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Statutory and Programmatic Updates for Preservation of HUD Multifamily Housing - Section 202 Redevelopment, Post-M2M Projects, Partial Payments of Claim, and Other Affordable Housing Programs

Housing Update

Authors: Scott E. Fireison and Sheldon L. Schreiberg



I. Section 202 Elderly Housing – Some Basics and Important Revisions to Statute and Guidance

On January 4, 2011, President Obama signed the Section 202 Supportive Housing for the Elderly Act of 2010 (PL 111-372) – one of the final acts of an outgoing 111th Congress. This "202 Supportive Housing Act" provided statutory recognition for many of the programmatic changes and updates that HUD had implemented, or for which HUD was nearing publication of standardized guidance without explicit statutory direction, including subordination of existing 202 loans, conversions of efficiency units, deferral of flexible subsidy loans, Section 8 increases for Section 202 redevelopment, and limited liability company ownership structures. The Act also contained a very important provision for new project-based subsidy, guidance on distributions and authorization for use of transaction proceeds by project owners and sponsors.

Although relatively brief, the law is complex, and possibly at some variance with preceding law concerning vouchers for 202 projects with unsubsidized tenants. As a result, formulation of HUD policy and programs to implement the 202 Supportive Housing Act will not be soon forthcoming. Nevertheless, given previously published HUD guidance and existing statutory authorities, many options for modeling Section 202 redevelopment transactions have been opened.

In any discussion of Section 202 redevelopment it is also important to note other recent authority targeted specifically to those oldest 202 projects – those built before 1975. Last year’s publication of H2010-14, implementing several provisions of Section 234 of the most recently passed Omnibus Appropriations Act (PL 111-8), for the first time instituted a program for prepayment and redevelopment of projects in this pre-1975 Section 202 portfolio.

Perhaps even more importantly, in December HUD published H2010-26, promulgating guidance for application and approval of subordination of pre-1990 Section 202 loans, confirming the terms for Section 8 rent increases and providing multiple restructuring options for existing Section 202 loans (as opposed to prepayment). This new policy/program now explicitly permits redevelopment of 202s by funding through additional debt without prepayment, and was confirmed in part, while subject to modification in part, by provisions subsequently included in the 202 Supportive Housing Act. Finally, in February HUD released H2011-05 concerning deferral of Flexible Subsidy (Flex Sub) loans and H2011-03 concerning conversion of efficiency units. Both are applicable to redevelopment/preservation transactions involving Section 202 projects, as well as several other HUD portfolios (and discussed elsewhere in this Housing Update).

It is certain that this year’s crop of Section 202 redevelopment projects will be both more complex and wide-ranging in their design and use of subsidy and funding models.

Section 202 Basics. Over the past ten years we have discussed each statutory change and HUD publication affecting Section 202 in our Housing Updates, as they were being proposed and implemented. Nevertheless, given increased appetite for, attention to and activity with these projects demonstrated by our clients, new participants and the industry generally, we have provided an updated general summary in this Housing Update, along with a description of recent changes.

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. The Section 202 inventory can generally be broken down into three distinct portfolios, each bounded in time roughly by the period in which a particular 202 programmatic regime was in effect: (i) pre-1975 (direct below-market loans), (ii) 1975-1990 (direct loans and rental subsidy), and (iii) post-1990 (capital grants with rental subsidy). With respect to redevelopment activity, we have seen efforts most strongly directed toward the first two of these classes, as they have more often reached an age of need for substantial rehabilitation and, due to this need, have benefited most from statutory and programmatic authority and attention in recent years.

In 2002, groundbreaking programs for redevelopment of older direct-loan Section 202 projects were implemented by HUD following targeted statutory direction from Congress. For nearly a decade this "Section 202 prepayment" program, targeting projects built between 1975 and 1990, has provided for the full redevelopment of hundreds of Section 202 projects having Section 8 subsidy, by all imaginable combinations of tax-exempt bond and mortgage financing, FHA and Risk Share insurance, tax credit equity, local and federal grant, and soft funds. Although there has been some legislative and programmatic tinkering since 2002, this year and last have seen remarkable, if sometimes uncertain, revisions in the Section 202 prepayment program by both statute and HUD-published guidance.

