From Our Affordable Housing and Community Development Practice Group
Over the past few months, following enactment of the 2012 Appropriations Act (PL 112-55), HUD has worked with almost unbelievable speed in producing updated and comprehensive programmatic guidance to meet preservation needs within several of its portfolios. The Appropriations Act provided multiple new tools and some funding for transformation of various affordable housing categories, including by authorization of the Rental Assistance Demonstration (RAD), confirmation of funding for Section 8 vouchers and other subsidy to protect at-risk groups of low-income veterans, elderly, and families living in expiring-use projects; and by extensions of Mark-to-Market and so-called “318” authority (now “212”), by which Section 8 and use restrictions may be transferred from nonviable projects. That is a long way of saying that in March, April and May, HUD has produced and released several notices and other guidance of great interest to those members of the affordable housing industry involved in preservation. Given that RAD’s transformation of Public Housing and Mod Rehab continues to be refined in response to comments following release of PIH2012-18, at this time a summary of Rent Supp and RAP conversion authority currently in effect and actually in use is appropriate. In addition, Section 202 and post-Mark-to-Market prepayment/redevelopment guidance was nearly wholly restated in May, including elimination of the QNP three-year rule and new Green incentives. A more detailed review of these matters is in order. Section 8 Renewal Guide changes, as well as restatement of enhanced voucher policies (under H2012-19), are also of immediate impact to many projects with which we are involved.
In this Housing Update we discuss these matters, and a few others that have proved to be common topics of query by our clients and others who participate in the affordable housing industry.
I. Rental Assistance Demonstration (RAD) – Conversion of Public Housing, Mod Rehab, Rent Supp and RAP to Project-Based Vouchers
RAD, as enacted under HUD’s 2012 Appropriations Act (PL 112-55), and as implemented (in part) by HUD’s Notice PIH2012-18, represents some success in the Department’s ambition of transforming public housing into a model that can attract private debt and equity for purposes of redevelopment. RAD also represents a partial success in meeting the stated goal of HUD’s previous PETRA (Preservation, Enhancement or Rental Assistance Act) and its precursor, TRA (Transforming Rental Assistance), initiatives – a consolidation of various project-based rental subsidy programs into a single model of common application and rule. PIH2012-18 responds to the Appropriation Act’s mandate that several provisions of RAD, concerning Public Housing and Mod Rehab, be subject to public notice and comment prior to implementation, by providing a 150-page detail of program qualification, application requirements and processing, but then requesting comments, which have been delivered, and which now must be reviewed in development of the final program.
With regard to Public Housing, and certain Mod Rehab projects, involvement in RAD will be subject to competition for limited demonstration authority and funding provided by the Appropriations Act. The details of that competition, and implementation of conversions for public housing projects into project-based Section 8 voucher (PBV) properties will be revised in response to industry comment. For this reason, attention to currently effective provisions of RAD, concerning Rent Supp and RAP conversions to Section 8 PBVs (during FY 2012 and 2013) is of greater immediate interest. Rent Supp and RAP conversions under RAD are now taking place under PIH2012-18.
Rent Supp and RAP Generally
Section III of the Notice is specifically directed to owners (and potential purchasers) of Rent Supp and RAP projects. These projects generally will be found to be an older vintage of 236, 221(d)(3) and even some 202 properties. Their rental assistance contracts were entered into at least thirty years ago, and have limited remaining terms (generally 40-year contracts). Most commonly, RAP and Rent Supp did not fully subsidize each project, but often covered only 20 percent of units. Subsequent or special circumstances did sometimes provide additional units, and we have seen fully subsidized Rent Supp and RAP projects. RAP and Rent Supp contracts generally will provide rental subsidy familiar in format to Section 8 project owners: tenants are restricted as to income and will pay 30 percent of that income toward rent, with the remaining paid by HUD. Over time, however, funding for individual contracts often runs low, as they were initially funded at the time of contracting (40 years earlier), and appropriations for additional RAP or Rent Supp funds have been sporadic. This has, over time, tended to keep RAP and Rent Supp rents low, and has often resulted in a reduction of units by attrition, coordinated between HUD field offices and owners – in order to utilize available funding without losing all contract units upon full depletion.
During a small window in the mid-1980s RAP and Rent Supp owners were offered an opportunity to convert their contracts to project-based Section 8. A majority of owners took advantage of this option and window. One might recognize this in project documents by noting a post-1980 HAP Contract that nevertheless appears to have “old reg” (pre-1980) HAP Contract terms. RAP and Rent Supp conversions maintained their eligibility for the LMSA (Loan Management Set Aside) HAP Contract form.
RAP and Rent Supp contracts are each subject to a Regulatory mandate that they terminate immediately upon prepayment or maturity of the underlying mortgage debt (even in cases in which the 236 debt is not FHA-insured). Many of those RAP and Rent Supp contracts that lasted beyond the 1980s conversion window were subsequently terminated as a result of mortgage loan prepayment (in most cases resulting in formerly subsidized tenants receiving Enhanced Vouchers or regular Section 8 vouchers). In many cases, however, we and others obtained Regulatory waivers in order to permit continuation of the RAP or Rent Supp following redevelopment or preservation events, such as 236 IRP Decouplings. It is a providential circumstance for many owners that RAD permits conversion of projects to PBVs even if their RAP or Rent Supp was previously terminated. PBVs under RAD may be available to RAP or Rent Supp projects with contracts that expired or terminated after October 1, 2006, although a “reach back” or retroactive conversion is subject to additional constraints and tenant consent procedures.
Of the 35,000 to 40,000 units of Rent Supp and RAP that remain, all are nearing the end of their terms, or have been extended on an annual basis. Many of these projects are nonprofit-owned or sponsored.
