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Housing Update

Programmatic Updates for HUD-Subsidized, OAHP-Restructured, FHA-Financed and Other Affordable Housing

Tuesday, April 15, 2008

Yes, we are tracking and have participated in several legislative initiatives that continue their winding path through Congress; and yes, there is much that could be said concerning the state of housing tax credit equity markets.

Both of these topics, however, lead largely down a road of educated speculation that has less-than-certain application to transactions that will mature as the year moves forward. During these past several months, HUD has released and instituted several important programmatic guidelines and policies, which we are now seeing implemented with practical effect. HUD Headquarters Multifamily Housing shop and Office of Affordable Housing Preservation (OAHP) have been thoughtfully energetic in their development of new tools and release of standardized guidance, offering assistance in difficult redevelopment and direction for simpler transactions that may now require additional planning. In this Housing Update, we discuss these initiatives, recent legislative items, a few proposals, and other items of interest to our clients and others who participate in the affordable housing industry.

Prepayment/Assumption and Redevelopment of Post-M2M Projects. Many Mark-To-Market properties, several years after their initial restructuring, show great need for substantial rehabilitation if they are to remain viable for the long term. Based in part on prior negotiated work and on preliminary results from the application of “draft” guidance, last year’s Notice H2007-5 has now been applied to several transactions, allowing relief from “due on sale” for HUD-held restructuring debt, while providing financial return and continued economic participation for both developers and HUD. (Please see Section I, “Redevelopment of Mark-to-Market Properties.)

Mark-to-Market Regulations and Revisions. On November 26, 2007, final regulations containing important modifications and standardization were implemented for the Mark-to-Market Extension Act of 2001 (P.L. 107-116). In addition, we note OAHP’s release of a new policy regarding Section 236 IRP in M2M restructurings. (Please see Section II, “Mark-to-Market Programmatic Update.”)

Efficiency Conversions for HUD Housing. The existence of efficiency units in older Section 202/811 and 236 projects, and HUD’s general bar on reduction of units (including conversion to marketable one-bedrooms) have combined to discourage preservation/redevelopment of many older housing assets. Although we and a few others have been able to work with HUD for some successful conversions, project-specific approvals have proved an inefficient method of preservation. In February, HUD Hub directors and Multifamily staff were provided some common directive for conversion of efficiency-bound properties. (Please see Section III, “Permitted Conversion of Efficiency Units.”)

Deferral of Flexible Subsidy (Flex Sub) Loans. In a January 2008 memorandum, Hub directors and the industry were provided with another good example of HUD evaluating results, from individually negotiated waivers to develop a policy for general application to a now-common issue. As with efficiency conversions noted above, we have worked well with headquarters staff, under an ad hoc process, to obtain warranted waivers for relief from immediate repayment of outstanding Flex Sub loans in redevelopment transactions. This new guidance will allow for some consistent application and result, based on lessons learned from prior preservation efforts. (Please see Section IV, “New Policy for Flexible Subsidy Loan Deferrals.”)

Preservation Prepayments. HUD’s policies and requirements for prepayment approvals have continued to evolve with better compliance tracking, and as Wellstone Amendment and 250(a) processing collide with one another under various transaction structures. HUD has updated its extended use restrictions and has instituted new rehab requirements for some approvals. Early evaluation of transactions must account for these matters if they are to avoid issues that can prove lethal when discovered late in the development process. (Please see Section V, “221(d)(3) and 236 Prepayment Basics.”)

2008 Appropriations - Section 318 - Now Section 215/Section 8/Section 202 and Other Matters. Although carrying much less programmatic change than had been hoped by many, HUD’s FY2008 Appropriations (P.L. 110-161) did include some important program items. Subsidy transfers (formerly known as Section 318 transfers) were updated/expanded; Section 8 HAP contracts will now survive HUD-foreclosure and may even be shift among properties. Section 202 was updated to relieve the need for some waivers that had been previously required for mixed-finance 202 projects. (Please see Section VI, “2008 Statutory Highlights.)

LIHTC and Other Housing Legislation. Because we cannot help it and, at this time, both the House and Senate have similar legislation moving forward, we note Senate Bill S.2666, which contains several provisions that would indeed “improve coordination [of the LIHTC] with other federal housing programs” and draft bills now circulating in both houses concerning other matters. (Please see Section VII, “Housing Legislation Proposals.”)

I. REDEVELOPMENT OF MARK-TO-MARKET PROPERTIES

HUD’s Mark-to-Market program has a continued record of success in meeting goals of reduction in excess subsidy for Section 8 properties while limiting FHA insurance claims. As administered by the Office of Affordable Housing Preservation (OAHP), Mark-to-Market does not generally leave owners, PAEs, HUD and tenants all equally satisfied. However, that may be an indication of its largely even-handed application. Nevertheless, Mark-to-Market was not designed as a means by which decades-old Section 8 projects would be rehabilitated and maintained for another 20 or 30 years of service. It is not a preservation program.