Pre-1990/Post-1975 Section 202 Properties. These Section 202 properties were developed by allocation of funding authority to each state during the 1970s and 1980s. They were restricted to nonprofit ownership, required HUD-approved budget-based rents, and provided for no distributions to the nonprofit owner. Projects in this Section 202 class, however, have been the focus and target of great attention over the past eight 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.

By passage of the American Homeownership and Economic Opportunity Act of 2000 (the AHEO Act) – Title VIII of the Affordable Housing for Seniors and Families Act – Congress explicitly permitted prepayment of these 1975-1990 Section 202 loans (prepayment had previously generally been prohibited). Further, the AHEO Act permitted ownership by for-profit limited partnerships, thus allowing for LIHTC redevelopment, provided that a nonprofit or its wholly owned affiliate remain as the sole general partner. Prior to the AHEO Act, existence of prepayment lockouts for these loans and the requirement that 202 projects be owned solely and wholly by nonprofit organizations effectively eliminated any chance for redevelopment of this aging portfolio, other than a small subset developed during a 1977-to-1982 window. In some limitation on available redevelopment funding structures, and in recognition that the Section 8 rents for these older Section 202s can be budget-based, the AHEO Act did require that any new financing carry an interest rate set lower than the refinanced 202 debt, and have annual debt service at least one dollar lower than the prepaid 202 loan.

Prepayment and Mixed-Finance Redevelopment of Pre-1990 (Post-1975) Generally. Following the AHEO Act’s expansion of permissible redevelopment/financing structures, HUD published Notice H2002-16 (superseding prior Notice H00-26) and other guidance concerning prepayment and private equity investment for Section 202 projects. H2002-16 set out a specific procedure for prepayment of older HUD-held 202 loans, and maintenance of exemption from Mark-to-Market for 202/Section 8 contracts after prepayment. Additional clarification and some modification of certain provisions of that notice were later provided in November of 2004 under HUD Notice H2004-21 and its resolution of several programmatic issues as well as its outline for use of FHA insurance in these transactions.

Together with the AHEO Act, this guidance dramatically expanded the availability of financing and equity for 202 redevelopment, and triggered the growth of 202 development activity, with and without tax credits, that continues unabated.

Although for-profit limited partnership involvement in Section 202 redevelopment has been permitted by statute since 2000, activity was initially slow, in part due to ambiguity contained in HUD’s guidance, and in part as a result of the close margin on which older 202s seem to run. We often see aging 202s that have been operated by nonprofit owners without regard to excess cash flow. These projects may receive Section 8 subsidy in excess of comparable market rents but require these excess rents in order to maintain the level of services provided to elderly tenants. With an effective debt service coverage of 1.0 on their HUD-held loans, and operating statements that leave nearly no room for surplus cash or development fee payments, it can be difficult to refinance these projects, even with a significant interest rate reduction. While tax-credit equity can close a gap for rehabilitation, the rehab needs of older projects, limited cash flow projections under existing Section 8 contract levels, and uncertainty over continued availability of above-market Section 8 rents (through continued exemption from Mark-to-Market) can exceed the limits of good judgment.

We continue, however, to see a steady annual increase in the number of projects from this portion of the 202 portfolio, moving forward, both as simple refinancings with some interest rate savings, and as comprehensive redevelopment with new enhanced and unenhanced mortgage and bond financing and with tax credit investment.

Pre-1975 Section 202 (SH) Properties. These "SH" 202 projects, as they are often called due to the "SH" appearing at the beginning of their HUD project numbers, were funded with direct loans from HUD, set at below-market interest rates (most often 3 percent) commonly amortizing over a 50-year period. This portfolio is currently represented by approximately 33,000 units remaining nationwide. They were unsubsidized when built, and remain predominantly so today.