Conversion to PBVs under RAD
To be eligible for conversion:
Certain existing Regulations applicable to PBVs generally are lifted or waived for RAD conversions. The 25 percent limit on the number of PBV units, per project, is modified to a 50 percent cap. In addition, existing exceptions for unit-count limits continue under RAD and permit up to 100 percent project subsidy for units with elderly and handicapped tenants, and families benefiting from a social service plan.
HUD has been clear that all Rent Supp and RAP units covered by a contract may be converted, even if the number of units actually used under the subsidy contract has been reduced over time by attrition. It is also possible that, in certain prepayment events, the resulting PBV contract may cover more than just the Rent Supp and RAP units, but may be extended to cover all units, assuming compliance with PBV exceptions for caps stated above. It is very important (read: VERY) that those who intend to benefit from a RAD PBV contract covering more than existing RAP or Rent Supp units undertake early evaluation of mortgage maturity dates, other existing debt terms, and specific Regulatory provisions that apply to Rent Supp terminations generally (that are not authorized for waiver by RAD) within the context of target-project documents. We are aware of, and have seen over time, many program/project/documentation scenarios that can trigger less favorable transition results than might be available if proper coordination of transaction timing and existing project circumstance is attended to. In addition, cooperation among the local housing authority, the local field office and tenant representatives is crucial.
Finally, we note that conversion of Rent Supp or RAP to PBVs may not be appropriate for all eligible projects. Properties with contracts extending beyond 2013 may not be in a position to consider prepayment/refinancing at this time. In addition, we note that PBV rents generally will be set at the local housing authority’s voucher payment standard, and that may be considerably lower than subsidy available under Enhanced Voucher authority. Although many of these projects are eligible for Enhanced Vouchers in circumstances that also trigger RAD eligibility, rent setting for Enhanced Vouchers will not transfer to the PBV contract in RAD conversion.
II. Comprehensive Section 202 Redevelopment Guidance – Some Basics, and Some New and Important Revisions
Prior to HUD’s May 4 Notice, H20012-8, a full description of prepayment and redevelopment/preservation options for Section 202 required review and amalgamation of multiple statutory provisions from multiple Appropriations Acts, multiple and successive Housing Notices, and extended knowledge of policy and programmatic revisions that existed, at times, without formal writing. The very nature of this portfolio, authorized under a common name (“Section 202”) but implemented under disparate statutory authority over five decades, required some piece-by-piece implementation, to address its preservation needs as projects under differing statutory regimes aged into need for redevelopment. We have, over the past 10 years, written no fewer than five “202 Basics” articles/summaries, as law and policy shifted attentions and rose to meet updated needs, and experience taught some lessons in practical application.
While a few matters will require further attention as varying stages of the Section 202 portfolio age and bring their unique characteristics forward in challenge, H2012-8 has saved some less comprehensively experienced the trouble of reaching for more than a single document in their review of the majority of authorities and current directives. HUD begins H2012-8 by noting that the American Homeownership and Economic Opportunity (AHEO) Act of 2000 (PL106-569) applies to all pre-1992 direct loan 202 projects. It further cites many of the amending statutory acts applicable, and then cross-references to the history of Section 202 prepayment/preservation notices (including conversion of efficiencies, and subordination of 202 loans). It ultimately states those Housing Notices that have been superseded by H2012-8 and then reviews, in a well-organized manner, the programs and processing applicable to prepayment and redevelopment of the various types of 202 projects – generally designated by vintage. The Notice further describes current policy for some specific circumstances that have arisen recently. Although H2012-8 does not present solutions for certain difficulties that arise when tax credits (LIHTC, Historic, or even New Markets) are used for 202 redevelopment, nor practice models that are appropriate when for-profit developers combine their efforts with nonprofit 202 owners or sponsors, that is not HUD’s charge and the Notice does lay out a framework by which these ventures can succeed.
A Few Section 202 Basics
When addressing the needs and circumstances of any particular Section 202 project, it is important to first determine which type of Section 202 is at hand. Over the half-century during which the Section 202 program has been in effect, it has been revised, updated and rewritten to provide for various combinations of direct HUD loans, subsidized interest loans, project-based subsidy, and capital grants. Section 202 projects generally can be categorized into a few distinct portfolios, separated based on the year in which they were allocated funds:
(i) pre-1975 (direct below-market 50 year loans). These projects are commonly referred to as “SH 202s”, and are subject to a HUD-held mortgage loan with a very low rate of interest (often 3 percent). They may have Section 8, no rental subsidy at all, or even Rent Supp. They all require HUD approval to prepay.
(ii) 1975-1990 (direct loans and rental subsidy). These projects are generally subject to HUD-held higher interest loans, and benefit from project-based Section 8. All but a specific subset require HUD approval to prepay. These projects can have “old reg” or “new reg” HAP Contracts.
(iii) 1977-1982 (direct loans and rental subsidy). These projects look in their documentation almost identical to those noted in (ii) above, but their Section 202 mortgage loans may be prepaid without HUD approval. The HAP Contracts for this 202 subset also crosses the old reg/new reg transition period.
(iv) post-1990 (capital advance with rental subsidy). These projects were and are currently being built with the proceeds of a “capital advance” from HUD, which does not require repayment if continually used as regulated. Rental subsidy is provided under a Project Rental Assistance Contract (PRAC). There is no current statutory authority specifically targeted to redevelopment of this portfolio, but some statutory and regulatory tinkering over the years have provided the basis on which new developments now commonly include LIHTC and bond financing.
