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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2010

FHA Changes with the Times

Brokers and their developer clients must be aware of how these multifamily programs are evolving

As other sources of commercial  financing have dwindled, Federal Housing Administration (FHA)-insured loans have seen an exponential increase year over year. FHA programs were largely ignored in recent years because of “easier” sources of capital. Now, they represent a viable tool for multifamily financing by creating liquidity in a market with scarce private capital sources.

"In the long run, the changes implemented likely will help the FHA
remain a viable capital source for the foreseeable future."

Responding to market adjustments, especially in terms of risk management, the U.S. Department of Housing and Urban Development (HUD) released Mortgagee Letter 2010-21 ( sctsm.in/HUD10-21) this past July. It incorporates underwriting changes to the core FHA multifamily programs for the first time since their inception. The changes supplement other HUD revisions to lender capitalization, licensing and monitoring requirements, loan-document updates, and modernization of its information systems and business processes.

With the mortgagee letter, HUD implements new standards relative to changes in real estate and financing markets; enhances the Multifamily Accelerated Processing (M.A.P.) underwriting guide to incorporate new underwriting criteria that manage the risk to the FHA-insurance program, including increased financial support in transactions via upfront fees, cash escrows and reserves; and adapts loan-sizing parameters to take inherent market risk factors into consideration.

The changes are not just intended to meet the market’s current financial concerns but also to create long-term stability for the FHA’s multifamily programs. In the long run, the changes implemented likely will help the FHA remain a viable capital source for the foreseeable future. It is imperative that commercial mortgage brokers who work with these FHA programs be aware of the changes and how they may impact their borrowers.

Affordable transactions

The most significant of the proposed changes are to market-rate properties, especially new-construction market-rate transactions. HUD has prioritized preservation transactions — typically defined as properties with rental assistance on 90 percent or more of the total units — and affordable-housing transactions, as defined under the Low Income Housing Tax Credit (LIHTC) program.

HUD is returning to its core mission of serving affordable-housing needs. The three major criteria for determining if a property qualifies as affordable housing, as stated in the July mortgagee letter, are:

  1. Projects that have a recorded regulatory agreement, such as a Land Use Restriction Agreement, for at least 15 years after final endorsement;
  2. Rent restrictions of at least 20 percent of the units at 50 percent of the area median income or 40 percent of the units at 60 percent of the area median income. Economic rents on those units cannot be greater than LIHTC rents; and
  3. Mixed-income properties where the minimum rent restrictions and regulatory agreements are in effect.

Properties do not need to be associated with the LIHTC to qualify as affordable housing. They must, however, have and comply with a recorded regulatory agreement that imposes the minimum low-income-occupancy and restricted-rent tests. This distinction opens the door for nonprofit borrowers, housing authorities, governmental entities and other types of mission-based developers to be prioritized if their focus is to serve an affordable-housing need.

Underwriting enhancements

HUD also is revising its M.A.P. underwriting guide, which FHA lenders use when analyzing transactions. The following seven areas are affected:

  1. Affordable housing: Changes clarify the definition of affordable housing and provide guidelines to lenders on how to underwrite these transactions’ attributes.
  2. Mortgage-credit analysis: Lenders must increase review and scrutiny of borrowers’ real estate owned schedules and pay particular focus to contingent liabilities and loan maturities that are within five years of final endorsement of the proposed loan.
  3. Terrorism check of principals: Under the USA Patriot Act, lenders are required to provide checks and verifications on borrowing principals through the Office of Foreign Assets Control before initial endorsement, regardless of whether the lender is a regulated financial institution.
  4. Occupancy standards: The mortgagee letter states that properties must have an average physical occupancy of 85 percent for six months before submitting the firm-commitment application to HUD. For market-rate transactions, the maximum occupancy to be underwritten is 93 percent, and the maximum for affordable-housing transactions is 95 percent. This could delay transactions that are in the process of repositioning or that have experienced significant market occupancy fluctuations. But it likely will give FHA-insured projects a better outlook for sustained viability by requiring a longer stabilization period before the loan funding.
  5. Release of cash or equity from loan proceeds: Escrow must hold 50 percent of any cash proceeds after funding of transaction costs until all noncritical repairs are completed. Also, HUD must approve the release. Traditionally, HUD has allowed borrowers to receive all excess cash proceeds at closing. This shift will impact borrowers seeking cash out. It also should motivate borrowers to complete identified noncritical repairs more expeditiously, thus increasing the property’s overall quality.
  6. Financial statements for Section 223(f) refinancing and acquisitions: Previously, borrowers were responsible for providing financial statements with certifications of authenticity. The new mandate is that for refinances, borrowers must provide three years of tax returns for the borrowing entity, as well as a property financial statement that is reviewed by a third-party certified public accountant. The statement also must include actual copies of insurance and property-tax bills. This requirement may be waived for acquisitions. Essentially, borrowers will have to have more-comprehensive financial statements than before. This change was driven by circumstances where recently funded FHA transactions were quickly in less-stable financial positions post-closing than what was purported during underwriting.
  7. Past-due payables and liabilities: All past-due obligations and liabilities must be cleared before or at closing. HUD wants to see a clean slate upon the loan’s final endorsement.