Generally, full Mark-to-Market (M2M) restructuring will result in the reduction of Section 8 subsidy to comparable market levels, and the bifurcation of existing debt into an FHA-insured first lien that can be serviced by reduced rents, and either one or two subordinate mortgage loans, 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. We often see properties, restructured several years earlier, now in need of substantial rehabilitation if they are to be maintained as affordable housing assets.

M2M’s mortgage bifurcation process does not result in a reduction of outstanding mortgage debt, but only in a deferral of that portion that cannot be regularly serviced under lowered rents. In addition, HUD-held subordinate Mortgage Restructuring Mortgages (MRMs) and Contingent Repayment Mortgages (CRMs), 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 that rental income cannot support new debt sufficient to pay for rehabilitation and repay the combined full amount of outstanding first lien FHA-insured and subordinate HUD-held mortgage loans.

Specific OAHP incentives for nonprofit-sponsored projects (including those using tax credits) have been available and worked well in these circumstances. Additionally, we have seen many redevelopment/preservation transactions close with relief from due-on-sale and/or full assignment of HUD held debt to community-based organizations. Nevertheless, purchase/redevelopment transactions by some, including LIHTC partnerships without nonprofit general partners, have required ad hoc and negotiated treatment. Based in part on prior negotiated work with OAHP and on preliminary results we have seen from application of earlier “draft” guidance, last year’s Notice H2007-5 has now been applied to several transactions, allowing relief from due-on-sale, while providing financial return and continued economic participation for both developers and HUD. We have now worked through multiple projects under this “final” guidance, including prepayment or assumption of first-lien FHA debt while deferring repayment of subordinate MRMs and CRMs.

Notice H2007-5 has formalized the process that OAHP uses to determine whether owners or purchasers will be permitted to refinance or acquire previously restructured M2M projects, without full repayment of existing HUD-held mortgage debt. Conceptually, OAHP will evaluate whether the proposed transaction:

  • is in the best interest of HUD, tenants and the community (including provision for extended use restrictions, long-term financial and physical stability, and maintenance of value in outstanding HUD-held debt)
  • involves competent ownership and management
  • provides appropriate rehabilitation from non-HUD funds
  • allows HUD, after having previously paid for a large portion of the initial M2M restructuring through FHA-insurance claims, to receive its fair share of transaction proceeds.

In practical application, 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 where field office staff are efficient and knowledgeable in their TPA responsibilities. Upon comprehensive submission to HUD of transaction/financial model documentation and other information, OAHP will consider: (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; and (3) the appropriate distribution of transaction proceeds among the participants, including HUD.

Property Viability. OAHP will generate its own internal underwriting based on budgets and operating projections submitted by the applicant. It is expected that the proposed transaction will result in not less than a 1.2 debt service coverage, assuming appropriate operating expenses, adequate replacement reserves and vacancy estimates. The notice requires that new debt is fixed-rate, and describes what OAHP considers a sufficient operating expense “cushion.” In our experience, any rehabilitation plans will be largely reviewed by the field office for determination that they adequately meet project needs.

Continued MRM and CRM Value. Debt service on MRM and CRM debt held by HUD following M2M restructuring is cash-flow contingent. Under the Notice, OAHP will consider whether the net present value of projected and realized cash flows paid toward this debt service remains stable under the applicant’s presented transaction/operations model. In the event MRM or CRM value is reduced, given reduction in net present value of projected available cash flow when compared to that budgeted during original M2M processing or actual past performance, OHAP may require immediate up-front payment for a portion of the MRM and CRM notes to bring their values back into line with pre-transaction expectations.

This criteria and evaluation will generally use a 5.5 percent discount rate. If, however, the first-lien FHA-insured mortgage remains in place (assumed, without modification, by the new owner), OAHP will deem this criteria satisfied. Given that HUD/OAHP participated in the underwriting for the original M2M restructuring, which resulted in the project’s current debt levels, OAHP will not take this request as a second bite at the apple.

In addition, this criterion will not be considered when the request involves debt assignment or forgiveness in connection with qualified nonprofit incentives available under current guidelines. In such transactions, to accommodate statutory incentives for nonprofit ownership and/or control, MRM and CRM notes and mortgages are assigned by HUD to a “qualified nonprofit,” 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. Simply, HUD wants its share, given its prior investment.

Applicant proposals with regard to this issue will be sifted through a matrix of comparison between private interest financial benefits and available funds for repayment of HUD-held debt.

Although this evaluation is handled on a case-by-case basis, the Notice clarifies that 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.

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.

The devil, of course, is in the details of OAHP’s evaluation of “net proceeds.” OAHP’s discretion in treatment of deferred developer fees, existing debt obligations of sellers that are outside of HUD-insured or HUD held mortgage debt, existing project accounts and reserves, and other transaction costs is important to consider in planning, and are subject to overall transaction terms and review.

Transaction documents for closing will generally be handled through the field office, once OAHP has made its determination and notified the field of its conclusions. It should be noted, that in addition to repayment of a portion of MRM and CRM debt, prior to assumption by the new owner, OAHP will also require a statement of partial year surplus cash for the project, and that the prorated portion due for outstanding MRM and CRM debt service be paid by the seller prior to or at closing.