(v) Previously Refinanced Section 202 Projects. Given that prepayments of certain Section 202 projects have been permitted expressly for 10 years now, it is not surprising that some former 202s have come around for redevelopment/refinancing again. These projects are generally subject to the extended 202 Use Agreement required at the time of their initial prepayment, but are no longer encumbered by a HUD-held 202 mortgage loan.
All Pre-1990 Section 202 Properties
All of these projects were originally restricted to nonprofit ownership, required HUD-approved budget-based rents, and provided for no distributions to the nonprofit owner. Other than the subset noted above (1977-1982) all of these Section 202 properties require HUD approval for prepayment, and that approval may only be granted within applicable statutory authority. The post-1975 portion of this class of Section 202 has been the focus and target of great attention, over the past ten years, by developers, lenders and investors, due to the need for rehabilitation, the existence of project-based Section 8 contracts, and statutory exemption from HUD’s Mark-to-Market program. The pre-1975 class of SH 202s have been a more difficult target, although perhaps in greater need of preservation effort, and the subject of specific authority granted only recently under the 2009 Omnibus Appropriations Act (PL111-8) and the Section 202 Supportive Housing for the Elderly Act of 2010 (PL111-372).
In all cases, other than in that excepted subclass noted above, these pre-1990 (some were completed as late as 1992), must be owned throughout the term of their financing by a nonprofit or nonprofit-controlled limited partnership (LLC). Those projects that will be redeveloped with tax credits, or even by other means involving for-profit limited partners, must ultimately maintain ownership by either a limited partnership of which the sole general partner is owned entirely by a qualified nonprofit or an LLC, which may have more than one member, provided that all are qualified nonprofits. Allowance for this joint venture control by multiple nonprofits was a relatively new addition by the 202 Supportive Housing Act, and provided relief for difficulties concerning related party debt triggered by seller loans commonly used when nonprofit owners transfer projects to LIHTC partnerships of which they control the general partner interest.
H2012-8 sets out a specific procedure and requirements for prepayment of all older HUD-held 202 loans that require HUD approval and/or continued exemption from Mark-to-Market. Section 202/Section 8 contracts for 202 loans that do not require HUD prepayment approval may request approval to retain their Mark-to-Market exemption. The Notice restates and maintains as unchanged many previous requirements:
Notwithstanding continued common treatment of authorities and process recognized by H2012-8 for many matters, the Notice also indicates some very important changes with respect to Section 8 HAP Contracts, and implementation of specific provisions of the 2012 Appropriations Act, concerning use of 202 redevelopment transaction proceeds.
Use of Excess Transaction Proceeds
Until passage of the 2012 Appropriations Act, realization of excess transaction proceeds by nonprofit owners of Section 202 projects required some stretching of the rules, and was subject to significant negotiation among transaction participants, including HUD. “Proceeds” can arise in transactions that ultimately provide cash over and above that needed to satisfy refinancing and redevelopment costs. As a rule, 501(c)(3) organizations, such as 202 owners, should not transfer their property to for-profit limited partnerships (as is the case in LIHTC redevelopment) for less than full value, even if the nonprofit retains general partner interest in the transferee. The IRS can consider a transfer that breaks this “rule” to result in “private benefit” in violation of the 501(c)(3)’s mandate to serve charitable rather than private purposes. Many 202 prepayment/redevelopment transactions can be and have been modeled with seller financing, but often also produce some cash proceeds to the nonprofit that are best put to use in other community work. It is also not uncommon to see a decades-old Section 202 project with its HUD-held loan substantially amortized. A refinancing of that loan at lower interest rates, now available with a new 30-year amortization, can produce considerable loan proceeds, which after prepayment of the 202 mortgage, and even after repair of the property, are not fully used. These excess “proceeds” might also be put to good use in the community.
H2012-8 describes several options for use of proceeds by nonprofit 202 owners, keeping in mind an expectation that funds derived from Section 202 projects should be used to assist in meeting the needs of the elderly. Specifically, proceeds may be put to use at other “HUD-assisted” projects that are designated as senior housing. These recipient projects need not be Section 202 properties, but must have social service components, be restricted as to tenant income, and subject to a recorded use agreement. Proceeds may also be used to supplement funding of Section 202 capital advance projects currently being developed by affiliates of the prepaying project’s nonprofit owner. Of course, proceeds may be used at the 202 project that was the source of transaction proceeds, for purposes of additional repair, payment of fees, and subsidizing tenants without other rental subsidy available to them.
Section 8 HAP Contract Increases
In one additional welcome revision to existing guidance for Section 202 prepayments, H2012-8 expressly recognizes that existing HAP Contract rents may be increased in connection with preservation transactions, even if HUD’s approval to prepay is required. Recognizing that transactions involving prepayment of HUD-held 202 loans, other than SH 202s, must result in some reduction in debt service, Section 8 budget-based increases will be approved to fund operational needs. For pre-1975 SH 202 redevelopment, new debt service is not restricted, and Section 8 may be increased by budget-based increase, but may go as high as post-rehab comparable rents. This treatment has been successfully used by nonprofit sponsors of many HUD-subsidized project types (not just 202s) for many years, to fund debt service necessary for full redevelopment of aging projects, as described in Chapter 15 of the Section 8 renewal policy guide.
New Rental Subsidy
H2012-8 acknowledges that, for pre-1975 202 projects, tenant-based Section 8 vouchers may be made available to offset tenant impact for projects undergoing substantial rehabilitation (with associated increased debt service). If the transaction would otherwise result in unassisted elderly tenants facing a rent increase, vouchers can be employed. This is important, given that the majority of these SH202s do not benefit from Section 8 subsidy.
