Insight Center: Publications

Programmatic Updates and Proposals for FHA Insurance, Partial Payments of Claim, REAC Inspections, Section 202 Redevelopment, Section 8 Subsidy, Post-M2M Transactions and Other Affordable Housing Programs

Housing Update

Authors: Sheldon L. Schreiberg and Scott E. Fireison


For those involved with financing, development and preservation of HUD-assisted multifamily housing, this summer has not proved to be a time of ease and relief from the rush and press of activity. Demand for and strain on FHA financing programs and HUD’s continued efforts to meet market conditions while "modernizing" its procedures and oversight have resulted in a summer-long run of development, revision and release of updated program guidance and policy, and change-step modification of transactions in response. This activity and a near-continuous need for flexible treatment due to project and/or programmatic weaknesses, exposed by continued economic pressures, have required HUD administrators and industry participants to be thoughtful and nimble enough to re-think, restructure and resolve all manner of novel and difficult circumstances.

In this Update we discuss several recent program updates. While the FHA Modernization initiative, success and maturing of the Section 232 LEAN program for assisted living, and HUD’s proposed complete rewrite of the Section 8 Renewal Policy Guide are significant matters, summaries of these have either been covered in prior Updates or could easily fill this entire article. For this Update, our topics are a bit more discrete, but have proved to be important to our clients and others who participate in the affordable housing industry.

I. FHA - Multifamily Mortgage Insurance

HUD continues to make significant changes and announcements in its multifamily insurance programs. The FHA multifamily loan pipeline continues to grow beyond expectations. As a single indicative example, the Fort Worth Hub ended August with 213 projects in its pipeline, an increase of nearly 250 percent over the prior year’s activity. In the first nine months of fiscal year 2010, that same office closed 130 loans with a combined value of $1.6 billion, the first year that it had exceeded $1 billion in multifamily guarantees.

We know of many offices that have responded to this growth in demand by increasing their efforts and output levels. For one developer client, the Midwest HUD office involved has indicated its ability to complete a 221(d)(4) loan within four months to assist us in meeting a state-mandated closing deadline. We see this increased strong effort across HUD offices, as they are filled with projects that must meet end-of-year ARRA, TCAP, and 1602 funding deadlines.

In some response to demand, and in some response to necessity for expedited process, HUD has recently released three Mortgagee Letters that introduce or extend and modify FHA processing rule waivers.

Extension of Authority - FHA Insurance After Construction Start

There continues to be a shortage of available conventional construction financing sources. It has also become more common for projects that initially had received conventional financing commitments, and with construction begun, to experience conditions triggering loss of financing and/or sponsor funding. To mitigate this circumstance, HUD issued Notice H2009-12 and Mortgagee Letter 2009-26 last year, authorizing FHA insured mortgages for projects in cases where construction has already begun but other financing sources have failed or been withdrawn. This is perhaps most often seen in the context of condominium development plans now converted into multifamily rental. On August 30, HUD issued Notice H2010-18, extending and modifying this special and temporary authority.

These financings will proceed under MAP, and H2010-18 sets out several modifications to "normal" underwriting and processing requirements. Although the Notice is lengthy in its description of authority and criteria, we have found some to be of greater importance to project sponsor and lender understanding and consideration of the program:

  • Developers must demonstrate that alternative financing cannot be obtained. This can take the form of lender rejection letters or cancellation of prior loan commitments, and must include a certification by both the borrower and the lender that other credit is not reasonably available.
  • Construction cost records must be complete and comprehensive, and will be evaluated to determine eligibility. Proof of payment may take many forms, but will not be assumed based solely on developer representations.
  • Demolition of existing/incomplete structures due to defective work is not an eligible cost.
  • Davis-Bacon requirements will apply to all FHA financed work. We have found, and the Notice confirms, that prior completed work will not be subject to Davis-Bacon. Nevertheless, the bifurcation or renegotiation of contracting documents for increased wage requirements is often a complex matter and requires general contractor flexibility.

