National Housing Law Project Housing Law Bulletin

HUD Issues Section 8 Reengineering Demonstration Guidelines

HUD has recently published a Federal Register Notice providing the initial guidelines for Congress' Fiscal Year 1997 demonstration program to restructure debt and subsidies on HUD-insured multifamily properties with project-based contracts expiring during FY 1997.¹ This Notice addresses a number of important issues left unresolved by the statute, most of which are reviewed in this article.

Under the FY 1997 appropriations law, most contracts expiring in FY 1997 will be renewed at current rent levels if owners so choose (probably more than 200,000 of the estimated 235,000 total project-based units expiring in FY 1997). These rollovers for one-year terms are available to any properties with rents no higher than 120 percent of the area Section 8 Fair Market Rent (FMR) (or with higher rents but whose owners are willing to accept rents at the 120-percent level), as well as to properties with primary financing providing by state or local public agencies, Section 202 projects, Section 811 projects and Rural Housing Service/FmHA Section 515 projects, regardless of the current rent level.² Because the law limits renewals to current rents within the overall ceiling, some owners may choose to "opt out" of the Section 8 program if the property can command higher rents on the private market. Many owners of properties intending to prepay their HUD-subsidized mortgages are also seeking to opt out of the program when their Section 8 Loan Management Set-Aside (LMSA) contracts expire.

Properties with contract rents exceeding the 120-percent level have three options. First, a few will opt out, usually because they can command sufficient rents on the open market to cover debt and operations, or are close enough that relief from federal regulatory requirements makes the risk worthwhile. Second, some owners of properties with rents above the 120-percent mark will elect to reduce rents to the 120-percent maximum and renew for one year.³ Third, some owners of HUD-insured properties will elect to undergo a restructuring of their Section 8 rents and loans to permit renewal of the project-based Section 8 subsidies at lower market rent levels.

HUD estimates that approximately 18,000 units are eligible for the restructuring demonstration, but that only a maximum of 14,000 are likely to elect to participate. Ohio and Pennsylvania lead the pack in the number of eligible units.

Project Eligibility

The demonstration covers HUD-insured developments with contract rents exceeding the 120-percent benchmark and contracts expiring in FY 1997 or later.⁴ Properties with loans that have been assigned to HUD, are HUD-owned, have direct HUD loans or are conventionally financed are ineligible for the demonstration. Also ineligible are developments with units that fail to meet HUD's Housing Quality Standards at contract expiration where the owner has previously been given opportunity to cure the deficiencies pursuant to HUD's procedures. Since this disqualification is not statutorily mandated and could improperly exclude some properties with small numbers of substandard units, close monitoring of HUD's decisions here might be advisable. HUD will also disqualify owners who have engaged in "material adverse financial actions or omissions," defined as any act or omission that leads to a monetary or technical default or that violates a term of the Regulatory Agreement or Section 8 contract.

The guidelines cite as examples of disqualifying conduct the submission of false statements or certifications to HUD, diverting project funds or taking unauthorized distributions, or documented mismanagement. HUD recognizes that the contract for a project whose owner is disqualified may be renewed if the property is sold to a qualified purchaser. Disqualified owners voluntarily seeking to transfer properties must follow the preferential transfer procedure required by the statute and further detailed in the guidelines.

Procedural Framework

Processing for the demonstration program may be handled either directly by HUD or by a public agency designee for a particular geographic area. Where HUD is the administrator, owners seeking to participate must submit a request to the local HUD field office at least 45 days prior to scheduled contract expiration, unless HUD waives the deadline for good cause. Owners with contracts expiring fewer than 45 days from January 23, 1997, must file their request within 45 days of that date. HUD will apparently run the processing out of selected field offices through a "Demonstration Manager," assisted by a "Due Diligence Contractor" who will contract for appraisals and physical needs assessments.

At the time of the request, the owner must simultaneously provide notice to the tenants, the chief official of the smallest unit of local government with jurisdiction over the project, and the lender on the HUD-insured loan.⁵ Notice to tenants must be provided to each tenant and posted in each building, although HUD will permit individual notice to be supplanted by notice to an existing tenant organization that officially represents all tenants. Among other things, this notice must include:

• A copy of the owner's request to HUD to participate in the demonstration program;
• An explanation of the available tenant protections;
• Notice of the opportunity to provide written comments (especially on the project's physical needs and management) to the HUD field office within 45 days of execution of the Demonstration Agreement,
• A statement of the opportunity for tenant representatives to attend a meeting on 10 days' notice prior to the project's inspection by HUD's contractor that will comprise a key part of the Physical Needs Assessment;
• A statement of the owner's duty to provide a later summary of HUD's actual Restructuring Commitment;
• Notice of the right to comment later on any appeal of HUD's offer by the owner.