In addition, and perhaps of greater impact, the Supportive Housing Act authorized a new form of project-based subsidy specifically targeted to this pre-1975 202 class. With this authorization of a new Senior Project Rental Assistance Contract (SPRAC), and with some appropriations made available under the 2012 Appropriations Act, HUD is now working through guidance for offering SPRAC subsidy contracts in connection with SH202 preservation transactions. Stay tuned.
Post-1990 Section 202 Projects
Although the earliest developments under this less-old subset of the 202 portfolio are now reaching a time for needed attention to facility repair and modernization, these projects and the statutory regime under which they were authorized and operate has so far prevented development of a solid and broadly applicable redevelopment/preservation program. Unlike the predecessor direct amortizing loan 202 programs, these projects received a Capital Advance (effectively a grant), under which promissory notes and mortgages, having 40-year terms, were executed. These “loans” did not amortize and are forgiven at the end of their terms if project restrictions have been abided by. In addition, although subsidized, the rental subsidy for these 202 projects is delivered under a Project Rental Assistance Contract (PRAC), unique to post-1990 202s. It was not created and is not funded or administered under Section 8 of the United States Housing Act, and is excluded from coverage under MAHRAA. Rents and subsidy under PRACs are budget-based, and generally are found to be low, given that no debt service must be included in budgets. These projects effectively run at a 1.0 Debt Service Coverage, without any debt service.
Nevertheless, due to their age, some of these properties are beginning to draw attention. Industry participants, and HUD, are preliminarily reviewing options by which tax credit equity, hard and soft loans, and some increased subsidy might be combined with other sources to offer design for preservation within existing HUD authority and practical limitations imposed by available cash flow and a unique rental subsidy (limited PRAC resources). Consideration also must be given to challenges of income and basis recognition that arise when LIHTC investment is combined with older Capital Advance/PRAC projects that were not designed and are not well-positioned to accommodate mixed-finance and mixed-ownership models.
Re-Refinancing of Section 202 Properties
Finally, H2012-8 recognizes that current extraordinarily low interest rates can make refinancing of debt incurred under prior Section 202 prepayments attractive and beneficial to project operations. HUD generally has accepted that refinancing of a formerly refinanced Section 202 project does not require HUD approval, but does require maintenance of the existing Section 202 prepayment Use Agreement.
More importantly, in response to multiple queries, HUD has confirmed that the Mark-to-Market exception, which was retained when the 202 project was refinanced the first time, will not also apply automatically to the re-refinanced project. If FHA-insurance is used for this second refinancing, and Section 8 rents are above market at the time its HAP Contract next expires, the project will be referred to Mark-to-Market restructuring at that time.
Although comprehensive, the Notice does not address all matters that are important to 202 prepayment/preservation planning. For some 202 redevelopment tools, cross-references must still be made to other guidance. It is certain that the preservation needs of all categories within the Section 202 portfolio will continue to pose challenge and opportunity, within the framework of available but evolving programmatic and funding models.
III. Updated M2M Redevelopment and New Green Incentives
In May, HUD issued H2012-10, with restatement and revision of guidelines for waiver of the due-on-sale and due-on-refinancing provisions for HUD-held Mortgage Restructuring Mortgages (MRMs) and Contingent Repayment Mortgages (CRMs). H2010-10 does contain some modification to prior guidance, based on lessons learned over the past five years, and some policy change. The Notice’s most dramatic revision, however, is in its confirmation that the three-year rule for Qualified Non-Profit (QNP) transfers is no longer in effect. H2012-10 also introduces new incentive for purchasers to redevelop under “green” criteria, and additional incentive for transactions that meet a “pronounced affordable housing preservation need.”
The next article in this Housing Update provides a thorough discussion of current QNP transaction requirements and terms. First, however, without restating “Mark-to-Market Basics,” which we have provided in prior Housing Updates, and which we have published over the years in various industry periodicals, we review general requirements for redevelopment of Mark-to-Market projects, indicating program updates contained in H2012-10, and describing some new incentives available to for-profit developers.
Mark-to-Market (M2M) restructurings are handled by HUD’s Office of Affordable Housing Preservation (OAHP). M2M processing will result in the reduction of Section 8 subsidy to comparable market levels, and the bifurcation of existing FHA-insured debt into a new FHA-insured first lien that can be serviced by reduced rents (under an OAHP produced M2M Model), and either one or two subordinate mortgage loans (MRM and CRM), held by HUD and payable from a portion of annual surplus cash. The restructuring process will also commonly involve evaluation of the project’s immediate physical needs, and provide for some funding of necessary repair, but not for long-term substantial rehabilitation. Properties restructured several years earlier are often now in need of substantial rehabilitation if they are to be maintained as affordable housing assets. M2M projects are all subject to a 30-year use restriction.
M2M’s mortgage bifurcation process does not result in a reduction of outstanding mortgage debt, but only in a deferral of the portion that cannot be regularly serviced under lowered rents. In addition, HUD-held subordinate MRMs and CRMs that are created contain “due-on-sale” terms that require full repayment in the event of refinancing or sale of the project. Necessary rehabilitation for many post-M2M projects, however, cannot be adequately funded if repayment of all outstanding debt is required upon transfer to redevelopment purchasers. It is common that redevelopment plans for these projects fall short of funding, given rental income that cannot support new debt sufficient to both pay for rehabilitation and repay in full the combined balances of outstanding first lien FHA-insured and subordinate HUD-held mortgage loans.
Notice H2012-10 restates its predecessor guidance, allowing waiver of “due-on-sale” provisions in MRMs and CRMs, while providing financial return and continued economic participation for both developers and HUD. We have worked on dozens of post-M2M acquisitions and redevelopments requiring relief under OAHP’s waiver policy, with and without prepayment and/or assumption of the M2M first lien FHA-insured mortgage, while deferring repayment of subordinate MRMs and CRMs.
