or warehouse space, and hotels) where the prospects for repayment and recovery on the exposure depend primarily on the cash flows generated by the asset. The primary source of these cash flows would generally be lease or rental payments or the sale of the asset. The borrower may be, but is not required to be, an SPE (Special Purpose Entity), an operating company focused on real estate construction or holdings, or an operating company with sources of revenue other than real estate. The distinguishing characteristic of IPRE versus other corporate exposures that are collateralised by real estate is the strong positive correlation between the prospects for repayment of the exposure and the prospects for recovery in the event of default, with both depending primarily on the cash flows generated by a property”.
2. The Income Producing Real Estate (IPRE) is synonymous with Commercial Real Estate (CRE). From the definition of IPRE given above, it may be seen that for an exposure to be classified as IPRE / CRE, the essential feature would be that the funding will result in the creation / acquisition of real estate (such as, office buildings to let, retail space, multifamily residential buildings, industrial or warehouse space, and hotels) where the prospects for repayment would depend primarily on the cash flows generated by the asset. Additionally, the prospect of recovery in the event of default would also depend primarily on the cash flows generated from such funded asset which is taken as security, as would generally be the case. The primary source of cash flow (i.e. more than 50% of cash flows) for repayment would generally be lease or rental payments or the sale of the assets as also for recovery in the event of default where such asset is taken as security.
3. In certain cases where the exposure may not be directly linked to the creation or acquisition of CRE but the repayment would come from the cash flows generated by CRE. For example, exposures taken against existing commercial real estate whose prospects of repayments primarily depend on rental / sale proceeds of the real estate should be classified as CRE. Other such cases may include ; extension of guarantees on behalf of companies engaged in commercial real estate activities, corporate loans extended to real estate companies etc.
4. It follows from the definition at para 2 and 3 above that if the repayment primarily depends on other factors such as operating profit from business operations, quality of goods and services, tourist arrivals etc.,the exposure would not be counted as CRE.
5. UCBs should not extend finance for acquisition of land even if it is part of a project. However, finance can be granted to individuals for purchase of a plot, provided a declaration is obtained from the borrower that he intends to construct a house on the said plot, within such period as may be laid down by the banks.
Simultaneous Classification of CRE into other Regulatory Categories
6. It is possible for an exposure to get classified simultaneously into more than one category, real estate, CRE, infrastructure etc as different classifications are driven by different considerations. In such cases, the exposure would be reckoned for regulatory / prudential exposure limit, if any, fixed by RBI or by the bank itself, for all the categories to which the exposure is assigned. For the purpose of capital adequacy, the largest of the risk weights applicable among all the categories would be applicable for the exposure. The rationale for such an approach is that, while at times certain classifications / categorizations could be driven by socio-economic considerations and may be aimed at encouraging flow of credit towards certain activities, these exposures should be subjected to appropriate risk management / prudential / capital adequacy norms so as to address the risk inherent in them. Similarly, if an exposure has sensitivity to more than one risk factor it should be subjected to the risk management framework applicable to all the relevant risk factors.
7. In order to assist banks in determining as to whether a particular exposure should be classified as CRE or not, some examples based on the principles described above are given below. Based on the above principles and illustrations given, banks should be able to determine, whether an exposure not included in the illustrative examples is a CRE or not and should record a reasoned note justifying the classification.
A. Exposures which should be classified as CRE
1. Loans extended to builders for construction of any property which is intended to be sold or given on lease (e.g. loans extended to builders for housing buildings, hotels, restaurants, gymnasiums, hospitals, condominiums, shopping malls, office blocks, theatres, amusement parks, cold storages, warehouses, educational institutions , industrial parks) In such cases, the source of repayment in normal course would be the cash flows generated by the sale / lease rentals of the property. In case of default of the loan, the recovery will also be made from sale of the property if the exposure is secured by these assets as would generally be the case.
2. Loans for Multiple Houses intended to be rented out
The housing loans extended in cases where houses are rented out need to be treated differently. If the total number of such units is more than two, the exposure for the third unit onwards may be treated as CRE Exposure as the borrower may be renting these housing units and the rental income would be the primary source of repayment.
