HUD Mark-to-Market Restructuring

By Abraham E. Haspel

In Brief

To Restructure or Not to Restructure?

The Department of Housing and Urban Development (HUD) subsidizes the cost of housing to certain disadvantaged persons through a number of programs. One such program under Section 8 is the direct payment to projects of the rental value for such housing.

HUD has acknowledged that because of the way certain tenant rent subsidies were calculated and adjusted over time, the rentals for many low-income projects now exceed those charged for unregulated, unsubsidized housing of similar quality and location.

Legislation effective in October 1998 has created a process where HUD must readjust its rental payments to market levels, while at the same time giving projects with HUD-insured mortgage financing a chance to restructure based upon the lower rental levels. The losses on the mortgage restructurings will be absorbed by the FHA general insurance fund.

There are a number of options that HUD-regulated projects must choose based upon the economics of the new rental levels HUD is prepared to pay. The issues are complex, and project owners and their advisors have a lot to digest before deciding on a course of action.

In 1997 Congress passed the Multifamily Assisted Housing Reform and Affordability Act (MAHRAA) to address the runaway cost of subsidizing project-based tenant rental assistance. Congress concluded that a substantial portion of tenant-based assistance units had higher rents than comparable unassisted rental units. It is estimated that if no changes in the terms and conditions of project-based assistance were made, the cost of renewing all expiring rental assistance contracts would increase from $1.2 billion in fiscal 1997 to almost $7.4 billion by fiscal 2006 and would continue to increase steeply for the foreseeable future.

Congress recognized that any reduction in project-based tenant assistance could cause many projects to default on their FHA-insured mortgage payments, resulting in claims to the FHA general insurance fund. Apparently, more than 15% of federally assisted multifamily housing projects are physically or financially distressed, and a number suffer from mismanagement. Ironically, the debt restructuring authorized by MAHRAA will be funded through claims to the FHA general insurance fund because existing mortgages will be reduced in size, necessitating payments to the insured mortgagee.

Effective October 13, 1998, the Department of Housing and Urban Development (HUD) issued interim regulations implementing MAHRAA. The act lowers HUD tenant subsidies through Section 8 housing assistance payments contracts (HAP contracts) for many low-income multifamily housing projects whose contract rentals exceed market rents, and it allows eligible projects to reduce the amount of their debt by restructuring their existing HUD-insured or -held mortgages.

Reduction to market rents will occur upon renewal of existing project-based HAP contracts. If market rentals are far below existing project rents, cancellation of debt taxable income could be generated because it is unlikely that a portion of the restructured mortgages will be repaid. IRS ruling 98-34 (coincidentally, the same number used for HUD Notice H98-34 regarding Section 8 contract renewals) exempts a subsidized below market interest rate second mortgage from the IRS original issue discount rules. However, a third mortgage would probably produce cancellation of debt income.

Owners classified by HUD as "bad owners" cannot participate in the restructuring process. If the bad owner's HUD project is not viable without restructuring, then the only recourse (other than default and foreclosure, which has the same tax effect) is to sell the project to a not-for-profit organization or another qualified purchaser. This forced sale by bad owners could generate significant phantom taxable income to the partners arising from their negative capital accounts. However, phantom taxable income from a forced sale might be avoided if the project is transferred to an UPREIT or is classifiable as an IRC section 1031 like-kind exchange. These solutions may not be available to all affected owners because of the poor financial or physical condition of the projects.

Projects Eligible for Restructuring

A project must meet all of the following three conditions to be eligible for debt restructuring:

* The project must have one or more FHA/HUD direct or insured mortgages.
* One hundred percent of the gross potential rent of the apartments under HAP contracts must exceed the total market rents for those units.
* Projects must have a Section 8 HAP contract under the following programs:
* New construction or substantial rehabilitation
* Rent supplement
* Moderate rehabilitation
* Loan management set aside
* Section 23 of the 1937 U.S. Housing Act
* Section 8 property disposition.

Projects Exempt from Restructuring

The following are exempt from restructuring:

* Projects funded by a state or local agency (e.g., state or local bond financing) that are not insured by HUD; or, if HUD-insured, where restructuring would conflict with applicable law or agreements governing such financing
* Projects funded for elderly or disabled housing under section 202 of the Housing Act of 1959 or section 515 of the Housing Act of 1949
* Section 8 single room occupancy projects under section 441 of the Stewart B. McKinney Homeless Assistance Act.

Section 8 contracts for both exempt and ineligible projects (e.g., projects without HUD mortgage insurance) qualify for renewal under amended MAHRAA new section 524(a) if the rental levels do not exceed comparable market rents. Under certain limited circumstances, rents for these projects can be raised to market levels. Exempt projects can also renew under new section 524(b)(1), which, under certain circumstances, allows rents in excess of market levels.