Escrows and reserves

The 221(d)(4) program for new construction and substantial rehabilitation is a major area of concern for the FHA. Many developers have new-construction transactions that are taking longer to lease than anticipated, that are not achieving projected rent or income levels, or both. Often, this is because of numerous market dynamics, such as shadow-market competition from single-family or condominium developments, job losses, general economic malaise, higher-than-anticipated concessions and changes in  lifestyle dynamics.

To mitigate these risks properly, HUD has made changes to the following major areas:

  • Developer cash-out from land equity: Previously, the borrower could receive any excess mortgage proceeds because of land equity at HUD’s discretion at the time of final endorsement. Now, the property must achieve six months of breakeven occupancy before borrowers can receive excess mortgage proceeds. This change will impact borrowers who own land outright or who have owned land for a long time and have thereby seen an increase in value. It also will help ensure that borrowers remain committed to the asset’s long-term viability and stability, and can reduce the FHA-insurance risk by not providing significant cash-out before the project is  fully stabilized
  • Working-capital escrow: Historically  2 percent of the loan amount, the new guidelines increase working-capital escrow to 4 percent. There is a caveat that the additional 2 percent will be a construction contingency for cost overruns and approved change orders. If it is not used, the additional 2 percent can be refunded to the borrower at final endorsement. The remaining working-capital portion will not be released until 12 months after final endorsement or until HUD determines that the project has achieved six months of breakeven occupancy.
  • Operating-deficit reserves: This calculation will be based on the greater of: the appropriate amount as determined by an appraisal and underwriting analysis; 3 percent of the mortgage amount; or four months of debt service.
  • Pre-application fees: Market-rate pre-applications must pay a 15-basis-point review fee, which will be credited against the 30-basis-point firm-commitment fee when the pre-application package is submitted to HUD. Traditionally, the full 30-basis-point fee was paid with the firm-commitment application submission. Many feel that this fee will require developers to do more research on the proposed transaction and to have “skin in the game” much earlier in the FHA process than before.

Loan parameters

HUD’s new loan parameters indicate a strong desire to focus its attention and resources on the preservation and creation of affordable-housing stock.

For several programs, it has decreased required loan-to-value (LTV) or loan-to-cost (LTC) ratios and increased required debt-service-coverage ratios (DSCRs). Loan parameters for a few programs — the FHA 221(d)(4) with 90-percent-or-greater rental assistance, the 223(f) affordable and the 223(f) refinance of a Section 202 property  — remain unchanged.

New loan parameters for other FHA multifamily programs are as follows:

  • Section 221(d)(4) affordable-housing transactions: Previously required a 1.11 DSCR and 90-percent LTC; now requires a 1.15 DSCR and 87-percent LTC
  • Section 221(d)(4) market-rate transactions: Previously required a 1.11 DSCR and 90-percent LTC; now requires a 1.2 DSCR and 83.3-percent LTC
  • Section 221(d)(3) affordable-housing transactions: Previously required a 1.05 DSCR and 95-percent LTC; now requires a 1.11 DSCR and 90-percent LTC
  • Section 223(f) with 90-percent-or-greater rental assistance: Previously required a 1.176 DSCR and 85-percent LTV; now requires a 1.15 DSCR and 87-percent LTV
  • Section 223(f) market-rate refinances or acquisitions: Previously required a 1.176 DSCR and 85-percent LTV; now requires a 1.2 DSCR and 83.3-percent LTV
  • Section 223(f) cash-out refinances: Previously required a 1.176 DSCR and now requires a 1.2 DSCR; LTV remains unchanged at 80 percent.

Adjusting to change

Property-developers and their mortgage brokers likely will need time to adjust to HUD’s changes and to the equity and additional documentation required for the FHA multifamily programs. The overall program parameters remain the most competitive in the marketplace today, with rates lower than any other financing source available to property developers.

FHA’s long-term viability is paramount to the market, and the continued liquidity it provides is crucial to overall economic recovery. Developers will adjust to the new paradigm, lenders will be more focused on projects’ economic viability, and communities will benefit from HUD’s renewed focus on providing affordable-housing options to their residents.


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