Notwithstanding their age these projects have been largely ignored as redevelopment targets, given that few years remain before their loans fully amortize, and that redevelopment options have been hampered by a lack of statutory authority for prepayment of their SH 202 loans. Although the AHEO Act specifically provided terms for prepayment of otherwise locked-out pre-1990 market-rate Section 202 loans, it generally ignored these SH 202s, and by subtle language even specifically prohibited most from being redeveloped. While we have had a few successes in obtaining waivers and stretching authorities over the past decade for some redevelopment of specific classes within this older 202 stock, the AHEO Act’s mandate that any new financing for a 202 prepayment carry an interest rate lower than that of the prepaid Section 202 loan, effectively eliminates practical options for these projects, which carry below-market rate 202 debt. Subsequent determinations at HUD during the past eight years also served to nearly eliminate the potential that these below-market loans might be restructured in place or subordinated, so that additional senior or subordinate soft debt and/or equity might be wrapped into a redevelopment funding plan.

Even in those cases in which we have seen successes, they have come with greater difficulty than is had in redevelopment of post-1975 202 projects. This very old pre-1975 stock is most 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 have not often attracted private equity nor adequately underwritten for new debt.

In 2009, however, AHEO Act restrictions and difficulties caused by lack of subsidy for this pre-1975 stock were eased under provisions included in that year’s Omnibus Appropriations Act. Section 234 of the Act specifically provided for prepayment of these older SH 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. Section 234 explicitly authorized prepayment of these older below-market interest rate 202 loans if accomplished in connection with a transaction meeting three conditions:

  1. the project’s physical needs must be met
  2. the benefit of refinancing/redevelopment must outweigh its cost, as determined by HUD
  3. the owner must accept a new Use Agreement extending 20 years beyond the original 202 loan maturity.

To further assist redevelopment plans for this pre-1975 portfolio, Section 234 expressly permitted that any Section 8 subsidy existing at a given SH project be marked-up-to-budget as high as post-rehab comparable market rents, using nonprofit incentives available under MAHRAA. Section 234 further, and most importantly, provided that unsubsidized eligible tenants in any redeveloped SH 202 project be given a Section 8 Enhanced Voucher, which would become a project-based voucher upon termination of any vouchered resident’s tenancy.

Unfortunately, and despite some successes we have seen, the provisions of Section 234 could not be comprehensively implemented on other than an ad hoc basis until HUD’s release of Notice H2010-14 in July of 2010. H2010-14, however, did provide a good and detailed path to application and approval for SH 202 redevelopment, and also incorporated prior HUD directives, which are often important to Section 202 redevelopment plans, including (i) conversion of efficiencies to one-bedroom units, (ii) addition of facilities for dining, care and community rooms, (iii) Uniform Relocation Act issues, and (iv) accessibility and other relevant matters. H2010-14 also provided 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, and guidance specific to FHA for application to these Section 234 pre-1975 202 prepayment/redevelopments.

Nevertheless, and notwithstanding that the statute remains effective, Section 234 was targeted almost exclusively at pre-1975 SH 202 projects, and left Section 202 redevelopment programs and authority bifurcated between AHEO’s provisions for pre-1990/post-1975 projects and Section 234’s provisions for pre-1975 projects. In addition, funding for Section 234’s Enhanced Voucher and project-based subsidy scheme is questionable at best.

Combined Authority for All Pre-1990 Section 202
Properties – Section 202 Supportive Housing for the Elderly Act of 2010

January’s 202 Supportive Housing Act was written as an amendment to the AHEO Act, and designed to address both pre-1975 SH 202s and post 1975 202s, in their prepayment of direct HUD loans, under common predicate and authority.

Prepayment/Refinancing Generally. Under the 202 Supportive Housing Act, there now exists a consolidated 202 prepayment authority, generally applicable to both pre- and post-1975 direct loan programs. There remains some distinction between the pre-1975 SH projects and pre-1990/post-1975 projects, but programmatic outcomes and incentives are generally aligned. For post-1975 projects, the requirement that any new loan used to refinance the existing Section 202 loan result in a lower interest rate and lower debt service is retained. This requirement is not imposed on pre-1975 SH projects with their below-market 202 loans. Beyond that distinction, prepayment transactions including project redevelopment plans that "will address the physical needs of the project" are granted common incentives and conditions.