Bad Owners

The debt of projects owned by bad owners is not eligible for restructuring. Bad owners are HUD project owners or affiliates of owners that--

have engaged in material adverse financial or managerial actions or omissions with regard to such project or other projects that are financed by a loan from or insured by an agency of the Federal government after receiving notice of an opportunity to cure. This includes violation of projects regulatory and housing assistance payments contracts and materially failing to maintain the property according to HUD housing quality standards.

Who Is Responsible for Restructuring?

Congress delegated responsibility for restructuring eligible mortgages to state or local agencies called participating administrative agencies (PAE). A private company can be a PAE if it partners with a public agency. PAEs are supervised by the Office of Multifamily Housing Assistance Restructuring (OMHAR), an independent office within HUD.

Section 8 Contract Renewal Process

Prior to the expiration of existing Section 8 contracts, project owners must notify HUD and their tenants under the program whether they plan to renew without restructuring, renew with restructuring, or let the contract expire.

The notification requirement for renewal is at least 90 days. One year's written notice is required to the tenants and HUD for the termination of Section 8 contracts (changed from 180 days by HUD notice H99-8 on May 27, 1999). HUD will grant up to a one-year extension of the current contract to allow the owner to meet the one-year notification requirement to tenants under an expiring contract.

If renewal with restructuring is selected, the owner must certify to the best of its knowledge that current project rents exceed comparable rents and that the owner or an affiliate is not suspended or disbarred by HUD. Requests for renewal or termination should be made to the program center hub at the appropriate HUD regional office. If a restructuring is involved, the request will be forwarded to OMHAR.

Most owners of HUD-insured or -financed projects with Section 8 project-based HAP contracts should attempt to determine whether their Section 8 contract rents are above or below market rents for comparable projects. Usually this requires an appraisal, the cost of which can be charged to the project.

If the appraisal, which must follow HUD's strict guidelines, shows that market rents exceed current contract rents, the owner should consider either renewal without mortgage restructuring, or termination of the Section 8 program. If 1) market rents are significantly less than current contract rents and 2) the loss in revenue by adjusting to market rents would not permit the project to meet its debt obligations or its contribution to replacement reserves, the owner should select renewal with restructuring. A discussion of these options follows.

Contract Renewal Without Restructuring

MAHRAA section 524 offers most project owners the choice of renewing their Section 8 contracts under two separate provisions:

* Section 524(a) [formerly Section 524(a)(1)] applies to any project (including projects ineligible or exempt from debt restructuring) with a Section 8 contract--with or without HUD financing--and limits contract renewal rent to an amount that cannot exceed comparable rents for the market area in which the project is located.
* Section 524(b)(1) [formerly Section 524 (a)(2)] provides an option only for projects exempt from debt restructuring under MAHRAA. Renewal rentals are not capped at the market rent levels and are the lesser of--
* existing rents adjusted by an operating cost adjustment factor (OCAF) or
* a rent level that provides income to support a budget-based rent (i.e., rent sufficient to support operating expenses, debt service, and annual contribution to an equipment, building component replacement reserve).

The OCAF will be determined by HUD, and the adjustments may either increase or decrease previous rent amounts. Future rent adjustments at contract renewal for both Sections 524(a) and (b)(1) will be determined by applying the OCAF at the contract renewal date, except that rents for renewal of contracts under section 524(a) may not exceed comparable market rents. An annual comparable rent market study is not required; however, HUD will periodically check renewal contracts.

Furthermore, for projects electing section 524(a), HUD has reserved the right to redetermine project rents using a budget-based rent adjustment, which may require a new comparable rent market study. It would appear that HUD is trying to avoid increasing future rents using the OCAF adjustment factor to above-market rents, as was the case prior to MAHRAA. A proportionate amount of any OCAF adjustment must be applied to the reserve for replacements and, therefore, will not be available to meet other operating costs.

Owners eligible for debt restructuring may choose not to restructure if they and HUD believe they can successfully operate the project and meet current debt service and replacement reserve requirements with market rents. HUD requires that the project should be able to maintain an adequate debt service coverage ratio (generally 1.2 to 1, calculated using annual contribution to the reserve for replacements as an expense), and the project should be in good physical condition. Because mortgage restructuring involves a 30-year low-income residential housing commitment, choosing not to restructure gives an owner greater flexibility of opting out of the HUD program at a later date.

A project owner whose current contract rents are less than comparable market rents can also elect to renew its expiring Section 8 contract under section 524(a). Although MAHRAA does give HUD the authority to increase current contract rents to market, HUD notice 99-32 (December 1, 1999) limits the rent to the OCAF-adjusted rent or a budget-based rent not to exceed comparable market rents, with one exception.