Submissions and processing for this treatment of post-M2M HUD-held debt is comprehensive and time-consuming, and does require planning by the applicant. In response, 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 also have seen this policy employed to provide for necessary substantial rehabilitation and preservation where transactions would not have been otherwise possible.

II. MARK-TO-MARKET PROGRAMMATIC UPDATE

Although Mark-to-Market processing under the Multifamily Assisted Housing Reform and Affordability Act of 1997 (MAHRAA) continues apace, and has resulted in successful restructuring for thousands of Section 8/FHA-insured projects for a decade now, tweaking of the program continues as new structures arise and unintended consequences for specific project circumstances become apparent. In 2002, Congress addressed certain modifications as part of the Mark-to-Market Extension Act. The majority of the Act’s changes have been instituted over time by limited guidance and “policy,” but had not been instituted under final regulation, until late last year with HUD’s publication of implementing regulations. These final regulations mirror proposed regulations published March 14, 2006, but a few important provisions are discussed below:

Transfer to Qualified Nonprofits. 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…” OAHP has utilized this authority to institute its incentive program for nonprofits and nonprofit-sponsored LIHTC purchasers of M2M projects. Qualified nonprofits or their partnerships may purchase a M2M project and have the Mortgage Restructuring Mortgage (MRM) and/or the Contingent Repayment Mortgage (CRM) assigned by HUD, the original holder, to an affiliate of the nonprofit or entirely forgiven.

To qualify for this treatment, the nonprofit must be tenant-endorsed and meet several other statutory criteria. This incentive program for nonprofits was fully implemented several years ago, and we have seen it employed successfully by many of our nonprofit clients. The final regulations do not make many revisions to the proposed rule, but do solidify requirements for “tenant endorsement” of the nonprofit.

Many commenters to the proposed rule had sought implementation of an extended and complicated tenant notice and endorsement procedure. In its response and final rule, HUD reiterated its intent not to be unduly prescriptive in the methods used by nonprofit housing organizations or tenant-organizations in their delivery of information to residents and soliciting of endorsement for plans for nonprofit acquisition and redevelopment of M2M projects. A single informational meeting will continue to be required. Although in our experience nonprofit representatives are always in attendance at these meetings, regulations now require it. In addition, 51 percent written endorsement remains the standard, but OAHP will now consider requests for waiver of this for good cause after reasonable efforts are employed to meet the requirement.

Restructuring Rehabilitation Standards. Rehabilitation standards for restructuring plans are now stated in the regulations as intended to result in “a project that can attract non-subsidized tenants, but competes on rent rather than on amenities.” When a range of options exist for rehabilitation meeting this standard, the PAE must choose the least costly alternative, but taking into account future marketability. Rehabilitation may include the addition of “significant features,” such as central air conditioning, an elevator or community space.

Owner Appeal of PAE Determination. Given that PAE determinations and M2M models may have absolute and significant impact on owners and projects, the somewhat ambiguous process that had existed for appeals caused some consternation among owners with justified points of contention. The final regulations provide a clear path and administrative process for appeals going forward.

Use of Section 236 IRP and Exception Rents. The common M2M restructuring plan will include a reduction in existing Section 8 subsidy, given that MAHRAA’s Mark-to-Market program was largely pointed toward over-subsidized properties. Nevertheless, M2M authority does provide some limited discretion for grant of rent increases, in cases where restructuring and necessary rehabilitation would otherwise be infeasible and various circumstances of tenant population and housing need are present. In addition, it is not uncommon that existing Section 236 Interest Reduction Payments, allocable to a given M2M project, be retained following the full restructuring for application in support of first lien debt or replacement reserves (outside of the non-M2M IRP decoupling process, which is also common for these older buildings).

We have been successful at times in assisting clients combine these concepts to maintain the benefits of IRP as part of a full M2M restructuring, and also receive a rent increase under “exception rent” authority, to the great benefit of “additional funds” redevelopment transactions. However, late last year, OAHP, in concert with review by HUD OGC, determined that this treatment is no longer permissible. Section 236 IRP can continue to be available for application to M2M debt in full restructurings, but cannot be used when post-M2M rents will be set above pre-M2M rents. Effectively, owners in these very complex transactions will now be required to choose between the benefits of continued IRP or increased exception rent levels.

III. PERMITTED CONVERSION OF EFFICIENCY UNITS

For some time, the existence of efficiencies in older HUD-assisted projects has posed a particular quandary for owners, preservation advocates and HUD. Built at a time when this type of housing was widely accepted in the marketplace, these aging and outmoded properties often represent the remainder of a dwindling local resource of affordable housing, fated for loss as a result of obsolescence. We have assisted in the preservation of some of these buildings and obtained HUD approval for conversion/rehabilitation into affordable housing appropriate to their communities. Nevertheless, modernization from efficiency to one-bedroom or larger apartments, often through combining of units, has proved administratively inefficient at best, given HUD’s aversion to reduction/loss of unit numbers. On February 1, 2008, however, Deputy Assistant Secretary John Garvin provided Hub directors and Multifamily staff with important guidance for a more direct path to conversion of efficiency units. The conversion memorandum tracks and draws from prior experience gained in the processing of ad hoc negotiated waivers, which we and a few others have obtained.

