Close but no Cigar -recent changes in the HUD 221(d)(4) Loan program

2014-06-14 10.44.47
An exotic rectangular mixed use building on Alberta Street NE Portland, OR

The Regional Plan Association (RPA) recently prepared a report describing how real estate finance is structured and the unintended consequences of that structure impacting neighborhoods and the economic health of communities.

For smaller increments of development, the debt financing can be delivered in the form of off the shelf FHA, Fannie Mae, or Freddie Mac 30 year mortgages for buildings of 1 to 4 residential units.

If the project is 5 units or more, the small developer typically goes to a small local bank and takes out a commercial construction loan which will require a 25 – 30% down payment and a personal guaranty.  Once the building is completed and has a couple years of operating history, the developer can take out a nonrecourse loan which does not require a personal guaranty and pays of the construction loan.

As the RPA Report explains, small developers who want to build modest mixed use buildings on their town’s Main Street or provide Missing Middle buildings are not able to access the favorable financing available to the developers of large single use suburban apartment complexes.  The largest single source of federally insured financing for apartments is the HUD 221(d)(4) Loan Program.  In 2015 $2.9 billion in loans were issued under this program.  It is the largest single loan program for apartments in the US.  If a project meets the underwriting requirements of the program the terms are pretty great:

  • The down payment is only 16.5%.
  • The term of the loan is 40 years.
  • The loan starts out as a construction loan and is converted to a permanent mortgage without any additional fees.
  • There is no personal guaranty required.

The 221(d)(4) Loan Program has focused upon single use apartment projects and there are some serious issues that come up if you try to use the program to finance a mixed use building or series of buildings.  The underwriting standards have specific restrictions upon how much commercial space is allowed in the building and how much commercial income can be considered in the rents the project will collect.

These restrictions are listed in the RPA Report as:

  • a 10% Cap on Gross Income Derived from Commercial.
  • a cap of 15% of the Gross Leasable Area of the building devoted to Commercial Use.

A typical two story Main Street mixed use building has close to 50% of it’s building area devoted to commercial use, so you can see the problem.  That building can’t use HUD 221(d)(4) financing.  The appraisers certified by HUD and FHA to review 221(d)(4) applications are residential appraisers, so they have a hard time figuring out what the value of a building containing something other than residential apartments.

HUD recently released the 2016 Multifamily Accelerated Processing  (MAP) Guide on January 29, 2016.  This is the rule book HUD issues periodically to the banks that are certified to sell loans under the various HUD programs 221(d)(4), 220, and 223.  There have been some changes made to the rules following public comments over the last couple years on the issue of bringing HUD’s loan programs in line with HUD’s policy of supporting walkable mixed use neighborhoods.

  • The 10% Cap on Gross Income Derived from Commercial has been raised to 15%.
  • The 15% Cap on Gross Leasable Area of the building devoted to Commercial Use has been raised to 25%.

So if you want to build a four story mixed use building and devote the ground floor to commercial use, you can use the HUD 221(d)(4) loan program, (since one floor out of four would get you 25% of the gross leasable area of the building).  Unfortunately, the most income you can show on your pro forma to qualify for the loan from that ground floor commercial tenant is 15% of the building’s total income.  What HUD is saying here is, “Okay, you can build it, but we are not going to count much income from it.”

I suspect that the reason this new crop of rules is such an unfortunate half-measure is that the folks at HUD who periodically edit the rule book have been so focused upon single use apartment complexes in the suburbs for so long that they have a hard time understanding how a two or three story mixed use building on Main Street actually work.  At this rate, it may be a long time before small developers have access to the same financing as big outfits building apartment complexes on the edge of town.

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4 thoughts on “Close but no Cigar -recent changes in the HUD 221(d)(4) Loan program

  1. Bruce Tolar March 17, 2016 / 8:42 am

    John; of course you know 100 time more about this than me. In reading this below the information seems backwards compared to the bulleted statements. Please confirm.

    Bruce

    *

    * The 15% Cap on Gross Income Derived from Commercial has been raised to 25%.

    * The 10% Cap on Gross Leasable Area of the building devoted to Commercial Use has been raised to 15%.

    So if you want to build a four story mixed use building and devote the ground floor to commercial use, you can use the HUD 221(d)(4) loan program. Unfortunately, the most income you can show on your pro forma to qualify for the loan from that ground floor commercial tenant is 15% of the building’s total income. What HUD is saying here is, “Okay, you can build it, but we are not going to count much income from it.”

    • rjohnanderson March 17, 2016 / 9:21 am

      Thanks Bruce, A number of people caught this and I have fixed it in the blog text.

  2. Loni Gray March 24, 2016 / 7:37 pm

    John,
    Because there is an Congressional expectation that Fannie and Freddie serve low and moderate-incomed citizens with their programs – on paper anyway, FHFA does an annual review with a period of comment (Duty to Serve). It was done back in December with the comment period ending just this past week, March 17th:
    http://www.fhfa.gov/PolicyProgramsResearch/Policy/Documents/DTS-Webinar-Presentation_12-22-2015.pdf

    During their very dry, very canned webinar (They asked us to submit all webinar questions 3 days prior, they picked the ones they wished to answer, and read prepared responses to those that they chose! They seems quite terrified about answering “off the cuff”…. What might they have said by mistake?)

    They did cover the 5-50 unit affordable housing development. (P 9 in pdf above) In the core area of the Rule regarding “affordable housing preservation”, there were several questions where they requested comment regarding the 221(d)(4) loan program.

    Seems too early to assume that the report you site in this post encompasses any changes that came from this recent comment period. But might there be some thought put into doing so next year from those of us nurturing intimate development?

    Think we might try to impact the program?
    Loni

    • rjohnanderson March 24, 2016 / 8:02 pm

      Well, we’ve been trying to impact the program for a couple years and that turned into the increase in the amount of non-residential SF to 25% and this weird collection of waives that you can try to get from the regional HUD Director, who likely has little or no grasp of how mixed use neighborhoods built from structures of modest scale are supposed to work. The biggest miss in this latest round or revisions to the program is that they limit the revenue you can claim from the non-residential SF on your project proforma to 15%. Imagine a four story mixed use building with three floors of apartments over some top of the line retail operation like say, a Whole Foods or Trader Joe’s. How much of that revenue from the ground floor can be shown on your pro forma? no more than 15% of the total rent. Why 15%? It is an arbitrary number that makes no sense. Why not make the requirement that the ground floor non-residential rents must be validated by a serious commercial appraiser? You are going to have an appraiser review it any way. Why limit the project to 15%. A location that can attract an excellent ground floor retail tenant is going to cost more to acquire, so it would be good if the 221(d)(4) underwriting process would recognise the value of the ground floor lease. You pay extra for an excellent site and you cant get credit for the revenue an excellent tenant or tenants bring in? The cost of the site is in the proforma bu the revenue has to be capped? Really dumb.

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