HUD realized that projects in high-rent areas would seek to convert the Section 8 rents to market, thereby reducing the amount of available affordable housing. Consequently, HUD issued notice 99-15 (June 16, 1999), which allows Section 8 projects located in high-rent areas to increase rents to comparable market levels as long as they do not exceed 150% of the HUD-determined "fair market rents" (FMR). HUD defines high rent areas as those where comparable market rents are at or above 110% of the FMR. Projects that receive interest subsidies will have their market rent reduced to compensate for the interest subsidy. HUD can waive the "high rent area" requirement if there is a low vacancy rate in the area or if the tenants are elderly or disabled.

In order for owners to realize the benefit of high-rent areas, HUD allows qualified projects to increase the amount of the dividend or other distribution allowed by the project's regulatory agreement by the amount of the increase in existing rents to market level.

HUD compiles the FMR using a statistical study of the lowest 40% of rentals in 354 metropolitan areas and 2,350 nonmetropolitan county areas (FMR areas) throughout the country. As an example, the New York City FMR monthly rates for 1999 are no bedroom $704, one bedroom $785, two bedrooms $891, three bedrooms $1,114, and four bedrooms $1,249. FMRs are generally less than comparable market rentals.

The request for a budget-based increase can be prepared using the pre-MAHRAA procedures used to request budget-based rent increases (Chapter 7 of HUD Handbook 4350.1).

No rent increases will be allowed under section 524(a) unless the project's physical inspection score is 60% or greater. This physical condition scoring mechanism can provide unfair evaluations of property; therefore, project owners should review identified deficiencies to check for an inequitable result. However, the project can only appeal on the basis of actual errors made by the inspector and local regulatory requirements that supersede HUD requirements.

Mortgage Restructuring and Contract Renewal

The HUD project manager will review the completeness of owners' certifications as to comparable rents and the property's physical condition and will research whether the owner has been suspended or debarred. Acceptable submissions are forwarded to OMHAR for further review and ultimate referral to a PAE.

The PAE assists the project owner in developing a refinancing plan with the project's mortgagee or another appropriate lender. The plan will include the amount and terms of the new first mortgage, the amount and terms of the subsidized second and third mortgages, the type of Section 8 assistance (i.e., project-or tenant-based), the type and financing of the required rehabilitation of the property, and the terms of any sale or transfer of property. The restructuring agreement requires the owner to maintain the project as a low-income residential project for at least 30 years.

MAHRAA provides a number of approaches to help projects offset the effects of the rent reductions.

Debt Restructuring

First Mortgage. The terms of the first mortgage coming out of a restructuring will be based upon the expected cash flows from the rents HUD is prepared to pay (comparable market rents or, if no unsubsidized comparable rents can be found, 90% of FMR). Therefore, the new first mortgage will probably be less than the original unpaid mortgage. Any shortfall will require a second and possibly a third mortgage.

The new first mortgage could be with or without FHA insurance or other credit enhancement and will be self-amortizing at market interest rates. Neither the regulations nor the statute impose any term limit for the first mortgage. However, the Mark-to-Market Operating Procedures Guide only provides for a partial write-off of the existing mortgage balance to the FHA general insurance fund, a reduction in the interest rate, re-amortization within the remaining term of the loan, or a combination thereof.

The first mortgage can be restructured to provide funds for rehabilitation of the property. For example, one way to accomplish this is to increase the amount of the existing first mortgage (and the amount to be covered by the FHA general insurance fund) and substitute an additional rehabilitation loan amount.

Project owners will be responsible for paying at least 50% of the refinancing transaction costs (100% in the case of modification of the existing loan). Up to 50% of the costs for title search, site survey, recordation costs, and prepayment penalties may be financed through the first mortgage.

Second Mortgage. The HUD-held second mortgage is limited to an amount that the PAE reasonably expects can be repaid by the owner based on the amount of expected cash flow after debt service for the first mortgage, payments to replacement reserve accounts, and the expected residual value of the project at the end of the mortgage term. This mortgage will bear a simple interest rate of at least 1% but no more than the applicable Federal rate determined by the Treasury Department (1% will be the usual rate), with debt service of 75% of the remaining cash flow. The residual cash flow is payable to the owner if he or she is in good standing with HUD. The term cannot exceed the term of the first mortgage. The second mortgage amount cannot exceed the difference between the unpaid old mortgage and the new first mortgage. The IRS has ruled (Rev. Rul. 98-34) that no original issue discount taxable income is generated because projects subject to MAHRAA are exempt from IRC section 7872.

The second mortgage will become due and payable if any of the following occur: the first mortgage is prepaid, terminated due to default, or assumed by a purchaser of the project of whom HUD does not approve or the owner fails to cure a HUD violation.

Third Mortgage. If the new first and second mortgages are not sufficient to equal the unpaid balance of the old mortgage, HUD may require a third mortgage. This mortgage will bear interest at the same rate as the second mortgage and will not require debt service payments (interest will accrue but not compound) until the second mortgage is paid. The third mortgage may be considered cancellation of debt income because it is unlikely to be repaid.