There are additional A/E review requirements for these projects, which can take time, with results not necessarily consistent across HUD offices, given differing emphasis by different HUD engineers and A/E staff. These matters and others, however, can be and should be thoroughly discussed and vetted by project participants during the required concept meeting with HUD staff and the two-stage processing discussed in Mortgagee Letter 2010-21, containing a full description of HUD’s new Risk Mitigation standards and procedures.

Extension/Revision of Authority – Waiver of 3 Year Rule for 223(f) Acquisitions

In an effort to provide liquidity to the marketplace last year, HUD issued a succession of coordinated Mortgagee Letters and Housing Notices expanding the availability of the 223(f) program. Prior to Mortgagee Letter 2009-06, 223(f) loans could not receive commitment if the mortgaged project had been acquired or substantially rehabilitated within the preceding three years. Mortgagee Letter 2009-06, Mortgagee Letter 2009-22, Notice H2009-08 and their extensions this year provided waivers of this three-year rule in order to meet the needs of projects financed conventionally, but facing limited access to permanent or reduced-interest-rate conventional financing products.

At the beginning of September 2010, HUD simultaneously issued Notice H2010-18 and Mortgagee Letter 2010-30, extending the 223(f) three-year waiver. This guidance went a step further, however, and provided express authority for waiver of the three-year rule for the purposes of acquisition financing by new owners. The new guidance does not materially revise prior conditions, but does recognize that some will not apply to acquisition transactions. In summary:

  • the waiver is available to conventionally financed projects constructed or substantially rehabilitated fewer than three years from the Firm Commitment Application.
  • for non-acquisition transactions, refinancing is limited to outstanding indebtedness; this limit does not apply to acquisitions, but "seller profit" will be reviewed thoroughly in the context of market value and other financing sources available
  • documentation that efforts to find conventional financing have been unsuccessful must be submitted, including certifications signed by both the borrower and lender – as with insurance after the construction start discussed above
  • For non-acquisition transactions, the existing loan must be current and have a history of current payments
  • submission of audited financial statements is preferred, but unaudited statements may be accepted if certified in specified form by the owner
  • demonstrated occupancy of no less than 90 percent is required, but may be demonstrated post-application if the project has not yet fully rented up following construction/rehabilitation.

For these financings, general 223(f) underwriting criteria will otherwise apply, with some additional review of physical condition and improvements/repairs. Approvals may be granted at the HUD Hub level, with submission of conclusion and supporting documentation to HUD Headquarters.

Extension/Revision of Authority – Loan Application and Processing Notwithstanding Deferral of Final Plans and Specs Submission

With the need to increase the speed of process, due to continued high levels of demand for FHA insurance, HUD issued Mortgagee Letter 2010-26 and simultaneously issued Housing Notice 2010-16 in mid-August 2010, allowing Firm Commitment Application for projects involving tax credits and/or bonds prior to completion of final drawings and specifications.

The new Mortgagee Letter and Notice build upon Mortgagee Letter 2008-19 concerning streamlined processing for 221(d), 220 and 231 transactions involving LIHTC proceeds. The new Mortgagee Letter specifies that when final architectural drawings specifications are submitted before initial endorsement, HUD’s architectural analysis staff will finalize their review at that time. This may result in additional conditions being added to HUD’s Firm Commitment when HUD completes its review, but completion of those submissions will no longer necessarily delay the application process. HUB or program center will now accept schematic, line, or working drawings with the submission of a Firm Commitment Application allowing for review and adjustment to final plans and specs by other stakeholders, such as investors and issuers, while the FHA/MAP process moves forward.

Preliminary plans submitted must be complete enough for HUD to determine acceptability of construction elements without questionable design concepts or evidence of deficiencies. The Mortgagee Letter and Notice contain detailed requirements for preliminary plans submitted in place of deferred final plans.

It is important that the general contractor be able to provide a solid estimate of construction costs at the time of application in order to avoid extended subsequent review and new underwriting when final drawings are submitted. In friendly advice, HUD suggests owners consider using a "cost plus" contract so that any increases in costs recognized in final plans can be handled without renegotiation of the entire construction contract.

