This article first appeared in the June 2011 issue of the Novogradac Journal of Tax Credits. © Novogradac & Company LLP 2011 - All Rights Reserved.
The U.S. Department of Housing and Urban Development's (HUD's) Mark-to-Market (M2M) restructuring program has matured fully under its administration by the Office of Affordable Housing Preservation (OAHP) and the passage of the Multifamily Assisted Housing Reform and Affordability Act of 1997 (MAHRAA). M2M-restructured projects now represent a large portion of the national portfolio of Section 8 subsidized affordable housing. Many restructured projects have reached a need for substantial rehabilitation, and their Section 8 Housing Assistance Payments (HAP) contracts were generally renewed for 20-year terms and set for stable annual rent increases pegged to HUD's annually published inflation adjustment - operating cost adjustment factor (OCAF). Given that, we have seen ever increasing activity in M2M project acquisition and redevelopment with and without tax credit proceeds.
Generally, full M2M restructuring will result in the reduction of existing Section 8 subsidy to comparable market rent levels, the bifurcation of existing debt into an Federal Housing Administration (FHA)-insured first lien that can be serviced by reduced rents and either one or two subordinate mortgage loans, held by HUD. It is also common that the restructuring process involves some funding for necessary repairs, but not for long-term substantial rehabilitation. We often see properties that were restructured several years ago that are now in need of substantial rehabilitation.
M2M's mortgage bifurcation process does not result in a reduction of outstanding mortgage debt, but only in a deferral of the portion that cannot be serviced regularly under lowered rents. In addition, HUD-held subordinate cash flow mortgage restructuring mortgages (MRMs) and contingent repayment mortgages (CRMs) that are created contain "due-on-sale" terms that require full repayment in the event of refinancing or sale. However, necessary rehabilitation for many post-M2M projects cannot be funded adequately if repayment of all outstanding debt is required upon transfer to redevelopment purchasers. Notwithstanding stable and predictable long-term Section 8 subsidy contracts, it is common that redevelopment plans for these projects fall short of the funding necessary for rehabilitation and full repayment of all outstanding first lien FHA-insured and subordinate HUD-held MRM and CRM loans.
Specific OAHP incentives for not-for-profit-sponsored projects (including those using tax credits) have been available by statute and policy for nearly 10 years, and have worked well in these circumstances. We have seen many redevelopment/preservation transactions close with relief from due on sale and/or full assignment of HUD-held MRM and CRM debt to community based qualified not-for-profits (QNPs). Nevertheless, QNP treatment is available only for a limited period following M2M restructuring (the three-year rule), as discussed below.
Late last year HUD issued its guidelines in Notice H10-22 for waiver of the due-on-sale and due-on-refinancing provisions contained in MRMs and CRMs, permitting redevelopment of post-M2M projects by purchasers that do not have QNP participants. While these guidelines have been in place for several years, practical experience with these waivers in the for-profit context has provided some additional detail and insight.
In order to encourage preservation and redevelopment of its M2M portfolio, OAHP will consider purchaser requests to acquire and refinance M2M projects, without full repayment of existing HUD-held debt. Notice H10-22 and some precedent have provided detail and a predictable path for redevelopment transactions. Conceptually, OAHP will evaluate whether the proposed transaction:
- is in the best interest of HUD, tenants and the community (including provision for extended use restrictions, long-term financial and physical stability, and maintenance of value in outstanding HUD-held debt)
- provides appropriate rehabilitation from non-HUD funds, and
- ensures that HUD (after having previously paid for a large portion of the initial M2M restructuring through FHA-insurance claims) is receiving its "fair share" of transaction proceeds.
In practical application, requests for relief from the due on sale of MRMs and CRMs, in acquisition/rehabilitation, require the simultaneous processing of a full transfer of physical assets (TPA) by the HUD field office and a full transaction review and financial analysis by OAHP. This balancing of field office and OAHP processes, with respect to timing and overlapping concerns, can take some time, but is not overly burdensome. Upon submitting comprehensive transaction/financial model documentation and other information to HUD, OAHP will consider:
- whether the property's financial and physical viability will be maintained
- whether the value of HUD's MRM and CRM will be retained (or enhanced), and
- whether the distribution of transaction proceeds among the participants (including HUD) is appropriate.
