FHA Project in Trouble? Partial Payment of Claim May Be Your Solution
By Caitlin Jones
6 min read
Tax Credit Advisor, May 2009: More and more these days, lawyers are trying to help developer/owner clients save financially troubled apartment projects with multifamily loans insured by the Federal Housing Administration (FHA). The process often includes seeking approval from the U.S. Department of Housing of Urban Development (HUD) for a “partial payment of claim” (PPC), or a friendly note sale.
The soured economy is tossing a rising number of affordable rental projects into financial distress. Higher vacancy rates and lower-than-projected rents reduce net operating income, in some cases to the point of insufficient cash flow to service the existing first mortgage. In this case, sponsors increasingly are turning to law firms to help them seek financial relief, avoid foreclosure, and save their deal – and their ownership stake. When the property has low-income housing tax credits, avoidance of foreclosure prevents the tax credit investors from being wiped out.
“We’re starting to see more and more folks coming in with deals that are delinquent or in a very serious default mode,” says Washington, DC attorney Kristin Neun, a partner in the law firm of Hessel, Aluise and Neun, P.C. She said her firm is handling a number of cases where the owners are pursuing HUD approval of a PPC or otherwise attempting to find solutions that will avoid foreclosure.
Washington, DC attorneys Sheldon Schreiberg and Gerald Salzman, of Pepper Hamilton LLP, also reported that their firm is preparing a number of PPC requests and has had several approved.
Mortgage Restructuring
In a PPC, a borrower that has defaulted on their unsubsidized FHA multifamily mortgage, where foreclosure hasn’t yet occurred, seeks to persuade the lender to apply to HUD for approval of a partial payment of claim. The request is submitted to the HUD field office, but must be approved by HUD Headquarters. If approved, the original first mortgage is restructured into (1) a smaller first mortgage that can be serviced by the current project income, and (2) a new second balloon loan that is held by HUD and repayable upon sale or refinancing. The second mortgage amount represents the size of the insurance claim that HUD pays to the mortgage lender. The interest rate on the first mortgage may or may not be modified; the rate on the second is the Applicable Federal Rate.
HUD benefits from a PPC by paying only a partial rather than a full insurance claim. The PPC also restores the project to financial stability, and enables the current owner to stay in place.
Since 2007, HUD has resurrected the PPC as a workout tool for troubled projects with unsubsidized FHA multifamily loans, such as the popular Section 221(d)(4) product, according to Schreiberg and Salzman. This resurgence is largely due to HUD’s response to the worsening economy and soured local rental markets.
Until the mid-1990s, HUD Headquarters and project owners negotiated PPCs to modify/restructure unsubsidized FHA multifamily loans. But in the mid-1990s, buried by a heavy volume of loans that had been assigned to it, HUD abandoned the PPC process and instead held loan sales, a much less staff-intensive task. In a number of cases between 2003 and 2006, HUD either negotiated restructurings on a one-off basis with owners, or overrode the loan prepayment lockout and reduced the mortgage rate. This occurred at a time when many project renters were able to buy a home because of historically low interest rates, then moved out. In the past two years, softer rental demand and the worsened economy have caused financial shortfalls in a number of projects built during this decade, due primarily to rents below the originally underwritten projections.
Says Schreiberg, “Whereas earlier, in the weakening multifamily market cycle, an interest [rate] reduction through HUD override of prepayment lockouts was sometimes enough to achieve financial stability, now, with rates higher and markets weaker, the PPC process is often necessary to achieve financial stability.”
Schreiberg and Salzman, though, cautioned that PPCs requests are complex. The prospects for success are heavily dependent on the quality of the application, how it is presented to HUD, and the degree to which the HUD field office pushes HUD Headquarters for approval. “We’re beginning to see field offices taking a much more aggressive, pro-active role,” said Schreiberg.
Salzman said PPC requests must satisfy certain HUD handbook criteria. In this process, HUD reviews the project’s ownership, management, and financial projections. Two criteria are that the PPC amount can’t exceed (1) 50% of the outstanding loan balance, or (2) three times the owner’s post final endorsement cash contribution. Neun noted that in certain markets, particularly those hard-hit by the economic downturn, there are deals that may not be able to be structured under such thresholds.
Neun said some her current PPC requests are for housing credit projects. “We areÉtrying to stress to HUD that there are other tools within their arsenal [such as a PPC] that would be much more advantageous to pursue than a foreclosure, where you’re basically discouraging tax credit investment,” she said.
Schreiberg contended that the PPC process requires some “tweaking” to make it a more effective tool for preservation, and was hopeful that the HUD under new Secretary Shaun Donovan will be receptive to considering and making improvements including some flexibility in the criteria now being used.
According to HUD data, in Fiscal Year 2009 as of late March, two PPC requests had been approved and five rejected – all for Section 221(d)(4) loans. Another six requests were under field office review.
Note Sale
Neun also reported that when the project loan has already been completely assigned to HUD, her firm sometimes tries to “see if we can’t work out some sort of negotiated note sale.”
She indicated, for example, that there might be interest by the local city in purchasing the note to maintain the property as affordable housing and otherwise encourage private investment in such housing. While such negotiated sales may require certain waivers from HUD, a key goal is to keep the current owner in place. Schreiberg and Salzman said they’ve completed such negotiations with not-for-profits and local governments. In instances where negotiated sales are not possible, a loan might go into a HUD competitive note sale which may or may not result in a holder willing to work with the owner on viable payment terms. In dealing with either case, Neun said the ultimate goal is to take whatever steps are necessary to try to avert a foreclosure and protect the interests of any tax credit investors.