The memorandum applies generally to Section 202, 811, 236, 221(d)(3) BMIR, Project-based Section 8, RAP and Rent Supp properties, and other projects subject to HUD deed or use restrictions. Of primary importance, with respect to owner proposals, HUD administrators must find that conversion is warranted by local demand and will result in the long-term financial and physical viability of the project.

Owner proposals for efficiency conversion must be comprehensive and include a long list of items, including strong description of project circumstance and need, a PCNA, proof of tenant notice compliance, and local governmental support letters. In addition, any proposal must address several programmatic requirements, not inconsistent with prior waiver approvals, but containing some targeted specificity.

Program Compliance. As with approvals for HUD waivers generally, and deferral of Flexible Subsidy repayment (discussed elsewhere in this Housing Update), the project and owner must be in compliance with existing HUD agreements. If there is non-compliance, some flexibility is available where the owner can show that this will be cured through conversion. Any non-compliance (i.e. financial statements have not been filed) that limits HUD’s ability to analyze a conversion request must be cured before submission.

Evidence of Demand. Owners must provide evidence of their efforts to market existing efficiencies and of demand for the proposed post-conversion unit type. The memorandum notes that average vacancy in the efficiency units should have been at least 25 percent for at least 24 of the preceding 36 months.

Operating Projections. Post-conversion project operating budgets should demonstrate a 1.1 debt service coverage, or better.

No Increased Subsidy Cost. The proposal must demonstrate that no increase in existing project-based assistance budget authority will result from conversion. This does not require that individual unit subsidy remain unchanged, but will require a showing that the subsidy applied for new one-bedrooms does not exceed the pooled subsidy of efficiency units combined to create them.

Certain limitations and requirements also will apply with respect to rehabilitation plans, rent levels and extended use restrictions.

Rent Limitations. Rents for newly created one-bedroom units will initially be capped at the lesser of current one-bedroom rents at the project, or the combined rents of the two converted efficiencies. Section 8 rents will be further restricted to comparable market rents (or lower LIHTC rents, if applicable). The notice does imply that Mark-up-to-Market for Section 8 will be permitted if the project and owner are otherwise eligible, but nonprofits are limited to Mark-up-to-Budget as provided under current Section 8 Renewal Guide authority. In addition, we expect that Section 236 IRP decoupling processing in connection with this type of conversion/rehabilitation will allow for budget-based rent increases for 236 Basic Rents, as is common in those transactions, and as we have seen in prior conversions predating this guidance.

Combination of Dissimilar Units. Although statutory limitations are not clear, HUD will not approve plans that combine unsubsidized with subsidized units (in partially assisted projects). Proposals must provide that Section 8 units will only be combined with Section 8 units, and unsubsidized but restricted units will only be combined with unsubsidized units. In addition, consistent with prior HUD interpretation, original HAP contract units, those that have not experienced expiration of their initial contract term, may not be combined with Section 8 units subsidized under HAP contracts that have been previously renewed pursuant to MAHRAA.

Handicapped Access. Rehabilitation plans will generally be required to demonstrate compliance with accessibility regulations.

Use Restrictions and Owner Section 8 Commitment. The memorandum contains a short form Use Agreement that will be signed by the owner, and owners are further required to accept Section 8 rental assistance for as long as it is offered by HUD.

Section 236 IRP. With regard to Section 236 Interest Reduction Payments, this guidance notes the possibility of some reduction in IRP resulting from reduction in the number of Section 236 units. Whether or not IRP reduction is required for individual projects is a determination that must be made after a review of the original Section 236 loan and subsidy documentation. Not all units in all Section 236 projects were originally designated as 236 units, and we have seen unit reductions under prior waivers that did not result in loss of IRP.

Section 202 PRAC, Rent Supp and RAP units will be treated similarly to those of Section 8.

This new guidance is welcome, as a confirmation that unit conversions are available as a preservation tool and as some direction for consistent treatment of these proposals. HUD has provided a framework that allows transactions to be more clearly defined. The memorandum contains additional guidance including discussions of prepayment and treatment of Section 8 contracts for older HFA-financed projects. Upon even quick review of program requirements, it is apparent that comprehensive and thoughtful planning and proposal development are necessary if approval is to be granted, and funding source schedules require HUD review and conclusion within tolerances of pre-development timetables.

IV. NEW POLICY FOR FLEXIBLE SUBSIDY LOAN DEFERRALS

Early in President Carter’s administration, Congress authorized HUD to provide “flexible subsidy” (Flex Sub) assistance to projects suffering from physical and/or financial distress. Initially these funds were delivered as grants, and subsequently through loans, as requested by developers and owners in order 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 221(d)(3) and 236 projects, older Section 202 projects and certain uninsured subsidized properties. Under the direct loan program, Flex Sub obligations are owed directly to HUD, often including a nominal interest rate and limited repayment requirements. Although we find that these loans were often not properly or consistently documented in past decades, and commonly the subject of poor record-keeping by owners and HUD, now it is not unusual for those involved in redevelopment transactions to discover the existence of an outstanding Flex Sub obligation that must be satisfied before obtaining other necessary approvals.