H2012-10 has not modified, but rather restates, many of the policies, requirements and evaluation criteria applicable to requests for waiver of MRM and CRM due-on-sale. OAHP will evaluate the proposed transaction to determine:
(1) whether the property’s financial and physical viability will be maintained
(2) whether the value of HUD’s MRM and CRM will be retained (or enhanced)
(3) whether there is an appropriate distribution of transaction proceeds among the participants (including HUD), and
(4) whether the transaction is otherwise in the best interest of HUD, tenants and the community.
In practice, requests for relief from due-on-sale of MRM and CRM, in acquisition/rehabilitation, require simultaneous processing by the HUD field office of a full Transfer of Physical Assets (TPA), and by OAHP of a full transaction review and financial analysis. We have found this balancing of field office and OAHP process, with respect to timing and overlapping concerns, can take some time, but is not overly burdensome when field office staff are efficient and knowledgeable in their TPA responsibilities.
It is expected that the proposed transaction will result in not less than a 1.20 debt service coverage. In addition, OAHP will determine if the project will maintain a sufficient operating expense “cushion.” If redevelopment plans include new financing that will pay off the existing first lien (often the case in bond/LIHTC transactions), the new debt must be fixed-rate and fully amortizing. Rehabilitation plans and proposed adjustments to reserve requirements also will be reviewed.
Continued MRM and CRM Value
Debt service on MRM and CRM debt is contingent on cash flow. OAHP will consider whether the net present value (NPV) of projected and realized cash flow paid toward this debt service remains stable under the applicant’s transaction/operations model. In prior years it was possible to propose a transaction by which projected cash flow would result in a reduction of NPV of the MRM and CRM, when compared to that budgeted during original M2M processing, or actual past performance. In those cases, OHAP would require an additional up-front “catch up” payment on the MRM and CRM notes, to bring their values back into line. In a change to this policy H2012-10 states that OAHP will reject applications that demonstrate a reduction in NPV of HUD-held debt when compared to that produced under the original M2M Model. It is important that the original M2M Model be maintained by owners, and available for review by purchasers, in order that it may be considered in redevelopment planning. This NPV criteria and evaluation will generally be deemed satisfied if the first lien FHA-insured mortgage remains in place (without modification).
In addition, the NPV criteria will not be considered when the request involves MRM and CRM assignment or forgiveness in connection with QNP incentives. In such transactions, to accommodate statutory incentives for nonprofit ownership, MRM and CRM notes and mortgages are assigned by HUD to a “qualified nonprofit,” thereby relieving OAHP of concern for their future value.
Transaction Proceeds Available for Partial Repayment
MRM and CRM notes are the product of HUD payment on FHA insurance claims during M2M restructuring. Applications for relief from due-on-sale in post-restructuring redevelopments must clearly indicate who is making how much money from the transaction. HUD wants its “fair” share, given the Department’s prior investment.
Although this evaluation is handled on a case-by-case basis, generally, OAHP will require paydown on outstanding MRM and CRM equal to the greater of:
i. an amount equal to one-half of net proceeds received by the seller, or
ii. an amount equal to one-third of combined net transaction proceeds received by the seller and the purchaser (and affiliates, such as the developer) – if any.
Notwithstanding this apparently straightforward formula, the devil is in the details of OAHP’s evaluation. In some warning, H2012-10 adds an additional consideration for determining appropriate distribution of proceeds. OAHP will consider “the extent to which the availability of Proceeds results from the M2M restructuring.” This statement of considered element should be read to mean that OAHP does and will review the extent to which a seller, at the time of restructuring, received exception rents, extraordinary M2M relief in order to prepare for future project rehab needs (large reserves were funded), or other unusual benefits; and if these M2M “benefits” are now the basis on which a large purchase price is being paid to the seller, OAHP may determine that its “fair share” is higher, or that the transaction should not be approved. Early evaluation by purchasers of the M2M Model is important to ferret out these issues.
Submissions and processing for waiver of the MRM and CRM due-on-sale clause is comprehensive and time-consuming, and requires planning by the applicant. We have found OAHP’s administration of applications thorough and thoughtful, with consideration for project-specific preservation needs, equitable distribution of transaction proceeds among participants (including HUD and private parties), and future financial stability for these affordable housing assets. We have also seen this policy employed to provide for necessary substantial rehabilitation and preservation in transactions that would not have been possible otherwise.
New Incentive for Green Redevelopment
Finally, H2012-10 contains a new incentive for promotion of green redevelopment in connection with post-M2M transfers and waiver requests. Given that many proposals submitted in connection with due-on-sale waiver requests contemplate substantial rehabilitation, it might be that developers could introduce additional energy savings into their plans. To encourage green proposals, OAHP will now offer an increase in Incentive Performance Fees (IPF) to purchasers, in exchange for redevelopment that results in green certification.
An annual IPF is available to owners of M2M restructured projects. It is determined under the M2M Model as a small percentage of effective gross income. The IPF can be paid annually to the project owner, prior to determination of cash flow split between the owner and HUD for payment toward HUD-held MRM debt.
The IPF may now be increased by 50 percent if project redevelopment achieves LEED Certification, Enterprise Green Communities Certification or other equivalent certification. The IPF will be raised following completion of rehabilitation, upon proof of certification.
IV. M2M Transfers to Qualified Nonprofits (QNP Transactions)
It is official. The three-year QNP rule is over. Nevertheless, before nonprofits, public housing agencies and for-profits targeting joint venture opportunities rush out the door to sign up every project that has been restructured through Mark-to-Market over the past 10 years, it is important that they consider HUD’s new “preservation criteria” for approval of QNP transactions. Below is a discussion of QNP transaction modeling and authority, with evaluation of new criteria and opportunity.