Project-Based Section 8 Increases. Previously, under the AHEO Act, Section 202 redevelopment could not result in an increase in cost of project-based Section 8. Under the revised statute, Section 202 prepayment proposals that include rehabilitation may request Mark-up-to-Market (current comparable market rents) or Mark-up-to-Budget (as high as post-rehab comparable market rents), as is now often accomplished by nonprofits and nonprofit sponsors for other types of projects with Section 8 HAP Contracts.

New Project-Based Rental Subsidy. It is mandated that rent charges for unassisted tenants of these projects not be increased as a result of the approved prepayment/redevelopment transaction. Nevertheless, unlike Section 234’s voucher scheme, the 202 Supportive Housing Act includes authority for grant of a new project-based rental assistance contract – "senior preservation rental assistance contract" – for units with unassisted tenants. The Act goes further to provide that these new project-based subsidy contracts will have 20-year terms, and be governed "under the same rules governing project-based rental assistance made available under Section 8."

It is not clear from the Act that these new project-based preservation rental assistance contracts are indeed appropriated and governed by Section 8 of the United States Housing Act of 1937 (the Section 8 with which we are all familiar). Preliminary HUD review and the recently published comprehensive Manual of HUD programs do indicate HUD’s view that contracts entered into pursuant to this 202 Supportive Housing Act provision will be considered "Section 8" for all purposes. Questions regarding available appropriations for the subsidy, and some need to develop contract forms, are certain to delay implementation of this very important new benefit for low-income elderly tenants. Over time, however, it can be easily seen that this new project-based subsidy will be a building block in support of rehabilitation and preservation for many older 202 projects.

Project Ownership. Long guarded as a nonprofit-only program, Section 202 ownership was opened to for-profit ownership models by the AHEO Act, permitting use of various funding methods, including private equity and joint ventures with and without tax credits. Redevelopment/preservation proposals may be approved where the nonprofit remains the sole project owner, or where a nonprofit (or a wholly owned affiliate) is the sole general partner of a new limited partnership owner. HUD Headquarters had generally rejected joint-venture GP structures and those using limited liability companies. The 202 Supportive Housing Act has clarified that both GPs owned by more than one qualified nonprofit and limited liability companies are now permitted ownership structures.

Use of Existing Project Reserves. Inevitably, any refinancing of HUD-held or HUD-insured debt involves the question of disposition of mortgagee-held reserves. Having been owned by nonprofit organizations subject to distribution prohibitions, these older 202s can have significant accrued residual receipts. The new law did not revise authority for use of existing residual receipts in excess of $500 per unit, nor use of existing Reserve for Replacement funds in excess of $1,000 per unit. We will expect those limitations/requirements contained in Notice H2002-16, as updated by subsequent HUD guidance, to remain in effect.

Distributions. The new law does not address or revise Notice H2004-21 clarification that calculations of future distributions for redeveloped Section 202 projects will be based on all owner equity contributions toward development, including LIHTC equity proceeds.

New Use Agreement. All owners proceeding with Section 202 prepayments are required to enter into a new Use Agreement, by which they will covenant to maintain project affordability for elderly tenants. The 202 Supportive Housing Act has extended the term of this use period to 20 years beyond the original maturity date of the prepaid Section 202 loan.

Seller/Nonprofit Proceeds of Transaction. Perhaps no single issue in the context of Section 202 redevelopment has been more disparately treated by HUD field offices than that of nonprofit sponsor transaction proceeds. We have seen offices and Hubs absolutely ignore whether or not any 202 sale, refinancing or redevelopment transaction has produced a windfall for the project owner – their demonstrated concern directed solely toward preservation, and long-term financial and physical stability of the project. Alternatively, we have seen HUD field offices and Hubs that have undertaken their review of prepayment applications with a view that the 202 loan was made directly by HUD, and that HUD has paid all project expenses and debt service through its provision of Section 8 or other subsidy (without regard to the nonprofit’s stewardship). In these cases, nonprofit owner/seller proceeds generated by the transaction have been rejected or sequestered under various escrow models, and available solely for future use at the project. In between these two extremes we have seen a varied modeling of proceeds presentation and partial restrictions for various uses.