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. We have, however, seen multiple transactions where funding for repayment of this debt is not feasible in the context of redevelopment and preservation. In such cases, HUD has granted regulatory waivers necessary to allow Flex Sub loans to remain outstanding and subordinate to primary financing. As with all waiver processes, however, final terms for HUD approval have been less than perfectly predictable, and obtained at considerable expense.

Deputy Assistant Secretary John Garvin’s January 9, 2008, Memorandum to Hub Directors, however, is good example of HUD evaluating results from individual waiver processing to develop a thoughtful policy for general application. The memorandum reflects policies that we have seen in waiver approvals over the past two years, but also confirms that deferral of Flex Sub repayments in project repositioning is, in fact, possible. Relief from immediate repayment continues to require a regulatory waiver, as the memorandum cannot serve as a modification of existing regulation. Nevertheless, application criteria and approval conditions are set out for consistent treatment, provided thresholds are met.

Proposals and projects must meet certain criteria, not distant from those released earlier under HUD’s efficiency conversion policy.

Program Compliance. The project and owner must be in compliance with existing HUD agreements. If there is non-compliance, some flexibility is available where the owner can show that this will be cured through conversion. Any non-compliance (i.e. financial statements have not been filed) that limits HUD’s ability to analyze a conversion request must be cured prior to submission.

Operational Compliance. The project and owner must meet HUD standards of operational compliance:

  • current REAC over 60
  • satisfactory MORs
  • up-to-date financial reporting
  • recent history of timely debt service payments
  • 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 that demonstrate income and expense projections that fall within an acceptable range of comparable properties and 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 or a purchase price exceeding outstanding debt. The Multifamily Hub must also concur with the waiver request, and indicate the nature of public benefit that will be provided by approval.

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, but subject to review of operating pro formas. The memorandum concurs that this debt, not amortizing, may be included in future budget-based reviews of rent levels.

2) The owner will execute an extended use agreement for the longer of (i) 20 years beyond the original mortgage term, or (ii) the date scheduled for full repayment of the newly amortizing Flex Sub debt. There is not a form provided for this use agreement, but we have seen the original form of Flex Sub restriction modified to meet extended use terms.

3) Residual Receipts (or Cooperative General Operating Reserves) are expected to be applied toward paydown of the Flex Sub at closing of the transaction. Replacement reserves also may be applied to the extent 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.

The memorandum recognizes that, after 30 years, properties remain in tight operating positions and that important justifications for deferral include the need for new capital for 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. Some future modification of policy to provide appropriate incentives may be necessary. Nevertheless, this new guidance appears to be a solid step forward, by addressing practical needs and clarifying what has been occurring in limited practice.

V. SECTION 221(D)(3) AND 236 PREPAYMENT BASICS

Over the past two years we have received an ever-increasing number of calls from owners, lenders, developers and investors who are confounded by the prepayment approval process for older Section 221(d)(3) and Section 236 mortgages. Although statutory authority and HUD-published guidance have been in place for quite some time, overlapping restrictions and requirements present an intricate and often obscure path. In addition, HUD’s increased oversight of borrowers, and some recent guidance to HUD field offices, which owners may not be aware of until confronted by them late in the transaction process, have served to frustrate many caught between funding/construction deadlines and prepayment approval delays, which might have been foreseen. Although we have described prepayment approval requirements and administration in prior Housing Updates, it may be time to refresh memories and introduce those newly involved with this process. There are, of course, exceptions to nearly each of the rules cited below, but the following provides some good review for general understanding and consideration in transaction planning.

To begin, note that these mortgages, due to several programmatic and regulatory terms, will generally fall into one of two categories:

1. Requires HUD’s explicit and discretionary approval for prepayment.

“This Note may not be prepaid either in whole or in part prior to the final maturity date without the prior written approval of the Federal Housing Commissioner” (or similar language contained in the body of the promissory note or a rider attached).

2. Does not apparently require HUD approval for prepayment.

“Privilege is reserved to pay the debt evidenced by this Note in whole or [in part] prior to maturity upon at least thirty (30) days’ prior written notice to the Secretary” (or similar language contained in the promissory note body).

Various combinations and modifications of this language were commonly used, including among them 20-year lockouts and specific provisions for Rent Supp properties. In addition, owners often find that restrictions imposed many years ago, but after initial loan closing, due to receipt of additional HUD funds or by other agreement with HUD, trigger the necessity for HUD’s explicit approval for prepayment of notes that, on their face, do not require other than 30 days’ notice.

Also note that, even if an owner may prepay its FHA-insured or HUD-held mortgage by right, without HUD “approval,” all applications for prepayment and payoff balance must be processed in HUD headquarters. That processing will include HUD review for past regulatory noncompliance. The finding of past noncompliance by the owner can, and often does, delay prepayment and closings until resolved to HUD’s satisfaction.