These updated procedures can help resolve multiple timing issues for redevelopment when FHA insurance is the financing source. With this flexibility exercised appropriately by HUD offices, and exploited thoughtfully by LIHTC developers, FHA processing may now move forward in a more coordinated timeframe with other funding sources.

II. Redevelopment of Section 202 Projects – New Guidance

Section 202 of the Housing Act of 1959 represents one of HUD’s most active programs for housing of the elderly. The program currently provides a capital advance for affordable housing development, in combination with rental subsidy under a multi-year Project Rental Assistance Contract (PRAC). Prior to 1990, however, Section 202 was administered as a direct loan program, with HUD providing a direct mortgage loan for 202 project development. Most 202 direct loan projects developed in the 1970s and 1980s were subsidized with project-based Section 8. Nonprofit ownership was mandated by statute at that time.

As this portfolio aged, Congress specifically amended Section 202 (and its sister program for disabled housing, Section 811) as part of the American Homeownership and Economic Opportunity Act of 2000 (AHEO Act) to permit for-profit limited partnership participation in 202 project redevelopment, making room for use of LIHTC equity. As a result, over the past ten years we have seen hundreds of Section 202 redevelopment transactions. This nationwide portfolio of 202 housing, with low unit turnover, lower levels of wear by elderly tenants, and Section 8 subsidy that is statutorily exempted from Mark-to-Market, immediately attracted and continues to attract equity and debt funding in recognition of the inherent stability of 202/Section 8 projects.

Notwithstanding strong activity in 202 elderly redevelopment, one subset of these pre-1990 Section 202 projects remained largely untouched. The oldest members of this portfolio most in need of rehabilitation – those developed between 1959 and 1975 – could not be redeveloped as a consequence of statutory quirk. The AHEO Act required that any new financing for 202 redevelopment have an interest rate below the original Section 202 loan rate, and result in debt service lower (if only by a few dollars) than that of the original 202 loan. This was easily accomplished for post-1975 projects, which generally carried interest rates of 8 percent and higher. Pre-1975 Section 202 loans, however, were commonly set with a rate of 3 percent.

Even in those cases where we have been successful in stretching statutory authority and obtaining redevelopment approvals, we have noted that these older Section 202 projects suffer from an additional market handicap. This very old stock is often operated without project-based rental subsidy, having been developed prior to enactment of Section 8. Without rental support, and dependent on low income elderly tenant rent payments, these projects could not attract private equity or underwrite for new debt.

Both the interest rate restriction and the lack of subsidy difficulties were addressed and solved last year by provisions included in the 2009 Omnibus Appropriations Act (PL 111-8). Section 234 of the Act specifically provided for prepayment of these older 202 loans, without regard to interest rate, and further granted both tenant-based and project-based Section 8 subsidy to those projects that are redeveloped.

By statute, these older below-market-interest-rate 202 loans may now be prepaid under two conditions:

  1. the project’s physical needs must be met as part of the transaction
  2. the benefit of refinancing/redevelopment must outweigh its cost, as determined by HUD.

As assistance for undertaking the redevelopment of these projects, any existing Section 8 subsidy may be marked up to budget as high as post-rehab comparable market rents, using nonprofit incentives of Chapter 15 of the Section 8 Renewal Policy Guide. Perhaps most importantly, unsubsidized eligible tenants will each be provided with Section 8 Enhanced Vouchers, and further, upon termination of any vouchered resident’s tenancy, the unit will be designated as a project-based voucher unit.

Although a few of these now-authorized older 202 redevelopment transactions have moved forward under this relatively new authority, each has required a bit of ad hoc negotiation with HUD as to terms and transaction model. With lessons learned, however, in late July, HUD issued Housing Notice H2010-14, providing comprehensive guidance for transaction application and approval.

With regard to meeting a project’s physical needs, H2010-14 provides a good detail of requirements, and also pulls in by reference those prior HUD directives that are also often important to Section 202 redevelopment, including (i) conversion of efficiencies to one-bedroom units, (ii) addition of facilities for dining, care and community rooms, (iii) Uniform Relocation Act issues, (iv) accessibility, and (v) other relevant matters.

