Many projects currently in construction scrambled to locate financing over the last few years, inspiring some developers and principals to get creative. They included sustainable features to qualify for additional federal or state grants or tax incentives and they stopped shirking the FHA mortgage insurance programs.  As the financial crisis loomed, the only reliable financing of market rate or affordable housing has been through the GSEs, Fannie and Freddie, and the FHA.

The good news is that in HUD-subsidized housing, better energy efficiencies and healthier indoor environmental quality have become standard requirements. These improvements are tested post construction and must meet or exceed the original design, but even this kind of requirement hasn’t deterred the rate of applications. In fact, the extra interest in FHA insurance has been one of the factors that pressured the U.S. Department of Housing and Urban Development (HUD) into developing its new FHA mortgage insurance rules.

Announced on July 7th, 2010, the revisions will become effective 60 days from that date, but applicants can expect underwriters to begin implementing them immediately.  HUD published the announcement  as Mortgage Letter 2010-21 and specifically named multifamily risk mitigation as a lead motivation.  In other words, HUD wants the FHA to tighten up, but not shut off the faucet, inspiring us to call this the ‘aerator’ underwriting method.

The mortgagee letter revisions of underwriting standards will assist in strengthening the program and lowering its risk, but it will not be easy in the current market for the multifamily sector to adjust even to these small changes. It should be noted that it has been 40 years since the last major overhaul of FHA’s multifamily insurance program, which has been in need of updating. The following is our analysis of those revisions.

Principals on the Hotseat: First a principal must pass a terrorism check. Any principal with more than $250 million in outstanding FHA insured debt will need pre-approval from HUD before they can apply for additional insurance commitments. A much more comprehensive analysis of borrowers’ financials will be undertaken. This type of scrutiny will evaluate even contingent liabilities – like an impending  balloon payment on another property – that could undermine a borrower’s  stability. Three years of tax returns for the project or borrowing entity will be required, as well as a CPA-prepared property financial statement with copies of insurance and property tax bills.

Before, during and after funding: Developers and principals will no longer be able to get cash out from land equity until project completion. Photos of the surrounding area will be required in addition to project photos. Details that relate to community, sustainability, environmental issues and market conditions will now be required. Physical site inspections by staff will be performed as a standard procedure.

Tougher underwriting: Pre-screening of all proposals will reject weak or non-feasible transactions quickly. Proposals that make it past the initial pre-screening will be deeply and thoroughly analyzed by staff – which will probably result in many of these proposals being culled from the herd as well.  Market rate applications will become more complicated, as they will be submitted under two-stage processing with a pre-application submittal.

Increased Debt Service Ratios: Although these are not being increased substantially and some loan programs are not affected, any increase might have an impact.

Higher Reserve Requirements: New requirements will include higher working capital escrow accounts (generally 4% of the mortgage loan amount). Break-even occupancy has been re-defined as 1.0 debt service coverage.  Amounts required for operating deficit escrows - in which the monies will be used to supplement net income during initial lease up – will be increased. Substantial Rehabs will require 10 to 15 percent of construction costs be set aside as contingency escrow funds. Notoriously underfunded in the past, reserves for replacement of improvements have been increased. Allowed absorption periods have also been lowered from 24 to 18 months, reflecting concerns about volatility and weakness in the real estate market.

People will matter: Projects with substantial tenant displacement will generally require market and appraisal studies be performed by independent firms to gain greater insight and analysis of the project and avoid possible conflicts of interest. More complete financial and credit information will be required for the developer, principals, management company and general contractor. Special emphasis will be paid to any participant in the project “with adverse credit actions like bankruptcies, foreclosures or a pattern of renegotiating debt.”

Greater sophistication: The site’s sustainability will be considered, as well as consideration of how the proposed development will impact other neighboring developments within the FHA pipeline. If it is perceived as a competitive project that might lower an existing development’s asset value, it is probably not going to be approved under any circumstances. In refinancing or acquisition proposals, current physical and economic occupancy rates will have much greater weight than they previously have.

Condominium Ownership Regimes: Projects that were initially built as condominiums, but are now being operated as rentals, may be considered as eligible for multifamily mortgage insurance if certain conditions are met with regard to ownership. There may be some tolerance for a limited number of individually owned units if they are located in a separate building or separated from the rental units. The Multifamily Hub Director may consider waivers, but not if ownership units and rental units are mixed together.

Frankly, many of these procedures should have been performed in depth previously.  They are good, solid underwriting practices and only seemingly Draconian by comparison to the loose underwriting often practiced before the recession.

Other Articles of Interest:

• FHA Multifamily Lenders’ New Rules
• Renting Outlook Shifts
• What’s New, Pussycat: Multifamily Spring 2010
• Tech Rescue for Multifamily Crisis Situations