With some eye toward this issue, the 202 Supportive Housing Act was drafted in a manner to acknowledge that "proceeds" may be realized by the nonprofit sponsor, but that this apparent "equity" has been realized in part by HUD’s long-term investment in the project. Although less than clear in its definition of "proceeds," the new law does recognize that some excess funds may be realized in a 202 prepayment transaction, and explicitly permits use of these funds at the project, or for the benefit of "other tenants of other HUD-assisted senior housing" operated or sponsored by the other nonprofits.

The new law does provide some suggestions on appropriate use of transaction proceeds, including:

  • increase of supportive services for aging in place
  • rehabilitation activities that might include conversion of efficiencies (also the subject of new guidance discussed elsewhere in this Housing Update)
  • rental assistance for unassisted tenants
  • payment of development fees.

For good or for bad, it is likely that this provision of the 202 Supportive Housing Act law will result in less disparate treatment by HUD field offices of transaction proceeds over time, allowing for their receipt by nonprofit sponsors, but with some direction for their use in support of affordable housing, rather than in support of non-housing purposes.

Deferral of Flexible Subsidy Loans. As discussed elsewhere in this Housing Update, HUD has for several years provided options and a procedure for requesting deferral of due-on-sale or due-on-refinancing terms in Flexible Subsidy loans. We have seen that waiver process used on several occasions for the benefit of rehabilitation/preservation transactions. Most recently HUD published H2011-05 concerning Operating Assistance Flex Sub loans. Section 204 of the 202 Supportive Housing Act provides explicit statutory authority for these waivers, although we do not expect it to trigger change in procedures already established and implemented by HUD.

Subordination of Section 202 Loans. Finally, and by short statement, the 202 Supportive Housing Act has authorized an additional and very significant redevelopment tool. All pre-1990 Section 202 loans may now be subordinated to new financing, rather than prepaid. If we had not, over the past 10 years, worked so hard to obtain sporadic approvals for a small number of 202 subordinations, we might consider this new authority a relatively small matter. It is not uncommon to find a project with a below-market interest rate Section 202 loan, in need of significant and immediate rehabilitation, but incapable of supporting fully amortizing new debt sufficient both to meet rehabilitation needs and to provide adequate proceeds for repayment of outstanding 202 debt. When existing 202 loans carry a lower interest rate than that which can be obtained from new lending sources, prepayment of that loan with proceeds from higher interest loans serves only to reduce available rehabilitation funding.

Statutory change was not necessary for authorization of subordination for post-1975 Section 202 loans. Section 202 loans of that era, however, are generally found to carry interest rates of 8 percent or higher. New debt currently can be obtained at significantly lower rates. Only the AHEO Act’s mandate that new debt for 202 redevelopment carry a lower debt service than the prepaid 202, and its prohibition on rent increases in 202 prepayment transactions (both of which have been effectively rescinded by the 202 Supportive Housing Act) produced the somewhat rare circumstance indicating subordination of the existing 202 debt to be appropriate. In a small number of cases we have seen substantial rehabilitation needs combined with large outstanding 202 loans, thus requiring transaction financing with debt service on the new debt that could not be structured to meet the AHEO Act’s former debt-service limit. In rarer but not-unheard-of cases, it has been important to retain the nonprofit owner’s ability to Mark-up-to-Budget for post-rehab comparable market rents, in order to meet the revenue requirement necessary to satisfy increased debt. In these cases, the AHEO Act’s prohibition on rent increases during prepayment transactions had to be sidestepped, thus requiring that the Section 202 loan not be prepaid, but instead be subordinated.