All interested parties should be familiar with the two statutory frameworks directly governing prepayment of FHA-insured 221(d)(3) and 236 mortgage loans. Section 219 of the Veterans Affairs and HUD Appropriations Act of 1999 (P.L. 105-276), commonly referred to as the Wellstone Amendment, addresses many preservation projects with mortgages that will soon become eligible for prepayment without HUD “approval.” Section 250(a) of the National Housing Act also generally addresses prepayment requirements for those 221(d)(3) and 236 mortgage loans that cannot be prepaid, without explicit HUD consent.

Can you prepay without HUD approval? Yes? Then Wellstone may apply.

Do you require HUD approval to prepay? Yes? Then 250(a) will apply.

Wellstone Amendment. The Wellstone Amendment applies to mortgage loans that can be prepaid without HUD approval, or will be eligible for prepayment by right within the next two years. The Wellstone Amendment requires owners to provide 150-days prepayment notice to tenants, local government and HUD, or alternatively, to record an extended-use agreement, if appropriate notice has not been delivered. There are also some exceptions for nonprofit purchasers. Wellstone requirements should be acknowledged when reviewing any 221(d)(3) project receiving project-based Section 8 as a result of conversion from Rent Supp, any 221(d)(3) BMIR, and any FHA-insured 236 project.

Generally, even if an owner believes that its 221(d)(3) or 236 mortgage note provides explicit authorization to prepay upon 30 days notice, the owner must determine whether Wellstone’s statutory modification has effectively extended that prepayment notice time period to 150 days.

It is important that owners provide a prepayment notice to tenants, local government and HUD that satisfies statutory requisites. Delivering notice in bad form will only result in HUD determination that the 150-day clock has not yet begun. In any event, the notice, by statute, expires 270 days after delivery. If closing for refinancing is delayed beyond this 270-day deadline, the 150-day notice must be delivered again and the clock reset. Alternatively, the owner may avoid the 150-day notice requirement by agreeing to record an extended use agreement, restricting project operation through the original mortgage term.

Section 250(a) Approval. Section 250(a) of the National Housing Act has been in place since the early 1980s, providing guidance to HUD when explicit approval is required for prepayment. Generally, Section 250(a) is concerned with those owners who cannot prepay without HUD consent. These most often include: (i) nonprofit-owned Section 236 and Section 221(d)(3) mortgages; (ii) Section 236 and Section 221(d)(3) BMIR mortgages that are not yet 20 years old, a few remain; (iii) Section 236 and Section 221(d)(3) mortgages on properties that have been transferred by the original nonprofit mortgagor to a for-profit entity; (iv) some properties with Rent Supp contracts; and (v) many properties with Flexible Subsidy loans or other use agreements between HUD and owners limiting prepayment rights.

Section 250(a) states that HUD may not grant its discretionary approval for prepayment unless the HUD secretary:

1. determines that the project is no longer meeting the need for affordable housing in the community.

2. determines that tenants have been appropriately notified and has taken any tenant comments into consideration.

3. determines that appropriate options and assistance are available for any tenant relocated as a result of prepayment.

In practice, HUD grants this discretionary 250(a) prepayment approval upon determination that the project is physically healthy and that the owner has given acceptable notice to tenants without return of negative comment, and provided that the owner records an extended use agreement insuring continued affordability through the original mortgage term.

Notice H06-11. Although 250(a) has been a statutory requisite for more than two decades, it was common that its requirements were not energetically applied by HUD in approving prepayments. In 2006, however, HUD issued Notice H06-11. That notice was identical to prior notice H04-17, but its reissue signaled a new intent that 250(a) requests would now be reviewed and considered thoroughly. Indeed, since that time, prepayment approvals have taken a great deal more effort and consideration on the part of owners and HUD staff.

H06-11 effectively re-implemented 250(a) statutory requirements to ensure that prepayments requests are appropriately evaluated. The notice provides description of prepayment proposals that will allow the HUD secretary to make determinations required by statute as described above. Although there have been some “policy” modifications over time, that notice remains a good guideline for what owners can expect.

For owners of subsidized projects that intend to prepay and redevelop their property as other than affordable housing, there will be an extended tenant notice and application process, including submission of considerable documentation showing that the community no longer requires this housing resource and that existing tenants will be properly treated during the conversion process.

For owners that intend to prepay in connection with a redevelopment/preservation transaction, the notice provides both tenant notice formats and general description of extended use restrictions that will apply. Although the notice states that tenant notice must be delivered 150 days before prepayment, this requirement (unlike Wellstone circumstances) is not statutory, and will require HUD headquarters staff to be flexible as to timing when preservation/redevelopment plans are involved.

With regard to use agreements employed in connection with 250(a) prepayments and H06-11 processing, we had been working with decades-old outdated forms for years now, each requiring significant project-specific revision and some negotiation of terms. In October, however, HUD released to the field a package of new form use agreements (for both Wellstone and 250(a) prepayments). These new forms require considerably less haggling and are in multiple versions well-designed for application to most commonly occurring project circumstances.