Exception Rents. If HUD rentals are not sufficient to operate the project and replacement housing in the community is not available, the PAE can approve rents not to exceed 120% of the FMR for the market area. The PAE cannot provide exception rents for more than 20% of the projects the PAE is responsible for without a "special need" waiver from HUD. Furthermore, at the request of the PAE, HUD may allow rents to exceed 120% for a limited number of units.

In order to qualify for exception rents, the project must be determined by the PAE to be a "positive social asset in the community whose operating expense levels and lack of debt service capacity are not a function of bad management."

The rent provided under the exception rent provision should be able to support a budget-based rent designed to cover debt service of a second mortgage (the first mortgage having been written off), operating expenses, contributions to replacement reserves, and 25% of remaining cash flow return to the owner, plus an additional $25 per unit per month for superior performance.

Rehabilitation Requirements. In order to be approved for restructuring, the owner must present a plan of rehabilitation that will achieve a nonluxury standard adequate for the intended rental market. The physical needs identified should be those necessary to retain the project's original market position as affordable, safe, and sanitary. The plan should include the remediation of any deferred maintenance, repairs likely to be required in the next 12 months, and any capital repair and replacement items necessary to maintain long-term physical integrity of the property, as well as the sources of funding of this work.

Rehabilitation Funding Sources. The PAE will first look to any balances in the residual receipts, surplus cash, and excess replacement reserve accounts. Other potential sources of funds include the following:

* The restructuring of the first mortgage
* Interest reduction payment recaptures from the mark-to-market restructuring of a section 236 loan
* Increases in Section 8 budget authority for Section 8 assistance contracts (to the extent HUD has determined that such funding is available).

The owner must contribute 20% of the total cost of rehabilitation from nonproject funds, and the regulations state that a reasonable proportion of the owner's contribution (HUD estimates 3% of total rehabilitation costs) must come from nongovernmental resources. The PAE may exempt housing cooperatives from the owner's contribution requirement. Up to 10% of any excess rehabilitation project funds can be paid to the owner after completion of the required rehabilitation.

Project-Based or Tenant-Based Assistance. Relatively early in the restructuring process, the PAE must determine whether the project should continue to receive project-based rent subsidies or convert to tenant-based subsidies (vouchers). Project-based rent subsidies remain with the project and are available to any qualifying tenant that occupies an apartment in that project. Tenant-based rent subsidies belong to the tenant and can be used by the tenant to pay rent in any qualifying apartment building.

MAHRAA requires project-based assistance when the project is in a tight market, defined as a vacancy rate of 6% or less (based on census statistics of the 75 largest metropolitan areas--New York City is a tight market), is occupied at least 50% by elderly (at least 62 years of age) or disabled tenants, or is a nonprofit cooperative housing project.

In addition, a project may receive project-based assistance under the following conditions:

* The project is located in a city with higher vacancy rates. However, vacancies in the affordable housing submarket are tight.
* The project has a large minority of elderly or disabled tenants.
* The project is located in an area that has a low poverty rate (i.e., less than 20%).
* The project would have trouble marketing its apartments to replacement tenants.

For projects that do not receive project-based assistance, 100% of the units must be available to tenants that have vouchers or certificates allowing them to rent an apartment whenever there is a vacancy. The vouchers and certificates generally allow tenants to pay comparable market rents. The restructuring plan will not permit an owner to reject any prospective tenants solely because of their status as holders of vouchers or certificates.

Opting Out of the Section 8 Program

The ideal candidate to opt out is the owner of a project that can afford full debt service at market rents, who resents HUD regulation, and who is willing to accept marketplace risk. If the owner does not renew the Section 8 contract, the tenants will receive regular vouchers at comparable market rents (changed from FMR by the fiscal 2000 HUD appropriations bill).

A feasibility study should first be made to determine market rents, expected percentages of occupancy, expected increases in real estate taxes, and changes in operating expenses because of the absence of HUD in the process (i.e., loss of real estate tax abatements). The project owner should also estimate the amount of any improvements that would have to be made to reposition the property in the marketplace and whether financing is available to fund those improvements.

Complexity Requires Careful Study

The recent legislation and HUD implementation rules are very complex and constitute an enormous change in HUD's approach to funding tenant subsidies. Project operators and their advisors wishing to take advantage of the opportunities should carefully study the legislation and regulations. Furthermore, mark-to-market programs are relatively new, and, therefore, HUD procedures and policies are still evolving. *

Abraham E. Haspel, CPA, is director of quality control at H.J. Behrman & Company LLP and a member of the NYSSCPA Financial Accounting Standards and Real Estate Committees. The author would like to acknowledge the assistance of Richard M. Price, Esq., Michael R. Peress, CPA, and Isaac Schlosser, CPA, in preparing this article.

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