In late December, HUD published Notice H2010-26, providing procedure and options for subordination of post-1975 Section 202 loans. The Notice provides threshold criteria for all applicants, including (i) REAC over 60, (ii) satisfactory MOR, (iii) no outstanding notices of program or other federal debt default, (iv) current mortgage payments over the past three years and (v) Fair Housing compliance. Applications for approval may seek subordination and recasting of the Section 202 loan. Proposals can include surplus cash or interest-only payments, with extended maturity, but must demonstrate that repayment of the recast loan and the new first lien financing is feasible. In all cases the project will be subject to an extended use agreement for a term of 20 years beyond the recast 202 loan maturity date. All subordinations must be approved by HUD Headquarters.

With this new guidance in place for post-1975 Section 202 projects, the 202 Supportive Housing Act’s statutory authorization to subordinate pre-1975 below-market Section 202 loans has a readily convertible programmatic regime available for application. Of the new law’s many new 202 preservation tools and revisions to Section 202 redevelopment authority, and given the age of the SH 202 portfolio, this subordination of pre-1975 Section 202 loans may be most immediately seized upon and easily implemented.

As noted above, it is certain that Section 202 redevelopment projects will be both more complex and wide-ranging in their design and use of subsidy and funding models as we move forward through this year and into the next.

II. Redevelopment of Mark-to-Market Properties

Late last year HUD reissued its Guidelines (Notice H10-22) for waiver of the due-on-sale and due-on-refinancing provisions contained in HUD-held Mortgage Restructuring Mortgages (MRMs) and Contingent Repayment Mortgages (CRMs) resulting from full Mark-to-Market restructurings. While these Guidelines have been in effect since 2007, our nearly four years of practical experience with these waivers in the for-profit context and with assumptions of MRMs and CRMs by Qualified Nonprofits (QNPs) has provided some additional detail and insight.

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 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.

Specific Office of Affordable Housing Preservation (OAHP) incentives for nonprofit-sponsored projects (including those using tax credits) have been available by statute and policy for nearly 10 years, and have worked well in these circumstances. 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 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.

Nevertheless, QNP treatment is available only for a limited period of time following M2M restructuring, as discussed below. In addition, many redevelopment efforts for M2M projects do not include QNP participation, including acquisitions by LIHTC partnerships without nonprofit general partners. Notice H10-22 has restated its predecessor guidance, allowing relief from "due on sale," while providing financial return and continued economic participation for both developers and HUD. We have worked through dozens of projects under this guidance, with and without prepayment and/or assumption of the M2M first lien FHA-insured mortgage, while deferring repayment of subordinate MRMs and CRMs.

Following years of ad hoc negotiations, Notice H2007-5 initially formalized the process under which OAHP will consider proposals for refinance or acquisition of M2M projects, without full repayment of existing HUD-held mortgage debt. H10-22 has not modified this process, although some precedent has provided additional detail for redevelopment transactions. 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)
  • provides appropriate rehabilitation from non-HUD funds, and
  • whether HUD (after having previously paid for a large portion of the initial M2M restructuring through FHA-insurance claims) is receiving 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 when 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 1.20 debt service coverage, assuming appropriate operating expenses, adequate replacement reserves and vacancy estimates. The notice requires that new debt be fixed-rate, and describes what OAHP considers a sufficient operating expense "cushion." Rehabilitation plans will be 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 contingent on cash flow. Under the H10-22, 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 presented transaction/operations model. In the event MRM or CRM value is reduced, given reduction in NPV 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. It is important that preparation for waiver requests include review of the NPV of the MRM and CRM at the time of M2M restructuring and under current project operations, in comparison with future projected operations.

This NPV criteria and evaluation will generally use a 5.5 percent discount rate. In the event, however, that 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 consider this request as a second bite at the apple.

In addition, the NPV criteria will not be considered when the request involves MRM and CRM assignment or forgiveness in connection with QNP incentives available under current guidelines. 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. To be frank – 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, 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.

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 are important considerations in planning, and are subject to overall transaction terms and review.