H2010-14 also provides a very good description of the elements and calculation of "benefits" and "costs" to be applied for determination of the statutory mandate for cost-benefit analysis. We note that several "benefits" are necessarily subjective rather than quantitative (i.e., quality-of-life improvement, handicapped accessibility, etc.). Notwithstanding good direction and objective calculations contained in H2010-14, applications and processing for approval are not without discretionary elements.

Of course, many of these projects will be financed with FHA mortgage insurance. Processing and underwriting guidance specific to FHA for application to these prepayment/redevelopments is also included in the Notice.

This new Notice provides good guidance and some standardization of matters, which we have seen handled somewhat differently in the disparate circumstances applied to the first few of these older 202 project redevelopments. With this guidance, both HUD and industry participants can now approach an aging portfolio, in need of preservation, with greater predictability in transaction results.

Note for New 202/811 Development: We note that a draft of updated 202/811 new development guidelines have been posted on HUD’s Web site, and will be published in the Federal Register shortly. Comments will be due 40 days after publication in the Federal Register.

III. Partial Payments of Claims (FHA) – New Guidance

HUD’s use of partial payment of claims (PPCs) for multifamily properties has proved to be an important and successful tool in restructuring/working out troubled FHA-insured projects subject to difficult market conditions. At this time last year, only a couple of FHA lenders had participated in the program, and the program guidance that existed was far from up-to-date with actual practice. Over the past 18 months, however, we have closed more than a dozen PPCs in nearly as many states, and have seen most active FHA lenders involved in at least one. On August 15, HUD issued Mortgagee Letter 2010-32, with up-to-date guidance in conformance with our experience – both legal and practical.

Many PPC processing changes have occurred over time as interested parties have worked with HUD to improve the screening of projects. While HUD’s rules remain stringent, we believe them to be fair and to represent a good balance between holding owners responsible for misdeeds and missteps, while recognizing that market conditions have caused great difficulties that can be responsibly relieved at lower cost than would be incurred by simply awaiting project failure. PPC restructurings can be and are being completed with benefit to all stakeholders. We have seen the largest increase in activity among LIHTC projects, having tapped out, removed or defunct general partner/guarantors, and with syndicators who now look for relief from a monthly or annual contribution of new equity just to keep debt service payments current.

PPCs offer an opportunity to avoid full debt assignment to HUD by the mortgagee and continual feeding of operational shortfalls with no apparent end. As a quick summary: (1) an insured loan is re-sized to a sustainable level, at market interest rates, underwritten by HUD during processing at 125 basis points above the 10-year Treasury Bill; (2) the insured mortgagee receives payment on a partial claim and retains the balance as an insured loan; (3) HUD, in recognition of its partial insurance payment, receives a second cash flow mortgage in the amount of the claim payment, set at the Applicable Federal Rate; and (4) a 20-year use restriction is recorded against the project.

HUD second mortgage loans are due and payable upon the earlier of a stated maturity, or the sale or refinancing of the property. They also convert to a higher rate if there are future owner/project violations. Repayment is made from 75 percent of cash flow, with maturity and outstanding balance due at a now-standardized 20 years.

In seeking a PPC, HUD will require owners and lenders to coordinate their efforts and the application for review by both the field office and HUD Headquarters. The process and variables are complex, but HUD Headquarters staff charged with administration of this program can now be counted on to perform a justifiably thorough but thoughtful review. With HUD’s upgrade of functional and comprehensive evaluation tools, projects are, in our experience, now presented with an underwriting conclusion that reduces FHA claim amounts while supporting new Ginnie Mae issues for resulting restructured first liens.

H2010-32 repeats many conditions, requirements and terms that have become "common knowledge" among those who have worked through several PPCs, and should be reviewed by those considering these transactions. It is important to note, however, that the subtleties of appropriate use of project funds versus need for non-project monies to cover various costs that will certainly arise during and following the PPC process are not complete in their detail, and might be matters for future audits. We note below that HUD/OAHP are currently working through an audit program for projects with HUD-held cash flow debt, which must be taken into account during planning, processing and closing of a PPC. In addition, the establishment of "base year" operational projections and application of project funds during PPC processing require some judgments outside of direct guidance.

