Underwriting Criteria To Require More Conservative Assumptions
On July 7, FHA Commissioner David Stevens announced plans to implement a series of changes to the HUD multifamily insurance programs. The changes update underwriting policies, increase lender and underwriter quality, and align loan application, submission, and approval standards.
The revised underwriting standards will raise debt-service coverage ratios, lower loan-to-value and loan-to-cost ratios, increase project reserves and sponsor equity investment, and limit sponsor cash out. Underwriting ratios will be targeted to different property types based on their risk profiles, with lower ratios for subsidized affordable housing properties and higher ratios for market-rate properties.
The “hallmark of the HUD insured-loan program” is that it has been relatively static and has changed very little over the years, according to Nick Gesue, Senior Vice President and Director of Housing at Lancaster Pollard Mortgage Company. In fact, the core program underwriting standards haven’t changed since the inception of the program—until now.
The significant financial challenges that institutions of all stripes and sizes have been dealing with over the last 18 months have produced increased vacancy and delinquency rates, as well as increased defaults and claims in FHA’s portfolio. The tightening up of the underwriting criteria for HUD-insured loans will help to maintain the integrity of the FHA mortgage insurance fund, as well as FHA’s commitment to assist qualified borrowers to access mortgage financing when private capital is scarce.
Healthcare vs. Multifamily programs
It’s important to distinguish the two separate HUD offices that provide programs for senior living projects. The Office of Healthcare Programs oversees programs for licensed skilled nursing and assisted living projects (HUD 232). The Office of Multifamily Housing handles programs for market-rate family housing and age-restricted senior apartments that don’t require a license. “Assisted living licensure is kind of the dividing line,” said Gesue. “As soon as a project requires a license, it moves out of the multifamily programs and into health care.”
Whether the program is based in the Office of Healthcare Programs or the Office of Multifamily Housing, HUD-insured loans for senior living projects are still processed in HUD field offices. To process the requests more efficiently, the health-care side recently created LEAN processing, headquartered in Seattle; but a backlog of applications has created significant delays of up to four, five, six months. Meanwhile, many of the regional offices that process the multifamily housing projects, which are generally much slower at processing applications, have little or no backlog—perhaps a month or two, depending on the location.
The program changes that the FHA just announced apply only to properties covered by the Office of Multifamily Housing programs used to finance independent living, age-restricted apartments, and affordable senior properties that do not include a health-care component and, therefore, are unlicensed. The changes do not apply to the capital advances granted by the Office of Healthcare.
With these reforms, the kinds of properties eligible for HUD’s insured-loan programs are not necessarily changing. When evaluating the reasonable success of a property, however, HUD will expect applicants to be more conservative with their assumptions than required under the previous criteria. For example:
The 1.11 times debt-service coverage requirement has been a long-standing metric within HUD for calculating loan amounts; that is, a new construction project must generate enough cash for the owner to pay its debt service 1.11 times. For market-rate properties, HUD is changing that requirement to 1.20 times debt-service coverage—“a seismic shift,” according to Gesue. For affordable housing, the debt-service coverage requirement will remain the same at 1.176 times; for market-rate refinance or acquisition projects, it will change from 1.176 times to 1.20 times.
Value/cost loan ratios for market-rate, new construction properties will change from the current 90.0% to 83.3%; for affordable housing, from 90.0% to 87.0%; and for market-rate refinance, from 85.0% to 83.3%.
In addition—and this is “not insignificant,” Gesue added—when evaluating a loan application, HUD has long accepted an assumption of up to 95% occupancy for a market-rate property that would be operating in a good market. Going forward, that assumption will be limited to 93% occupancy.
“If the developer or owner assumes a project will only reach 90% occupancy,” he explained, “then that change will have no bearing. But if the developer or owner feels confident that the project could generate, say, a 95% occupancy level, this change will reduce that assumption. On paper, HUD will assume only 93%. If the project actually generates 98%, that’s great for the developer/owner; but that data cannot be used to generate more debt.” The rate will remain at 95% for affordable properties.
Generally, too, HUD had allowed an absorption period of up to 24 months to be used in estimating market demand for a project’s proposed units; going forward, the absorption period will be restricted to 18 months, although an exception may be requested for large high-rise buildings.