Transaction documents for closing generally will be handled through the field office, once OAHP has made its determination and notified the field office of its conclusions. It is important to note that, in addition to statement of transaction proceeds that must be paid toward MRM and CRM debt, OAHP’s conclusions will also include a statement of required payment of partial-year surplus cash for the year of closing. In addition, we note that sellers should expect that their prior three years of operations will be reviewed, for improper use of operating cash to pay capital expenditures and other costs that should have been paid by replacement reserves or non-project funds. OAHP will calculate the lost cash flow payments to MRM and CRM debt resulting from these improper payments in prior years, and require recovery payments from the seller prior to 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. 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 cases in which transactions would not have been possible otherwise.

Transfer to Qualified Nonprofits (QNP Transactions). 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 used this authority to institute its incentive program for nonprofits and nonprofit-sponsored LIHTC purchasers of M2M projects. As described in Appendix C of the M2M Operating Procedures Guide (OPG), qualified nonprofits or their partnerships may purchase an M2M project and have the MRM and/or the CRM assigned by HUD (the original holder) to an affiliate of the nonprofit or entirely forgiven.

Although the OPG has not been updated with respect to timing limitations for QNP transactions, the three-year window remains in effect with some availability of waiver. For several years now, OAHP has been required to abide by a three-year window with respect to QNP approvals. As best stated: no QNP assumption transaction will be approved unless the QNP has signed a purchase agreement with the project seller not later than three years following close of the M2M restructuring. For some time, this policy has been in flux and subject to special circumstances and waiver. Currently, however, OAHP is applying the three-year limit more stringently. We have seen M2M project owners and nonprofits lose the potential benefits of QNP transactions due to their delay in contracting, and belief that prior waivers necessarily provided guaranty of future waiver terms. They do not. The three-year window continues to be reviewed by HUD and OAHP, and the Office of General Counsel, and we will keep you informed of adjustments in this policy.

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 have obtained HUD approval for conversion/rehabilitation into affordable housing appropriate to their communities. In February, 2008, Hub directors and multifamily staff were provided with important, if imperfect, guidance concerning requirements for approval of efficiency conversions. Experience with conversions prior to 2008 and under that 2008 guidance has allowed for HUD’s February 1, 2011 publication of Notice H2011-03, and its comprehensive direction for this redevelopment tool.

The Notice applies generally to all Section 202, Sections 811, 236, and 221(d)(3) BMIR, Project-based Section 8, RAP and Rent Supp properties, and other project 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 a strong description of project circumstance and need, a PCNA, proof of tenant notice compliance, market-study materials and a record of marketing efforts. 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 noncompliance, some flexibility is available in cases in which the owner can show that this will be cured through conversion. Any noncompliance that limits HUD ability to analyze a conversion request must, however, be cured prior to submission (i.e., financial statements have not been filed).

Evidence of Demand. Owners must provide evidence of their efforts to market existing efficiencies and of demand for the proposed post-conversion unit type. Average vacancy in the efficiency units should have been at least 25 percent for the past 24 months, or support for determination that these efficiencies are obsolete must be strong. We have found that shortages in the community of affordable family-size units can also indicate need for larger units in place of existing efficiencies.

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

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

Rent Limitations. Rents for newly created 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 (similar limitations apply for conversions to two-bedroom units). Similar rules for RAP, PRAC and Rent Supp will apply. Section 8 rents will be further restricted to comparable market rents, but in a change from 2008 policy, will not be capped at 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. We have seen nonprofit-sponsored LIHTC acquisition/full redevelopment transactions benefiting from combination of efficiency conversion and Mark-up-to-Budget as high as post-rehab comparable market rents.

Combination of Dissimilar Units. HUD will not approve plans that combine unsubsidized units 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, original HAP contract units (those whose initial contract term has not expired), may not be combined with Section 8 units subsidized under HAP contracts that have been previously renewed under MAHRAA.

Handicapped Access, URA and Lead Disclosure. Rehabilitation plans must comply with accessibility regulations, the Uniform Relocation Act and applicable Lead Disclosure rules.

Extended Section 8 Commitment. Owners are required to accept an amendment to their existing Section 8 contract, extending its term to 20 years.

Section 236 IRP. With regard to Section 236 Interest Reduction Payments, the Notice indicates that some reduction in IRP will result from reduction in the number of Section 236 units.