Issues arising from existing tax-exempt and taxable bonds, multiple layers of soft financing and interplay of state agency and tax credit equity requirements still do require some up-front planning by participants, but they are no longer first-impression matters for HUD. HUD Headquarters and HUD field offices can also generally be counted on to coordinate their efforts and administration well, to accomplish TPAs with change of general partners, simultaneously with PPC processing.

IV. Post-M2M - HUD-held Debt - Audits of Reserves Draws

We and others in the industry have seen an increase in HUD audit activity for post-M2M projects. These projects are those that have been previously restructured through a Full Mark-to-Market, which has resulted in a new first lien FHA-insured mortgage and subordinate HUD-held cash flow debt. Post-closing audits of these projects have involved several matters, but the use of operating funds, rather than draws from replacement reserves for repair and maintenance work, has appeared as a particular item of concern.

Many do not realize that there are several programmatic regimes now regularly employed in which closing results with HUD holding a subordinate mortgage position securing cash flow indebtedness owed directly to HUD. We now frequently see Mark-to-Market, Partial Payments of Claim (PPCs), flex sub-loans and extensions, and other restructuring models with this HUD-held debt configuration.

These HUD-held notes are almost universally payable from some percentage of cash flow. As a result, both HUD and OAHP (as M2M administrator) do have an interest in whether cash flow is spent for items that might otherwise be paid from reserved funds. On the other hand, one might imagine that owners who give 75 percent of their project cash flow to HUD in debt service, might sometimes be less interested in drawing reserves for project maintenance and repair than from operating cash.

Currently, regulatory guidance for what constitutes an R4R cost item, versus what can be paid from operations, does leave room for subjective judgment. This has always been the case, and has served well when HUD asset managers and owners have like interests and are only concerned with maintaining a project’s physical stability. HUD-held debt has upset this convergence of interests. HUD audits have resulted in several findings and demand letters that maintenance and repair payments made from operations funds be returned to the project by project owners, with some permitting off-set draws from R4R accounts, but others requiring non-project funds be used.

Industry advocates, such as the National Leased Housing Association (NLHA), have directly addressed HUD and OAHP regarding this increasingly arising issue, and some matters of aggressive interpretation by OAHP. Owners should be aware that this issue exists and can contact NLHA directly with their experiences.

We do note specifically that those owners of post-M2M projects planning or moving forward with a sale that will include a waiver of "due-on-sale" clauses in their HUD-held MRM and CRM notes will likely have this issue brought to their attention during OAHP review. We are finding that these applications for waiver are now granted after a review of the use of operating funds in prior years and R4R draws at the project, and that approvals do commonly include a requirement that some past operating expenditure for physical plant work be repaid to the project operating account before closing can occur.

V. Revisions to the REAC Inspection Process and 2530 Flags

The Real Estate Assessment Center (REAC) annually inspects approximately 20,000 facilities owned, subsidized or insured by HUD. Over the years, we have seen the quality of HUD’s inspections rise and the problems diminish as inspectors have become better trained and have seen more properties. We still, nevertheless, frequently receive requests to help property owners who have received low or failing scores. Owners and project managers of properties that fail a REAC inspection can be "flagged" in HUD’s 2530/Active Partners Performance System (APPS). If this occurs, life suddenly becomes more difficult for them– e.g., they are not eligible for Mark-to-Market, the flag must be removed or waived before eligibility to purchase and/or manage another facility is confirmed, transfer of the facilities become more complicated, etc.

While the goal of every owner and manager is to pass the REAC inspection, it is sometimes necessary to request a re-inspection due to an odd circumstance at the project on the inspection day, or some overly aggressive findings by the inspector. These re-dos, or re-inspections, had in the past required involvement and authority by HUD Headquarters. Obtaining a new inspection could be, at times, a trying experience for owners, and required more attention by Headquarters staff than was often warranted.