OAHP will generate its own internal underwriting based on budgets and operating projections submitted by the applicant. It is expected that the proposed transaction will result in no less than a 1.20 debt service coverage, and meet an operating "expense cushion."
Continued MRM and CRM Value
Debt service on MRM and CRM loans is contingent on cash flow. Under the H10-22, OAHP will consider whether the net present value (NPV) of projected and realized cash flow paid toward this debt service remains stable under the applicant's presented transaction/operations model. In the event MRM or CRM value is reduced, given reduction in NPV of projected available cash flow, OHAP may require immediate up-front payment for a portion of the MRM and CRM notes to bring their NPV back into line with pre-transaction expectations.
Transaction Proceeds Available for Partial Repayment
MRM and CRM notes are the product of HUD payment on FHA insurance claims during the M2M restructuring. Applications for relief from due on sale for post-M2M redevelopments must indicate clearly who is making how much money from the transaction. To be frank – HUD wants its share, given its prior investment.
Applicant proposals with regard to this issue will be sifted through a comparison matrix covering private-interest financial benefits and available funds for repayment of HUD-held debt. Although this evaluation is handled on a case-by-case basis, Notice H10-22 clarifies that, generally, OAHP will require a pay down on outstanding MRMs and CRMs equal to the greater of:
- an amount equal to one-half of net proceeds received by the seller, or
- an amount equal to one-third of combined net transaction proceeds received by the seller and the purchaser (and affiliates, such as the developer) – if any.
The devil, of course, is in the details of OAHP's evaluation of "net proceeds." OAHP's discretion in the treatment of deferred developer fees, existing debt obligations of sellers, existing reserves, and other transaction costs are subject to overall transaction terms and review.
Once OAHP has made its determination and notified the field office of its conclusions, transaction documents for closing generally will be handled through the HUD field office. It is important to note that in addition to the statement of transaction proceeds that must be paid toward MRM and CRM debt, OAHP's conclusions will also include a statement of required payment of partial-year surplus cash for the year of closing. In addition, sellers should expect that the prior three years of their operations will be reviewed for improper use of operating cash to pay capital expenditures. OAHP will calculate the cash flow payments lost to MRM and CRM debt, which resulted from these improper prior years' payments, and require recovery payments from the seller.
Transfer to Qualified Nonprofits (QNP Transactions)
Section 517(a)(5) of MAHRAA provides that: "The Secretary may modify the terms of the second mortgage, assign the second mortgage to the acquiring organization or agency, or forgive all or part of the second mortgage ... if the project is acquired ... by a tenant-endorsed community based nonprofit ..." OAHP has used this authority to institute its incentive program for nonprofits and nonprofit-sponsored LIHTC purchasers of M2M projects. Qualified nonprofits or their partnerships may purchase an M2M project and have HUD (the original holder) forgive or assign the MRM and/or the CRM to an affiliate of the nonprofit.
OAHP has been required for several years to abide by a three-year window with respect to QNP approvals. As best stated, no QNP assumption transaction will be approved unless the QNP has signed a purchase agreement with the project seller not later than three years following close of the M2M restructuring. This policy has been in flux for some time and subject to special circumstances and waiver. Currently, however, OAHP is applying the three-year limit more stringently. We have seen M2M project owners and nonprofits lose the potential benefits of QNP transactions because of their delay in contracting, and belief that prior waivers necessarily provided guaranty of future waiver terms. They do not. The three-year window continues to be reviewed by HUD and OAHP, and the Office of General Counsel.
As noted above, however, with or without QNP treatment, post-M2M projects continue to draw greater interest from LIHTC developers and syndicators, as subsidized projects with stable long-term rent levels and HUD/OAHP work to build and maintain a viable redevelopment incentive program.