H2011-03 is more comprehensive in its submission and review requirements than HUD’s 2008 guidance. It provides a solid framework around which transactions may now be more clearly defined. The Notice contains much additional guidance including discussions of prepayment and treatment of Section 8 contracts for older HFA-financed projects. In our experience with these conversions, it has become clear that early comprehensive and thoughtful planning and proposal development are necessary if approval is to be granted, and transaction schedules require HUD approval with predevelopment timetables.

IV. Flexible Subsidy Loan Deferrals

Flexible Subsidy (Flex Sub) assistance was provided to projects suffering from physical and/or financial distress in the form of either "operating assistance" or "capital needs assistance." Initially these funds were provided as grants, and subsequently through loans, due to requests 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 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. We have, however, seen multiple transactions in which funding for repayment of this debt is not feasible in the context of redevelopment and preservation. 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.

In January 2008, Hub directors were provided with guidance for evaluation of requests to defer repayment of Flex Sub loans (both operating and capital needs). Before that guidance and subsequently, we have seen several Flex Sub waiver requests processed and approved. On February 14, 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. Oddly, H2011-05 purports to address only waivers applicable to Flex Sub operating loans, and to supersede all prior guidance. Nevertheless, we expect continued processing of Flex Sub waivers for capital needs loans, although the subject of other regulations, in accordance with past practice - which as noted above, has been largely in conformity with this new Notice.

Relief from immediate repayment continues to require a regulatory waiver, as the Notice cannot serve as a 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, but subject to 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.

  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. Additional payment requirements are included in the Notice, that have not previously been in place. For future waivers of these operating assistance Flex Sub loans the Notice 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 also be applied annually to pay down the Flex Sub.

H2011-5 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, and some future modification of policy to provide appropriate incentives may be necessary. Nevertheless, this new guidance appears as a solid step forward, by addressing practical needs and clarifying what has been occurring in limited practice.

V. Partial Payments of Claims (FHA)

We have written successive articles regarding Partial Payments of Claim (PPCs) during the previous three years, and have shepherded dozens of successful restructurings during that period. We write here to note some few programmatic changes and that Mortgagee Letter 2010-32 remains the most recent written guidance from HUD for these transactions. A comprehensive rewrite of HUD Handbook chapters concerning PPCs remains in drafting, while existing Handbook provisions contain largely obsolete guidance. Over the past 24 months we have seen HUD’s PPC program mature from difficult and oblique in its application, and at times impractical, into a well-documented and efficiently employed process, administered by HUD with thoughtful consideration of both legal and practical circumstance and result.

ML 2010-32 repeated many conditions, requirements and terms that had become "common knowledge" among those with experience working through PPCs. Since its release, we note that PPC restructuring models and loan documentation have been standardized, allowing for much greater efficiency in process – which, unfortunately for attorneys, has resulted in HUD’s reduction in the level of lender counsel fees that may be paid from project funds. Borrower counsel fees and some other transaction costs remain payable only from non-project funds. It is important that subtleties of appropriate application and use of project funds versus the need for non-project monies to cover various costs during and following the PPC process be monitored by project owners as they are easy targets for future audit.

Having revived and built the modern PPC program from near zero into an important and successful tool in restructuring troubled FHA-insured projects during an extraordinary period of economic downturn, Housing staff in Headquarters have begun turning over program administration to the Office of Affordable Housing Preservation (OAHP). OAHP has begun to process PPCs from a limited number of Hubs, and will ultimately carry all Headquarters activity for the program. It is hoped that OAHP’s extended underwriting and restructuring experience will relieve field offices from much of their review duties. It is certain that disparate treatment and some delay must result when PPC review is conducted by individual field offices with differing experience, staffing levels, and priorities. If OAHP’s administration of that other restructuring program, Mark-to-Market, is any indication, the evaluation and processing of PPCs by OAHP is almost certain to increase efficiency over time – and, sadly, further reduce legal fees.

Scott E. Fireison and Sheldon L. Schreiberg

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.

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