Within 10 business days after receipt of the request, the HUD field office must forward to the owner a "Demonstration Agreement" which sets forth the owner's duty to proceed in good faith to reach a "Restructuring Commitment" with HUD within 180 days and to provide the necessary information to HUD and notice to tenants, lenders and the applicable local government(s). An addendum to the Demonstration Agreement is a short-term "Demonstration Renewal Contract" to continue the current subsidies on an interim basis while the restructuring process moves toward conclusion.⁶ The owner must execute the Demonstration Agreement at least 10 business days prior to the scheduled expiration date of the existing Section 8 contract.

Following this agreement, HUD's Demonstration Manager will meet with the owner to begin discussions of project characteristics and restructuring options. Tenants have no formal role early in the process, other than general comment rights without the benefit of any actual proposal, until their official participation in the pre-inspection meeting. Curiously, HUD subsequently prepares its restructuring proposal without formal input from anyone else and presents it to the owner, who must then forward a summary to the tenants and the local government, but there is no formal opportunity to comment on any owner proposal or HUD's commitment. The owner must agree to HUD's proposal within 30 calendar days or request a modification. HUD is supposed to reach an agreement on the modification request within the next 40 calendar days, unless HUD extends the deadline. The owner may appeal the result within 10 calendar days; tenants, the lender and local government have 20 days to comment; and HUD will either modify the commitment in writing within 30 calendar days or refuse to do so. Closing of any commitment must occur within 60 (presumably calendar) days of execution, unless extended by HUD.

If HUD and the owner fail to reach agreement, the owner may accept a one-year renewal at the 120-percent-of-area-FMR limit. Alternatively, if the owner has provided the tenants and HUD with a proper one-year expiration notice, HUD will provide tenant-based assistance for eligible families. If no proper notice has been given, then the owner must permit tenants to remain for the full proper notice period without increasing their share of the rent from that paid under the interim Section 8 Demonstration Agreement.

Processing procedures established by designees may differ. Public agency designee letters of interest are due at HUD by February 15, 1997, and selection will follow by April 1. Compensation may be structured as a fee for service, with performance incentives, or as a joint venture with HUD where the designee assumes risks and shares savings with the federal government. HUD plans to publish a formal Request for Qualifications for interested nonprofit designees this spring. Designee processing must result in restructuring commitments within 180 days of the initial Demonstration Agreement and must follow certain of the statutory requirements, such as notice. HUD must approve the final restructuring commitments negotiated by designees. In jurisdictions without designees, owners may engage FHA-approved lenders to undertake the re-underwriting of the project, subject to approval by the local HUD field office.

Demonstration Approaches and Underwriting

Mandatory tools

For each property, HUD must use at least one of the following three tools: mortgage restructuring, debt forgiveness or budget-based rents. HUD's guidelines state that where a new market-based NOI for the property is positive, it will generally use mortgage restructuring or debt forgiveness; if it is negative, then budget-based rents will generally be used. The guidelines provide further detail on the mechanics of each of these mandatory tools.

Under mortgage restructuring, the existing HUD-insured first mortgage loan is divided into a performing first mortgage based upon market rents (and a debt service coverage ratio of 110 percent) and a second payable only out of any net cash flow after restructuring. A full or partial prepayment of the existing HUD-insured loan will be necessary. HUD will also allow owners to obtain an annual owner's distribution of $25 per unit per month, plus 10 percent on any new cash equity. Any remaining net cash flow gets distributed equally between the owner and HUD. Rehabilitation is financed first through funds available in the project's residual receipts or reserve for replacements accounts, then from additional equity contributions, a non-insured rehabilitation loan or through a loan or grant from HUD.

Debt forgiveness provides another option for HUD and the owner to reduce debt burdens and subsidies, again requiring a full or partial prepayment of the existing HUD-insured loan. The maximum amount forgivable is limited to the amount by which the current loan exceeds the project's appraised market value.

Budget-based rents may be used where mortgage restructuring or debt forgiveness is not feasible, usually where the project has a negative market-based NOI. Budget-based rents may also be used for some valuable projects where market rents equal or exceed both 120 percent of FMRs and gross rents under Section 8 (contract rents plus utility allowances). Elderly-designated and rural projects may receive a preference for this tool. Rents will be set at reasonable operating expenses, limited to the expiring contract rents, which include the owner's distribution and debt service on any remaining loan. Projects with negative market-based NOI may receive rehabilitation grants of up to $5,000 per unit, which HUD may increase in unspecified extraordinary circumstances.

Underwriting

The new underwriting process seeks to bring rents and expenses in line with comparable unassisted units in the same market, reducing the debt service burdens of FHA-insured first mortgages in the process. Briefly, HUD's Demonstration Manager will first estimate market rents, then a project's adjusted NOI, by deducting operating costs and reserve payments. After a further adjustment for debt service coverage, HUD determines the new amount of "supportable debt," which may be further reduced to permit rehabilitation and the owner distribution.