Finally, the notice reiterates HUD’s current administrative procedures, applicable to both Wellstone and 250(a) processing. Generally, the process is as follows:

a. Owner delivers notice/request for prepayment to lender/servicer.

b. Lender/servicer delivers request for approval to HUD headquarters.

c. HUD headquarters delivers prepayment checklist to field office, while reviewing whether issues of noncompliance are noted in HUD’s database, i.e., financial reporting deficiencies, unsatisfactory REAC or MOR results, failure to submit required debt service or excess income payments or reports. We have seen prepayment delayed due to a single failure in reporting that may have occurred years prior, even if compliance has been without error in recent years.

d. Field office obtains use agreement and/or proof of tenant notice from owner, and submits completed checklist to HUD headquarters.

e. Headquarters reviews checklist and any deficiencies in notice or programmatic noncompliance.

f. Headquarters delivers to lender approval, with appropriate conditions, or rejection noting deficiencies that must be corrected by the owner before approval.

As one can see, from the process described above, there are many steps and potential for misstep along the prepayment path.

Additional Processing Policies. Explicit authority, direction and processing guidance aside, owners also must be aware of an evolving review standard for 250(a) projects. Early last year, HUD supplemented or clarified H06-11 by memorandum to the field. Since its release, we have seen that memorandum guidance trigger additional administrative processing for nearly each 250(a) prepayment.

The memorandum purports to clarify the term “significant amount of repair” as used in H06-11. The difficulty with this is that neither the term “significant amount of repair” nor the concept of requiring rehabilitation is contained in H06-11.

Currently, in accordance with this guidance, owners requesting prepayment pursuant to 250(a), those requiring HUD approval, must provide a plan for rehabilitation of their property that will be undertaken in connection with the prepayment, and meeting one of three thresholds:

1. Total rehabilitation hard costs exceed $15,000 per unit.

2. Rehabilitation includes replacement or modernization of at least one major system (i.e. roof replacement, plumbing, foundations, HVAC, etc. – we have seen some flexibility on these).

3. Total rehabilitation hard cost is at least 25 percent of the total development cost (acquisition costs, development costs, legal and organizational costs, etc.).

As noted above, there are exceptions to nearly every rule. Nevertheless, given HUD’s current method of thorough review, even those who are eligible for prepayment by right should not assume that their 30-day notice to lender and HUD will result in prepayment 30 days later. FHA lenders must not accept prepayment on these loans without confirmation by HUD. Owners must prepare early to address and meet the needs of that confirmation/approval process, or be prepared for potential delays in closing.

It is very important that projects which have previously been owned, or are currently owned, by nonprofits be evaluated early with respect to prepayment requirements. It is possible that nonprofit prepayment prohibitions, which are not apparent in the loan documents themselves, have been carried forward to for-profit ownership and will modify prepayment processing at HUD Headquarters.

VI. 2008 APPROPRIATIONS STATUTORY HIGHLIGHTS

This year’s HUD Appropriations Act (P.L. 110-161) contained fewer programmatic changes than had been hoped. Several statutory proposals mandating change to existing HUD administrative policies continue to move forward, but this year’s enacted appropriations did include a few important provisions for flexibility and preservation. Section 318 transactions will now likely be known by Section 215, as the new Act’s designation in which this program has been restated and revised to include additional authority. Section 220 of the Act effectively mandates that HUD now maintain Section 8 HAP Contracts in the event of foreclosure, where previous authority only permitted it. With regard to Section 202 mixed-finance development, Section 202 of the Housing Act of 1959 was updated to clarify that capital advances may be loaned into the project-owning partnership, thus avoiding LIHTC basis issues without need for project-specific waiver.

Section 318/Section 215 Transfer of Section 8 and Other Subsidy. Section 215 of this year’s Appropriations Act generally restates what has previously been called the Section 318 program. Section 215 again specifically authorizes the HUD secretary to transfer project-based assistance, project debt and use restrictions from one property to another. This authority drew industry-wide attention when initially enacted in 2006, but the case-by-case evaluation, processing and negotiation with HUD required for these types of proposals has not yielded significant fruit. Section 215’s new authority will expire in 2009.

HUD had previously been authorized to approve transfers of several program subsidies from one property to another. Section 215 has added Section 236 Interest Reduction Payments to the list of subsidies that may now be moved from non-viable projects to other sites, including:

  • Project-based Section 8
  • Rent Supplement
  • Section 236 IRP
  • Section 202 PRAC.

Mark-to-Market and Section 202 use agreements also may be moved from one property to another, or to multiple property sites.

Section 215 provides specific authority for transfers of these subsidies and associated use restrictions, as well as other items, and codifies conditions we have previously found necessary to move pre-318 proposals forward. Specifically, approvals for transfers under this new authority must satisfy several conditions, among them:

(1) The number of low and very-low income units and the dollar amount of federal assistance must remain the same.

(2) The transferring project must be determined physically obsolete or economically non-viable.

(3) The tenants of the transferring project must be consulted.