Section 517(a)(5) of MAHRAA provides that: “The Secretary may modify the terms of the second mortgage, assign the second mortgage to the acquiring organization or agency, or forgive all or part of the second mortgage ... if the project is acquired ... by a tenant-endorsed community based nonprofit ...” Over the years, OAHP has used this authority as the basis for its QNP incentive program, promoting transfers of M2M projects to nonprofits, public housing authorities and nonprofit-sponsored LIHTC purchasers. As described in Appendix C of the M2M Operating Procedures Guide (OPG), qualified nonprofits/public agencies (QNPs) or their partnerships may purchase a M2M project and have the MRM and/or the CRM assigned by HUD (the original holder) to an affiliate of the QNP or entirely forgiven.
This QNP incentive program has worked well. Over the past 10 years, although subject to modifications in that time, we have seen many preservation transactions close with full assignment of HUD-held debt to community-based QNPs. This assignment by HUD of its interest in a project’s MRM and CRM relieves transaction funding from the burden of fully repaying the M2M debt, while permitting QNPs and their development partners to determine appropriate terms for restructure of the MRM and CRM.
QNP treatment, however, had been available only for a limited period of time. For 10 years, HUD has imposed a three-year time limit for QNP qualification. Generally, the OPG states this restriction to require that QNP incentives will only be available to a project for a period of three years following close of its M2M restructuring. For some time, this policy has been in flux and subject to special circumstances and waiver. Over the past year, however, OAHP has applied the three-year limit more stringently. In practice, this condition has required that a purchase agreement be executed between the project owner and the QNP prior to the third anniversary of M2M closing.
In May, with H2012-10, OAHP has effectively terminated the three-year rule. QNP transactions can now be undertaken without regard (nearly) to the length of time between M2M closing and QNP sale. This absolutely does not mean that every M2M project will now be approved for incentive. QNP application and approval had become somewhat of a “check the box” process over the years. Transactions and assignment of HUD-held MRM and CRM debt to nonprofit and public housing sponsors often were reviewed and approved if the purchaser indeed could meet stated QNP criteria and show that financial stability of the project would be enhanced by approval, without regard to whether the QNP’s project plan included rehabilitation. Simple QNP transactions involving acquisition and TPA assumption of all debt did fulfill a goal of long-term restriction on project use – the 50-year use agreements imposed as part of approval has ensured these properties will be maintained as sources of affordable housing well into this century. Nevertheless, determination of project need for this incentive had few criteria. Interest in long-term preservation within the housing portfolio took some precedence over evaluation of whether QNP approval was necessary to solve financial or physical distress.
With elimination of the three-year rule, but with introduction of “preservation criteria,” HUD/OAHP has both opened up the entire M2M portfolio to comprehensive redevelopment and notified all industry participants that check-the-box applications will no longer provide sufficient reason for approval.
It must also be noted that QNP treatment does not relieve purchasers of HUD’s requirements under the due-on-sale waiver process discussed in the preceding article. While some elements of that waiver process will be eased for QNP transactions, a full submission under that program must also be made along with QNP application.
Applications for QNP approval will continue to be evaluated under requirements previously in place, and described in Appendix C of the OPG. Although Appendix C has not been updated for some time, it is a good basis on which to build initial transaction planning, and determination by nonprofits, public agencies and their joint-venture partners concerning proper transaction design. QNPs will note that the QNP incentive may take one of two forms: (i) debt forgiveness, under which HUD will forgive the entire MRM and CRM; and (ii) debt assignment, under which HUD will assign its interest in the MRM and CRM to the nonprofit or public housing authority.
In almost all cases, as discussed below, we see assignment selected.
Assignment Versus Forgiveness
The Regulatory Agreement for most M2M projects will contain certain restrictions on distributions of cash flow. The MRM and CRM, however are paid from cash flow, and this requires modification of the Regulatory Agreement. As a result, M2M project Regulatory Agreements are executed with a Rider that provides that distribution limitations contained in the Regulatory Agreement will not be applicable so long as the MRM or CRM is outstanding. In addition, because the MRM and CRM are approved debt, payments supersede any distribution limits contained in “new reg” HAP Contracts. For this reason most nonprofit purchasers (and nonprofit sponsored limited partnerships) prefer that the MRM and CRM be assigned rather than forgiven.
In addition, the MRM and CRM represent indebtedness of the project, which, if assumed by an LIHTC purchaser, will generally accrue to acquisition credits.
New Ownership Entity Requirements
As with the Section 202 redevelopment program, the project may be purchased by either a nonprofit or a limited partnership with a nonprofit general partner. Public housing agencies are also eligible.
The nonprofit participant must be:
a. a governmental entity – or a wholly owned LLC, or
b. a nonprofit corporation that is:
i. community-based – CHDO, tenant group, meet a 1/3 test of board membership, and
ii. tenant endorsed – a majority of tenants endorse the new owner in writing, and
iii. independent – not controlled by any for-profit entity and the seller must not retain any financial interest in the project.
Procedure for Assignment of Debt
Unfortunately, MAHRAA mandates that the MRM and CRM be transferred to the project purchaser. Under generally applicable real estate law, if the owner of a property is also the holder of a mortgage on that property, the mortgage is deemed extinguished. For this reason, these transactions require an odd documentation dance at closing, which takes place in the following steps:
1. HUD assigns MRM to nonprofit (or limited partnership) purchaser
2. Purchaser assigns MRM to a nonprofit affiliate
3. Property is deeded to purchaser
4. Purchaser assumes MRM indebtedness from seller.
All documentation for this transaction is in the form provided by OAHP, must be executed beforehand by all parties other than HUD, and then delivered to OAHP in HUD Headquarters for its execution and delivery to closing.