The guidelines provide further detail on the steps for estimating income and expenses, as well as rehabilitation needs. Notable features of this process include:

• Re-evaluation of operating expenses with an eye toward possible reductions;
• Setting a new level for contributions to the reserve for replacements, based upon a new physical needs assessment and rehabilitation plan;
• Conduct of a physical needs assessment process by a HUD contractor who will use standards for FNMA-delegated underwriting and servicing, and that must also address the cost of improvements necessary for competition with similar unsubsidized market properties;
• Requirement that, after restructuring of the first loan, owners share any net cash flow 50-50 with HUD, except that owners may retain the first $25 per unit per month as an owner distribution to be held in escrow pending periodic compliance inspections; after initial underwriting, this distribution is not guaranteed, but must be earned by keeping rising operating costs in line with whatever rents and subsidies Congress annually decides to approve.

Optional tools

The guidelines repeat the optional restructuring tools provided by the statute, such as early partial or total prepayments to the first lender, transfer of HUD's economic interest (limited to a total of 5,000 units), new FHA insurance or other forms of credit enhancement (within the 25-percent limit for non-FHA transactions), tenant-based Section 8,⁷ and removal or modification of regulatory restrictions.⁸

Tax relief

On the critical issue of the tax implications of restructuring for owners, HUD invites owners to submit proposals for structures acceptable to the IRS that will limit or defer tax liability, so long as they will not adversely affect a project's financial integrity or management.

Affordability restrictions

On the issue of post-restructuring affordability restrictions, the guidelines state that the statutory obligation for the owner to accept renewals offered by HUD for up to 20 years will be placed in the Restructuring Commitments and any renewed Section 8 contracts. Should Congress not provide resources for renewal, HUD indicates that the owner and HUD will execute a Use Agreement requiring the owner to accept tenant-based subsidies (but only from the project's then-existing tenants who wish to stay) for the 20-year period. In addition, in exchange for restructuring or forgiveness, the owner must execute a recorded Use Agreement requiring occupancy of the property under the standards of the Tax Credit program, namely 20 percent of the units occupied by families with incomes under 50 percent of area median, and 40 percent of the units by families with incomes below 60 percent of median. HUD may waive even this weak standard for good cause.

Property transfers

Where an owner seeks to transfer a demonstration property, the guidelines establish a limited process for providing a preference to tenant organizations, tenant-endorsed nonprofits and public agencies.⁹ The owner must notify these potential buyers through specified means and during the first 90 days (from notifying HUD of its intention to sell) may accept a bona fide offer only from them. The demonstration program provides no predevelopment or technical assistance funds to implement this preference.

Sunshine provision. Accepted proposals will be posted on HUD's Web site (www.hud.gov/fha/mfh/mfhsec8.html). Once the demonstration really becomes operational, permitting ready public access to this information will be extremely helpful for determining how the demonstration is actually being implemented and the issues presented and lessons learned. To the extent that the results of the program form the basis for any subsequent federal policy concerning the Section 8 housing stock over the next year or two, this information may prove especially crucial.

¹Portfolio Reengineering Demonstration Program, 62 Fed. Reg. 3,565 (Jan. 23, 1997). Authority for the demonstration program was Pub. L. No. 104-204, §§ 211 and 212, 110 Stat. 2874 (Sept. 26, 1996). For further details on its provisions, see Another One-Year Reprieve for Most Expiring Section 8 Housing, 26 HOUS. L. BULL. 133 (Oct. 1996).

²Contracts eligible for renewal without restructuring are covered by HUD Notice 96-89 (Oct. 15, 1996) and a subsequent HUD Headquarters memorandum, "Memorandum for All Housing Directors, from Nicolas P. Retsinas, Assistant Secretary for Housing, Re: Clarification of Procedures for Project-Based Section 8 Contracts Expiring in Fiscal Year 1997" (Nov. 1, 1996).

³Voluntary rent reductions to 120 percent and renewals are available to owners of both HUD-insured and non-HUD-insured properties. See Pub. L. No. 104-99, § 405(a), 110 Stat. 26 (Jan. 26, 1996) (non-insured), and Pub. L. No. 104-204, § 211, 110 Stat. 2874, 2896 (Sept. 26, 1996) (HUD-insured).

⁴Those with contracts expiring in FY 1997 are given preference for participation, and HUD must process them first unless properties with contracts expiring later present no cost to the federal government under budget rules. Owners of properties with contracts expiring later must submit letters of interest, and HUD will make the necessary budget calculations.

⁵This notice is separate from the one-year notice of contract expiration required by 42 U.S.C. § 1437f(c)(9) and HUD Notice 96-89 (Oct. 15, 1996).

⁶HUD Notice H 96-89, Att. 3(c) (Oct. 15, 1996).

⁷Vouchers may be substituted only for up to 10 percent of the units restructured annually, and only where HUD determines and certifies that adequate available and affordable housing exists to enable successful use of tenant-based assistance.

⁸In light of the new structure for owner distributions, HUD will eliminate any prior restrictions on dividends or residual receipts after restructuring.

⁹This preference also applies where an owner has been disqualified from participating due to "material acts or omissions" and seeks to sell the property. HUD may renew and transfer the Section 8 contract to a new purchaser.