(4) Tenants of the transferring project must not be required to vacate their units until units in the receiving property are available.

(5) If either the transferring or receiving project is FHA-insured, all other mortgages must be subordinate.

(6) Use Agreements recorded against the receiving project will be for a period not less than existing restrictions.

(7) The transfer must result in a reduction of risk to the FHA Insurance Fund.

Although this authority (in the form of Section 318) gave rise to hope by many owners of Section 8 properties located in gentrifying parts of town, proposals that have so far been taken seriously in HUD headquarters involve projects that are truly physically obsolete or economically non-viable, and subject to lengthy submission, review and discussion process that has so far set little precedent for broader application.

Section 8 Retention Following Foreclosure. In the late 20th century, it was not unusual for owners of FHA-insured properties that required additional funding, or which were the subject of compliance disputes with HUD, to throw into discussions the veiled or explicit threat, “I’ll just give them the keys and walk away.” There was even a time when that position carried some weight in negotiations with HUD.

That time has passed, however, and now the more common response from HUD to such an owner includes notice of assignment of claim by lender, and HUD proceeding forward with foreclosure. One byproduct of this new aggressiveness has been subsidy savings. For some time, HUD foreclosure most often resulted in termination of any existing project-based HAP contract, never to return, and the resulting relief from its appropriations burden.

Congress did enact legislation requiring HUD to consider retaining Section 8 following foreclosure, and in some cases we have seen HUD do so. Nevertheless, in this year’s Appropriations Act, Congress has effectively mandated retention of these foreclosed HAP contracts, by significantly raising the burden of the showing that must be met prior to termination.

Section 220 of the Act now requires HUD to maintain the HAP contract in force, following foreclosure unless, after consultation with tenants and the local government, it is determined that it is not feasible to retain the contract. That determination must include finding that the cost of rehabilitation or operations, or environmental remediation exceed project viability. That determination, however, must review all available federal, state and local resources, including upward Section 8 adjustments. Following any finding that meets this threshold for termination at the site, the HUD Secretary is then authorized, to move the HAP contract to another multifamily project.

Section 202 Mixed-Finance development. Projects that have moved and are moving forward with Section 202 mixed-finance in concert with the federal housing tax credit are often stymied under HUD’s 202 regulatory and policy regimes that do not mix well with requirements of the Internal Revenue Code governing the LIHTC. As a result, those new 202/LIHTC developments, with which we have been involved, have required regulatory and policy waivers to allow the full benefit of private LIHTC equity to be realized and to allow for these developments ultimately to succeed.

This year’s Appropriations Act has provided at least one solution, in explicitly authorizing 202 Capital Advance loan structures that have already been used in several of these transactions. In some cases, however, structuring HUD funding as a sponsor/subordinate entity loan has been deemed to require a waiver, given the lack of clarity in HUD’s 202 mixed-finance regulations.

Section 223 of the Act now specifically permits the nonprofit recipient of a Section 202 Capital Advance award to establish a sole-asset subordinate affiliate (which may include a limited partnership, the general partner of which is controlled by the nonprofit), and to loan the capital advance funds to that affiliate. This confirms a structure that is obvious to those that have been involved in these transactions, but not always readily accepted by HUD in processing.

VII. HOUSING LEGISLATION PROPOSALS

Movement continues on multiple housing legislation fronts in both houses of Congress. Modifications to the LIHTC program are currently most advanced under Senate Bill S.2666, but that may change over coming weeks as proposals sponsored by Rep. Barney Frank (D-MA) and Sen. Charles Schumer (D-NY) solidify. For now:

LIHTC. S.2666 contains several provisions of great interest:

1. locking the LIHTC “Applicable Percentage” at 9 percent and 4 percent rather than tied to monthly economic/financial figures – or alternatively, float higher if indicators support

2. allowing the use of LIHTC against AMT

3. allowing use of LIHTC for Mod Rehab project

4. acknowledging that Section 236 IRP and Section 202 PRAC are not federal grants for LIHTC basis purposes

5. eliminating recapture for some project dispositions if use remains during the remaining compliance period.

HUD Multifamily Housing. Drafts and existing bills in both houses of Congress currently address several important issues:

1. conversion of RAP and Rent Supp to project-based Section 8

2. enhanced voucher availability for an expanded range of events, i.e., full amortization rather than prepayment

3. potential for project-based vouchers rather than enhanced tenant-based vouchers

4. inclusion of new debt service in budget-based rent increases for preservation projects

5. explicitly permit nonprofit owners to receive sale proceeds, now often limited by HUD policy.

All remains a bit speculative for now, and the brief listing above is not comprehensive, as bills currently in draft are very large and cover many issues. We will continue to track these proposals, however, and keep you informed.

Scott E. Fireison and Sheldon L. Schreiberg

Written by

Scott E. Fireison
Phone: 202.220.1572
Fax: 202.220.1665
fireisons@pepperlaw.com

Sheldon L. Schreiberg
Phone: 202.220.1421
Fax: 202.220.1665
schreibergs@pepperlaw.com


The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

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