HUD Notice H2010-17, issued on August 23, 2010, revised the procedure for requesting a REAC re-inspection by delegating greater authority to the Hub offices, and dovetails with new flagging procedures for low REAC scores discussed below. Headquarters has now designated your Hub director responsible for ordering physical inspections of the properties in his/her jurisdiction in three circumstances:

  1. The property receives, for the first time, a REAC score between 30 and 60 and the owner fails to submit the required Project Owner’s Certification (certification that the property meets the physical condition standards) and a comprehensive survey of all the physical deficiencies.
  2. The property receives a REAC score between 30 and 60 one year after a failed REAC inspection. In this circumstance, the Notice requires the Hub director to flag the owner and manager in APPS and instruct REAC Quality Assurance Inspectors to conduct a follow-up inspection of the facility.
  3. If follow-up inspection is required as part of a Compliance Disposition, Enforcement plan.

New Protocol for Placing REAC Flags in APPS

Those with low REAC scores should also be aware of HUD’s January 22, 2010 Notice, H2010-04, which implemented a new protocol for placing REAC flags in APPS when a property receives a physical inspection score below 60 but above 30. Such properties are no longer required to be immediately flagged. Owners are granted an opportunity to avoid flags by curing all physical deficiencies within 60 days.

Prior to the new protocol, REAC flags were often placed in APPS when a property received a physical inspection score below 60, and generally would be resolved only after the property achieved a score of at least 60 upon re-inspection. Although intended to alert HUD of potential risk when evaluating participants requesting to engage in new business, such protocol actually delayed new projects as HUD could not complete timely re-inspections, despite the owner’s certification of correction of physical deficiencies.

As noted above, Hub directors may now order re-inspections in many circumstances, and with H2010-04, Hub and field offices are no longer required to place a flag in APPS when a property receives a physical inspection score above 30, but under 60 on the first inspection. Instead, a default notice will be issued, and owners will be given the opportunity to discuss the matter with field office staff. The default notice will require the owner to 1) conduct a survey of the entire project and identify all physical deficiencies, 2) correct all physical deficiencies at the project, and 3) execute an owner’s certification of correction and compliance. REAC flags will be averted if owners comply with the requirements of the default notice within 60 days.

With these new protocols, we expect to see fewer 2530/APPS flags that are simply matters of minimal and corrected physical deficiencies rather than owner neglect.

VI. Revisiting the Frank Preservation Legislation

Finally, we note that the so-called "Frank preservation legislation," (H.R. 4868, the Housing Preservation and Tenant Protection Act of 2010, introduced on March 17 by House Financial Services Committee Chairman Barney Frank (D-MA)), continues to make its slow way through – or perhaps better said, linger – in Congress. The legislation has important elements, which have been discussed for three years. It has been generally embraced by the administration and continues to move, but is unlikely to be passed in this session. The package is important in that it does, legislatively, many of the things that HUD could do administratively, but has not under previous administrations, and has not entirely under this administration. The Frank legislation was just approved by the House Financial Services Committee, and is supported by more than 30 non-profit groups of developers and housing advocates. Most owner groups have expressed concerns about provisions of the legislation that offer a right of first refusal to state housing finance agencies or their designees. This represents a change from earlier drafts in which HUD had the right to make the purchase. While the legislation may yet pass the House this year, there is no similar bill under consideration in the Senate, so its passage is unlikely.

Owner groups and supporters of the package find much to admire in the legislation, including its authorizing the expansion of enhanced vouchers, and the right to convert older Rent Supplement and Rental Assistance Payment (RAP) contracts into Section 8. While some still hope the package may be enacted this year, we do not share that view; we believe that important changes will need to be made in the legislation, and that these may be introduced next year. The results of the fall elections, of course, can determine the makeup of the House and Senate and affect the likelihood of these changes being made legislatively.

Sheldon L. Schreiberg and Scott E. Fireison

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, 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.

Data protection laws have changed, so we have revised our Privacy Policy.