3. Loans for integrated Township Projects
Where the CRE is part of a big project which has small non-CRE component, it will be classified as CRE exposure since the primary source of repayment for such exposures would be the sale proceeds of buildings meant for sale.
4. Exposures to Real Estate Companies
In some cases exposure to real estate companies is not directly linked to the creation or acquisition of CRE, but the repayment would come from the cash flows generated by Commercial Real Estate. Such exposures illustratively could be:
5. General Purpose loans where repayment is dependent on real estate prices
Exposures intended to be repaid out of rentals / sale proceeds generated by the existing CRE owned by the borrower, where the finance may have been extended for a general purpose.
B. Exposures which may not be classified as CRE
1. Exposures to entrepreneurs for acquiring real estate for the purpose of their carrying on business activities, which would be serviced out of the cash flows generated by those business activities. The exposure could be secured by the real estate where the activity is carried out, as would generally be the case, or could even be unsecured.
(a) Loans extended for construction of a cinema theatre, establishment of an amusement park, hotels and hospitals, cold storages, warehouses, educational institutions, running haircutting saloons and beauty parlours, restaurant, gymnasium etc. to those entrepreneurs who themselves run these ventures would fall in this category. Such loans would generally be secured by these properties.
For instance, in the case of hotels and hospitals, the source of repayment in normal course would be the cash flows generated by the services rendered by the hotel and hospital. In the case of a hotel, the cash flows would be mainly sensitive to the factors influencing the flow of tourism, not directly to the fluctuations in the real estate prices. In the case of a hospital, the cash flows in normal course would be sensitive to the quality of doctors and other diagnostic services provided by the hospital. In these cases, the source of repayment might also depend to some extent upon the real estate prices to the extent the fluctuation in prices influence the room rents, but it will be a minor factor in determining the overall cash flows. In these cases, however, the recovery in case of default, if the exposure is secured by the Commercial Real Estate, would depend upon the sale price of the hotel / hospital as well as upon the maintenance and quality of equipment and furnishings.
The above principle will also be applicable in the cases where the developers / owners of the real estate assets (hotels, hospitals, warehouses, etc.) lease out the assets on revenue sharing or profit sharing arrangement and the repayment of exposure depends upon the cash flows generated by the services rendered, instead of fixed lease rentals.
(b) Loans extended to entrepreneurs, for setting up industrial units will also fall in this category. In such cases, the repayment would be made from the cash flows generated by the industrial unit from sale of the material produced which would mainly depend upon demand and supply factors. The recovery in case of default may partly depend upon the sale of land and building if secured by these assets. Thus, it may be seen that in these cases the real estate prices do not affect repayment though recovery of the loan could partly be from sale of real estate.
2. Loans extended to a company for a specific purpose, not linked to a real estate activity, which is engaged in mixed activities including real estate activity. For instance, a company has two divisions. One division is engaged in real estate activity, and other division is engaged in power production. An infrastructure loan, for setting up of a power plant extended to such a company, to be repaid by the sale of electricity would not be classified as CRE. The exposure may or may not be secured by plant and machinery
3. Loans extended against the Security of future rent receivables
A few banks have formulated schemes where the owners of existing real estate such as shopping malls, office premises, etc. have been offered finance to be repaid out of the rentals generated by these properties. Even though such exposures do not result in funding / acquisition of commercial real estate, the repayment might be sensitive to fall in real estate rentals and such exposures should be classified as CRE. However, if there are certain in built safety conditions which have the effect of delinking the repayments from real estate price volatility like, the lease rental agreement between the lessor and lessee has a lock in period which is not shorter than the tenor of loan and there is no clause which allows a downward revision in the rentals during the period covered by the loan banks can classify such exposures as non CRE. Banks may, however, record a reasoned note in all such cases.
4. Credit facilities provided to construction companies which work as Contractors
The working capital facilities extended to construction companies working as contractors, rather than builders, will not be treated as CRE exposures because the repayment would depend upon the contractual payments received in accordance with the progress in completion of work.
5. Financing of acquisition / renovation of self-owned office / company premises
Such exposures will not be treated as CRE exposures because the repayment will come from company revenues. The exposures to industrial units towards setting up of units or projects and working capital requirement, etc. would not be treated as CRE Exposures.