Although OAHP will approve the qualification of the nonprofit participant for this incentive, and will approve and execute all M2M transfer documentation, the local HUD office is responsible for all other required reviews and approval.
If the 223(a)(7) first lien mortgage will be assumed by the purchaser, the local office must process a full TPA. If the 223(a)(7) will be prepaid, the local office must process the prepayment request, 2530/APPS submissions for all participants and all management agent documentation; final approval of the prepayment must be obtained by HUD Headquarters.
Extended Use Restrictions
In exchange for the nonprofit incentive, OAHP will require that the M2M use restriction be extended to 50 years.
New Preservation Criteria
New “Preservation Criteria” are imposed on nearly all QNP transactions. Applications for QNP approval for projects that satisfy the three-year rule in effect prior to H2012-10 may be submitted in accordance with guidelines that existed prior to H2012-10. Additionally, the process for approving QNP incentives simultaneously with the closing of M2M restructuring is unchanged.
For most QNP transactions, “Preservation Criteria” are stated to enable HUD’s determination that the QNP transfer will benefit long-term preservation and affordability of the project. This is a relatively short statement that holds within it several concepts, and near absolute discretion.
Conceptually, QNP applicants should be prepared to show objectively that QNP treatment is necessary, rather than convenient, for preservation of the project. If rehabilitation needs require new debt that cannot be obtained while HUD holds the MRN (or that cannot be obtained with OAHP’s requirement that new first lien debt be fixed-rate and fully amortizing), QNP treatment is appropriate. If a project is just squeaking by under current ownership, realizing or close to realizing operating deficits, then a transfer with QNP incentive is appropriate. If substantial soft funding or other funding is available to assist in preservation and redevelopment of the project, but cannot be subordinated to HUD, then QNP treatment is appropriate.
If, however, a project has $500,000 in annual cash flow, it is not apparently in need of financial relief from MRM debt. If that same project is being sold to a nonprofit without any rehab plan, at a cash purchase price that effectively monetizes future cash flow and puts it into the seller’s hands, approval of QNP incentive is unlikely.
Applications for QNP approval must now include objective and demonstrative documentation to “assist HUD with such a determination.” A long, but not exhaustive list of examples is contained in H2012-10. Some include:
a. evidence of capital needs, and inadequate reserve balances
b. a history of poor or distressed financial performance of the project
c. a need for debt relief in order to maintain financial stability in the face of redevelopment costs
d. evidence of community support, which can be financial or otherwise
f. inclusion of non-HUD sources, and substantial deferral of developer fee in meeting project redevelopment needs; and
g. proof of sponsor preservation intent and experience.
This list is not exhaustive of all methods by which need for QNP treatment might be exhibited. It is strongly indicative, however, that OAHP’s movement from the three-year rule to an evaluation of true preservation need and benefit, will help to address many troubled and older M2M projects, but may also result in determination that QNP approval is inappropriate in circumstances that would have permitted approval in prior years.
V. Section 8 Renewal Guide Changes
HUD has just released change pages to the Section 8 Renewal Policy Guide that have been expected for some time. Modifications to renewal options have both positive and negative impacts for owners with Option 4 renewals. In addition, HUD has confirmed an exception to the use-restricted cap on Mark-up-to-Market renewal, and has instituted execution of a new 20-year HAP Contract under the “preservation exhibit” method we have seen applied in the last year to many discrete transaction renewals. This extension method will now be applied in most cases in which transactions require a 20-year HAP Contract, notwithstanding that the current contract term has not run.
Option 4 Renewals and Increases
Initial renewals under Option 4 (the lesser of test), and budget-based increases under subsequent adjustments (under a multi-year contract) must now explicitly use the then-current debt service. In addition, change pages contain a new rent limitation factor for Option 4 adjustments, which we have seen noted by HUD but, until now, not formally implemented. Subsequent budget-based annual adjustments by owners will be capped (in most cases) at comparable market rents. If a rent comparability study (RCS) has been submitted to HUD within the last five years, it may be used for this determination, with comp rents adjusted by the annual OCAF. In other cases a new RCS will be required. Requests for annual OCAF adjustments will not be subjected to an RCS comparison.
Option 1(B) Mark-Up-to-Market
Projects for which Option 1 – Mark-up-to-Market, or Mu2M – renewals are requested have always been subject to some limitation if the property is also encumbered with another Use Restriction that mandated lower rent levels (i.e., Flex Sub, LIHTC). Option 1(A) Mu2M renewal refers to those Mu2M renewals granted as of right, to project owners meeting all criteria for increased rents under Option 1. Option 1(B) refers to renewals under Option 1 for projects that do not meet all criteria, but otherwise serve elderly or at-risk populations, can demonstrate strong community support, or are located in low-vacancy areas. It has been implied, but is now express, that rents under Option 1(B) renewals will not be limited by the terms of other Use Restrictions encumbering the project.
New and Unusual Small Area FMR Procedure
Procedures for appraisers preparing Comparability Studies have been modified. In cases where the RCS determines that comparable rents exceed 110 percent of FMR, or HUD’s untried Small Area FMR, the appraiser must now include documentation concerning circumstances and comparable property conditions that indicate differentiation between properties above 110 percent of FMR and those below 110 percent of FMR. Given that an express cap on Mu2M at 110 percent of FMR is contrary to statute and other authority, this new requirement may either be intended to ensure appraisers pay greater attention to comparables, or as a fact-gathering device for the Department.
