Impact of New FHA Rules on Rental Housing Production

The Federal Housing Administration (FHA) mortgage insurance program—in line with what one would think is its historical New Deal mandate—was the only game in town that kept multifamily construction alive during the worst of the economic crisis in 2009 as banks shut down lending. Alas, it may not play such a role for much longer, it is suggested, as more stringent rules have recently been imposed that will make it harder for developers to use the program.

In its Mortgage Letter 2010-21 of July 6, the U.S. Department of Housing and Urban Development (HUD) announced finalized policy changes that incorporate revised underwriting standards, enhanced verification of property financial performance, expanded borrower mortgage credit analysis and pre-screening of proposals. HUD notes that the updates to the underwriting standards are the first in the history of the FHA multifamily programs.

Nevertheless, word is that developers are very unhappy with some of the changes. The National Association of Home Builders (NAHB) “appreciates and supports HUD’s goal of minimizing risk to the programs,” says Claudia Kedda, director, Multifamily Finance. However, she notes that the underwriting changes are “significant” and “come at a time when there are few options for obtaining financing for affordable and market-rate multifamily rental housing.”

In its defense, HUD is acting responsibly, proactively and boldly to tighten program requirements in response to increased current and projected default rates in the FHA program under inherited program guidelines. At a Mortgage Bankers Association (MBA) conference this past February, Carol Galante, HUD deputy assistant secretary for multifamily housing, explained that HUD forecasted a “substantial” uptick in the claims rate for the FHA multifamily program. And she expressed concern about “workouts that will inevitably take place over the next two years.”

According to HUD, default rates have increased across all multifamily insurance programs, but particularly for market-rate properties under the FHA 221(d)(4) program that do not benefit from affordable housing subsidies. HUD numbers show the claims rate doubled from 0.6 percent to 1.2 percent during FY2010. Moreover, the overall default rate for the market-rate FHA 221(d)(4) loans is 4.1 percent as of July 2010, compared to about 1 percent ($931 million) for the overall multifamily FHA-insured portfolio.

HUD projects the trend of increasing defaults in FHA 221(d)(4) market-rate properties to continue at least through 2011. The falling proportion of subsidized housing, which is normally the stronger properties, as well as the practice of making construction loans without stabilization requirements, noted Galante at the MBA meeting, are among the causes making the default rates worse.

Besides the changes announced this summer, more program changes will be announced in additional mortgage letters through December related to, for example, heightened requirements for lenders and underwriters, and an update on the Multifamily Accelerated Processing (MAP) underwriting guide.

Changes to the program

For borrowers in the FHA 221(d)(4) new construction/substantial rehabilitation mortgage insurance program, the most contested changes are a decrease in the required Loan-to-Cost or Loan-to-Value ratios (LTC or LTV) from 90 percent to 83.3 percent and an increase in the Debt Service Coverage ratio (DSC) to 1.20 percent from 1.11 percent for market-rate properties. For affordable FHA 221(d)(4) projects, the LTC or LTV is lowered to only 87 percent, and DSC is increased from 1.11 to 1.15. For FHA 221(d)(4) projects with 90 percent or greater rental assistance, the LTC remains at 90 percent and DSC at 1.11. The absorption period allowed in estimating market demand will be reduced from 24 months to 18 months.

For the FHA 223(f) refinance program, the LTV has been lowered from 85 to 83.3 percent for market-rate properties, and increased from 85 percent to 87 percent for properties with 90 percent or greater of rental assistance (no change in the 85 percent requirement for affordable FHA 223(f) transactions). The DSCs are increased to 1.20 from 1.176 for FHA 223(f) market-rate projects, stay the same at 1.176 for FHA 223(f) affordable projects, and are lowered from 1.176 to 1.15 for projects with 90 percent or greater in rental assistance.

For market-rate FHA projects, the requirements for the Operating Deficit Escrow to cover the initial lease-up period has been tightened, from four months of debt service previously, to whichever is greater of four months (for garden apartments) of debt service or 3 percent of the mortgage amount. And the Working Capital Escrow requirement has been increased from 2 percent to 4 percent of the loan amount.

According to Ron Davis, vice president and FHA specialist at Johnson Capital, the current low-interest environment does help to offset the increased requirements and make deals work. The interest rates for the market-rate 40-year construction-permanent rollover FHA 221(d)(4)-insured loans are in the 5 percent range, even with the 45 basis-point Mortgage Insurance Premium (MIP) added. Not so long ago, the all-in interest rates for the program were in the 7 percent range.

