Where a residential property is being constructed, and the mortgage loan finances both the construction and subsequent occupation of the property, and also provided that the loan is at all times fully and completely secured by the property in its current condition, for risk weighting purposes it is subject to Article 125 (1) (a) as “residential property which is or shall be occupied or let by the owner”, further assuming it also complies with the conditions in paragraph 2 of the Article, would the 35% risk weight apply under that Article during the construction period as well as during occupation of the completed property?
This query has arisen in the context of self-build mortgages – where a borrower, instead of purchasing an older, or ready built new, property acquires suitable land and contracts with a builder to construct the house he or she desires. UK building societies are active providers of finance to this category, and we believe the same concept is well known, perhaps under different terminology, in other member states.
A typical self-build project in the UK works like this. The borrower finds a suitable piece of land, decides exactly what design of house meets the needs of the family, and obtains planning permission. The borrower usually contracts with a builder, and/or may provide some or all of the labour themselves. The lender will finance a proportion of the land costs, with further advances during the construction period to pay the builder or pay for materials etc. The loan is therefore always fully secured by the current property value (and the 80% LTV threshold respected).
The close involvement of the borrower in securing what will be their family's permanent home ensures a high personal commitment to the project, and to the loan, compared with a borrower who merely buys a standard ready built property from a developer. The effective cost of the self-build home is also generally lower, reflecting the absence of developer profit, plus any labour contribution by the borrower's family. And the personal commitment is reflected in loss experience which our members indicate is certainly no worse, and in many instances rather better, than for the residential mortgage book as a whole. Finally, the self-build model makes a desirable contribution to the supply of affordable new family housing in the UK.
Our members have generally interpreted Article 125(1) so that the 35% RW applies throughout the life of the loan. However, another view could be that during the construction period the loan does not qualify under Article 125 (1) (a). This view would be based on an read across to Article 4(75), and the understanding that that definition of “residential property”, implying (though not stating) that the property is complete, overrides the clear language in Article 125(1) that contemplates future occupation of a property which may be under construction.
While the query has arisen in the context of self-build, the interpretation point cannot be limited to that circumstance. If Article 4(1)(75) is held to override the words “or shall be” in Article 125(1)(a), then this must apply to any type of property under construction, including the important category of loans to charitable housing associations to develop social rented housing for lower income residents.
We have made extensive enquiries through the European Association of Co-operative Banks, and found that the majority of EU or EEA member states do not require that the property must be complete to qualify for the 35% risk weight. In one instance the NCA even reaffirmed the 35% RW for the construction phase.
By reference to residential property “… which is or shall be occupied or let by the owner…” Article 125(1)(a) of Regulation (EU) No 575/2013 (CRR) allows the application of a risk weight of 35% to residential property under construction unless otherwise decided by the competent authority in accordance with Article 124(2) CRR. There is no contradiction between Article 4(1)(75) and Article 125(1)(a) CRR. The latter provision rather has a wider scope of application compared to what is defined in Article 4(1)(75) CRR.
For the avoidance of doubt, the exposure has to be secured by a mortgage on residential property which “is or shall be occupied or let by the owner”. This excludes situations where residential property “may” be built in the future (i.e. mortgages on land) but includes mortgages on building sites on which residential property will be built for the future owner of the property, or on residential property under construction, provided in both cases that there is certainty that the owner will occupy or let the property. In this sense, the 35% risk weight cannot be applied to exposures towards real estate developers. The conditions mentioned in Article 125(2) CRR shall be met, including those related to legal certainty, documentation and valuation of the property as set out in Articles 208 and 229(1) CRR. More specifically, according to Article 125(2)(b), the bank shall carefully assess that the risk of the borrower does not materially depend upon the performance of the underlying property or project but rather on the underlying capacity of the borrower to repay the debt from other sources, unless the derogation from this requirement set out in Article 125 (3) of the CRR is applied. Furthermore, for the purposes of Article 125(2) CRR the market value, in accordance with Article 4(1)(76) CRR, is the estimated amount for which the property could be sold on the date of valuation and not on the estimated value on the date of completion.
This treatment does only apply to exposures fully and completely secured by mortgages on residential property, and not where units were to be exploited commercially. For further guidance on residential and commercial properties, please see Q&A 1214.
Retail exposures that are not secured by a mortgage on residential property but which comply with the criteria in the first subparagraph of Article 123 of Regulation (EU) 575/2013 (CRR) shall be assigned a risk weight of 75%.
Additionally, in accordance with Article 124(2)of Regulation (EU) 575/2013 (CRR) the competent or designated authorities shall assess whether the risk-weight of 35% for exposures secured by mortgages on residential property located in their territory are appropriate and may set a higher risk weight or stricter criteria.
Exposures secured by mortgages on residential property which meet the definition of “speculative immovable property financing” in Article 4(1)(79) CRR and are therefore assigned to the exposure class for “items associated with particular high risk” according to Article 128(2)(c
d) of Regulation (EU) 575/2013 (CRR) do not qualify for the 35% risk weight.
Update 26.03.2021: This Q&A has been updated in the light of the changes introduced to Regulation (EU) No 575/2013 (CRR).