20-Year Contracts, Mid-Term
The industry has generally seen an increase in investor and lender demand for 20-year HAP Contracts, as congressional hyperbolic wrangling over budgets has increased. Investors in particular, have become less satisfied with the 20-year “comfort letter,” by which HUD offices have agreed to renew the HAP Contract for 20 years upon its next expiration. This increasing pressure from lenders and investors has not been contrary to HUD’s desire to lock in lengthy HAP Contract commitments by owners. We have seen HUD respond to industry demand and its desire for long-term preservation by the development of a relatively new “preservation amendment.”
Owners may now generally ask that HAP Contracts be extended for 20 years in almost all cases. HUD will cooperate by termination of the existing HAP Contract, and execution with the owner of a new contract having a 20-year term. In exchange for this cooperation, HUD will require that a Preservation Amendment be attached to the new HAP Contract. This Amendment will require the owner again renew the HAP Contract upon expiration of its 20-year term, for a period not less than that remaining under the just-terminated contract. We have seen 34-year owner commitments to continued Section 8.
VI. Flexible Subsidy Loan Deferrals
As a reminder, in March HUD went through the trouble of extending Notice H2011-05, detailing procedure for deferral of repayments of Flexible Subsidy (Flex Sub) loans. Although, the procedures dictated by HUD Notices generally remain in place, notwithstanding their stated expiration, H2012-4 has expressly renewed HUD’s authorization and procedure for Flex Sub waiver requests.
Flex Sub assistance was provided over the years to projects suffering from physical and/or financial distress in the form of either “operating assistance” or “capital needs assistance.” Initially these funds were delivered as grants, and subsequently through loans, due to requests by developers and owners that they be includable in basis and avoid treatment as taxable income. Flex Sub loans were provided to owners of several types of HUD-assisted and -insured projects but are most often seen in connection with Section 202, 221(d)(3) and 236 projects, and certain uninsured subsidized properties. Under the direct loan program, Flex Sub obligations are owed directly to HUD, and often include a nominal interest rate and limited repayment requirements.
Federal regulations, and loan documentation if handled properly at the time of loan origination, require that Flex Sub debts be repaid upon project sale or refinancing. Often enough, however, in the context of redevelopment and preservation sufficient funding for repayment of this debt is not feasible. In such cases, HUD Headquarters has granted regulatory waivers necessary to allow Flex Sub loans to remain outstanding and subordinate to primary financing. As with all regulatory waiver processes, however, final terms for approval have been less than perfectly predictable, and obtained at considerable expense.
As early as 2008, Hub directors were provided with some standardized guidance for evaluation of requests to defer repayment of Flex Sub loans (both operating and capital needs). Before that, we and some others had worked to obtain several Flex Sub waivers through a less-than-formalized process. In February 2011, HUD released Notice H2011-05 reflecting policies and terms consistent with those that we have seen in waiver approvals over the past five years. Technically, H2011-05 addresses only waivers applicable to Flex Sub operating loans. Nevertheless, Flex Sub waivers for capital needs loans are available, although the subject of other regulations, in accordance with past practice – which has been largely in conformity with this Notice.
Relief from immediate repayment does require a Regulatory waiver, as the Notice cannot serve as modification of existing Regulation. Nevertheless, application criteria and approval conditions are set out for consistent treatment, provided thresholds are met:
Program Compliance. The project and owner must be in compliance with existing HUD agreements. If there is noncompliance, some flexibility is available in cases in which the owner can show that this will be cured as a result of the proposed transaction.
Operational Compliance. The project and owner must be meeting HUD standards of operational compliance:
- current REAC over 60
- satisfactory MORs
- up-to-date financial reporting
- recent (three-year) history of timely debt service payments, and
- no outstanding and unsatisfied notices of default or violations.
At a minimum, applications for waivers must include complete transaction sources and uses, as well as operating budgets demonstrating both expense projections that fall within an acceptable range of comparable properties and the need for relief due to insufficient funds otherwise available for redevelopment/preservation – including evidence that other sources have been sought. In addition, requested waivers will not be granted if the transaction model provides for equity take-out by the owner. In consideration, however, of a common model used by nonprofits in their LIHTC development, the purchase price may be set above outstanding debt, provided that the excess is paid only in the form of a seller note.
In exchange for grant of the requested waiver, owners will be subject to modification terms that include:
1. Scheduled amortization for remaining Flex Sub will be established as determined by HUD. In prior waivers we have seen amortization stretched out as far as new financing terms, and even subject to cash flow, but conditioned on review of operating pro formas. The Notice concurs that this debt may be included in future budget-based reviews of rent levels.
2. The owner will execute an extended use agreement with a term ending 20 years after the later of (i) the original mortgage maturity, or (ii) the date scheduled for full repayment of the newly amortizing Flex Sub debt. No form is provided for this use agreement, but we have seen either the original form of Flex Sub restriction modified to meet extended use terms or the use restriction commonly required for 236 and 221(d)(3) prepayments modified and used for these purposes. In addition, although not stated in the Notice, owners should expect to be required to extend their HAP Contracts with HUD’s current form of “preservation amendment.”
3. Residual Receipts will be applied toward paydown of the Flex Sub at closing of the transaction. Replacement reserves may also be applied to the extent that they exceed $1,000 per unit. It is intended that any refinancing or sale that has triggered the waiver request will also provide for rehabilitation that mitigates retention of existing reserves beyond this level.
4. The Notice also indicates that an amount equal to 15 percent of developer fees will be paid toward Flex Sub debt reduction and, further, that 15 percent of the owners annual allowable distribution will be applied annually to pay down the Flex Sub.
Important justifications for deferral include the need for new capital improvements or the need for new ownership to address compliance issues. Careful structuring and some negotiation will continue to be a hallmark of these transactions. In practice, we have seen application of this guidance to meet practical needs and some permitted stretching for specific circumstance.