On the other hand, Johnson Capital has calculated that the total cash that developers need to cough up as a result of the stricter LTV and operating deficit and working capital escrows is an additional 10 percent of the deal. For example, a $15 million apartment complex will require an additional $1.5 million in cash to get the deal done: $900,000 in additional equity and $600,000 in the additional escrows, says Davis.

Effects of rules

Developer Sal Leccese, president of LeCesse Development Corp., argues that if HUD was worried about increasing losses on its insurance fund, it should have increased the MIP from 45 basis points to say, 100 basis points, to cover possible losses, instead of tightening the underwriting standards. The underwriting tightening is not dramatic or objectionable to Leccese on the FHA 223(f) refinancing program. The main objection, he says, is the increased LTC and DSC requirements on the FHA 221(d)(4) market-rate new construction/substantial rehabilitation program.

“The [tightened underwriting] will have a dramatic effect on the number of deals you would be able to get done. They made a mistake there. They need to go back to the previous underwriting standards,” says Leccese.

One of the effects of the tougher LTC and DSC would be a major hit in new housing units being produced, not so much in major metropolitan markets, but in second- and third-tier markets, says Leccese. Because the larger institutional equity, and possibly banks, shun these smaller markets, developers in second- and third-tier markets typically rely more on “country club cash”—from friends and families, contractors, partners, land sellers and so on—to raise their equity. And a 20 percent equity requirement is a much higher burden on these developers, especially if they are trying to execute larger, more cost-efficient developments with 200 to 300 units, says Leccese. “You can go to New York City, but not so much Des Moines, Rochester and Chattanooga,” says Leccese. “For a $25 million to $30 million project, it is harder to raise $5 million or $6 million cash in a secondary market.”

The new FHA rules are effective Sept. 4. According to Mark Humphreys, CEO of Humphreys & Partners Architects LP, there was a crunch of project submissions to his architectural firm in July from developers who wanted to get applications to HUD before the new rules came into effect. Humphreys & Partners had calculated that given the typical processing times, developers needed to have turned the packets into the firm’s offices by July 19 if they wanted to submit to HUD by Sept. 4, and the firm duly sent out a circular informing its clients and prospective clients of the deadlines.

Humphreys reported that in July, his firm received the largest number of FHA proposals it had ever received in one month as developers tried to beat the deadline. However, he expects a huge decrease in the number of proposals given to his office in August. “There is no question about it,” he says. “The number of HUD projects will drop off dramatically. It will be interesting to see if conventional financing will pick up the slack.” Humphreys says that the higher LTC requirement is the biggest obstacle for developers. And, he says, developers appear to be weighing their options at this point, with many saying perhaps they will obtain conventional bank financing instead.

Of course, a leverage of 90 percent for both construction and permanent loans appears to be extremely favorable; although the National Multi Housing Council (NMHC) argues that the 90 percent LTC is closer to 80 percent, when taking into account the extra cash that is needed to be put into escrows that are not mortgageable. From which banks, after all, can you ever obtain a combined construction and permanent loan that is 90 percent of the total construction cost (for a term and amortization of 40 years, no less)? And if FHA’s $41.7 billion in insurance should ever run into trouble, it would be easy for detractors to say “government fails again,” or say the terms, such as the 90 percent loan amounts, have been lax or unfairly favorable to special interests.

Indeed, for all the dissatisfaction that has been kicked up, Johnson Capital’s Davis does not think the consequences are dire for the FHA multifamily mortgage insurance program overall. Despite the 10 percent higher cash requirements, Davis maintains, “If you are a well-capitalized borrower, you can still move forward. It just costs a little extra … It is harder to get the ‘d4s’ built because of adverse conditions in many markets, but if you have a property you are trying to get done, from an interest point of view, I think there is no better time to do it.”

NMHC argues that it is the economic downturn, rather than the loose underwriting requirements, that leads to the increasing default rates of properties with FHA-insured mortgages. However, so far at least, HUD says there have been no changes in the default rate in recent months although the economy has supposedly improved. “Although there is some general evidence that the multifamily sector is beginning to stabilize with higher occupancies and rents no longer in decline, especially in the stronger markets, there has been no change in the performance of FHA’s insured portfolio at this time,” says Galante.

In any case, HUD will be revisiting the requirements down the road. “We have committed to reviewing the revised underwriting standards one year after they are fully implemented, in or around January 2012, to determine if changes in multifamily market conditions warrant a reconsideration of the standards,” says Galante.

Meanwhile, says NAHB’s Kedda, “We are continuing our discussions with HUD, with the goal of helping HUD meet its goals, while ensuring that FHA remains a viable option for multifamily developers, especially during this difficult economic environment.” It remains to be seen whether or not multifamily production volume will take a significant hit.

To comment on this feature, email Keat Foong at [email protected].