Also, larger projects (perhaps those in excess of $50 million) will have to be reviewed by an internal HUD Loan Committee to confirm—or at least to double check—the review completed by the HUD regional office. “HUD is trying to ensure that, on big deals, they’re dotting the I’s and crossing the T’s,” said Gesue, “and that inevitably will add a little time to the overall process.” The reviews by the Loan Committee are expected to begin at the end of July, according to the FHA’s notice.
HUD is looking to toughen the underwriting criteria for the insured-loan program as a reaction to the difficult economic environment, as well as to reduce the risk on loans to market-rate projects, both senior and family housing, by making the criteria a little less favorable. Since it’s unlikely that providers will bring in more revenues in this economy, the tightened underwriting criteria will most likely result in lower loan amounts for market-rate projects—or the developer will be forced to contribute more cash in order to make the same project a reality.
At the same time, HUD is looking to encourage loans to subsidized affordable housing projects by making more money available to developers or owners of affordable projects. On one hand, that’s a good thing; on the other, it changes the game a bit for those who rely upon HUD to finance market-rate projects and makes HUD financing for those projects a little less attractive.
Gesue doesn’t consider HUD’s changes to be unreasonable, but developers and owners need to be mindful of the new assumptions and incorporate them into their budgeting and planning processes.“Fannie Mae and Freddie Mac have been tightening their underwriting criteria for years,” Gesue pointed out. “HUD is now adjusting the underwriting criteria in reaction to extremely high demand for HUD loans, coupled with the difficult economy. It’s also a proactive measure on the part of HUD to help manage risk, address current economic issues, and mitigate the likelihood of a higher number of losses.”
Who will be most affected?
Unless they are tax-credit projects, independent living projects that use the HUD insured-loan program generally fall into the market-rate category. They don’t have Section 8 assistance or other types of low-income restrictions. Therefore, these program changes stand to reduce the amount of money an independent living developer or owner could borrow through a HUD loan.
HUD will continue to be willing to provide loans to market-rate projects but at a slightly lower dollar amount than it would have provided prior to implementing these changes. HUD’s primary concern has been that a new-construction project that is about to open in what continues to be a very challenging economy will likely experience much lower lease up. That could strain the financial capacity of the project.
Even with the more stringent underwriting criteria, though, Gesue believes that HUD financing will continue to be more palatable than nearly any of the other finance programs available today.
“One of the most common alternatives to putting a HUD loan in place is to get construction financing through a commercial bank,” he explained. “Banks and HUD both view the loan amount that they are willing to lend relative to the total cost to build a market-rate project. A bank might lend 65-70% of the cost, whereas HUD will lend (and continue to lend once the changes are implemented) 83.3% of the cost.” So, relatively speaking, HUD will still be very attractive and retain a favorable position from the borrower’s perspective. From a historical perspective, however, the changes mean that the loan amounts that can be accessed under the HUD programs for market-rate projects are effectively reduced.
Very strong borrowers, of course, will continue to have banking relationships that allow them to compare the bank’s terms with HUD’s new criteria and have options. If an organization is strong enough to put a deal together but is still bolstering its operating capabilities, though, HUD may be one of the few financing options available. So if the project developer or owner can afford the additional equity required under the new criteria, HUD will continue to offer one of the best financing mechanisms.
Smaller, less-established organizations are expected to be most impacted by these reforms. “Bootstrapped organizations that need every nickel of a HUD loan to make a deal work will be the most threatened by these changes,” Gesue predicted. “Those are the projects that are the potential casualties.”
On the other hand, organizations with well-established businesses and successfully operating facilities will generally have the additional cash—or the access to additional cash—to make the transaction work under the new criteria.
Implementation of these reforms will occur 60 days after the effective date of the announcement (July 6, 2010) for submitting a pre-application, up to 120 days for submitting a firm application for projects with outstanding invitation letters, and up to 90 days for any new applicant who proceeds directly to the firm application.
Applications already in the queue and any new pre-applications or applications submitted before the cut-off dates will be subject to the old standards. But after the interim period, applications will have to incorporate the new criteria.
Expect a mad dash to the finish line!