RHS Permits Section 538 Loans To Refinance Section 515 Property; Will Help Rural Preservation Effort
By Caitlin Jones & A. J. Johnson
5 min read
Tax Credit Advisor March, 2006: In a significant program change that could help preserve many aging rural affordable apartments, the Rural Housing Service (RHS) is permitting owners who have funded properties with Section 515 loans to rehabilitate those properties using Section 538 loans.
The welcome news was announced in RHS’s FY2006 Notice of Funding Available (NOFA) for Section 538 loans, which appeared in the Federal Register on January 27.
The NOFA said that the Section 538 loan program is being revised in FY2006 to provide for “the revitalization, repair, and transfer costs of existing direct section 515 housing.” It stipulated that in order for a 538 loan to be used for this purpose, the Section 515 properties “must need repairs and/or undergo revitalization of a minimum of $6,500 per unit.”
There are currently more than 16,000 properties carrying Section 515 loans. The average age of the loans is now over 20 years.
“With the portfolio of Sections 515 loans growing older, this will help prevent the loss of projects from the program,” said Carl Wagner, senior vice president at Lancaster Pollard, a Columbus, Ohio-based investment and mortgage-banking firm that provides Section 538 loans. Wagner was previously Deputy Administrator of Multifamily Housing at RHS and helped develop the Section 538 Program.
“RHS is also working hard to stretch the limited funding that’s available for its multifamily loan programs,” Wagner added. “The Section 538 NOFA helps to accomplish both these objectives.”
Under the older Section 515 loan program, established in 1962, the federal government is the lender, providing a credit subsidy that reduces the interest rate on these loans to one percent. The program targets renters at 60 percent of AMI and below.
Established in 1996, the Section 538 program relies on private-sector lenders, with the federal government providing a guarantee that repays 90 percent of the principal of the borrowing in the event of a default. Renters with incomes of up to 115 percent of Area Median Income can participate in the program.
Funding for the Section 538 program has held steady in recent years, with Congress appropriating $99 million in FY2006, the same as in FY2005. Funding for Section 515, meanwhile, has fallen from a peak of $540 million in FY1995, with $100 million appropriated for FY2006. President Bush’s FY2007 Budget requests increasing Section 538 program funding to $198 million, but would eliminate funding altogether for the Section 515 program.
Both Section 515 and Section 538 loans are generally used in combination with Low Income Housing Tax Credits.
Using Section 538 Loans with Section 515 Properties
Owners who have funded properties with Section 515 loans can now refinance those properties with Section 538 loans if the new loans are used for rehabilitation, said Wagner. This is possible because the NOFA authorizes RHS to subordinate an existing Section 515 loan to a new Section 538 loan. Previously only new owners of Section 515 properties could qualify for Section 538 loans.
Wagner provided an example of a financing being currently developed that would take advantage of the NOFA. He did not reveal the name of the property owner.
A 31-year old affordable housing property is funded with a 40-year Section 515 loan that has a remaining balance of $560,000. The property, which also has a 75 percent rental assistance contract, is badly in need of rehabilitation.
Before the release of the NOFA, a Section 538 loan could not have been used to refinance the Section 515 loan without an ownership change. Now the property owner is planning to use a Section 538 loan to reamortize and extend the term of the Section 515 loan, reducing debt service.
The Section 538 loan will also provide some additional funding for the rehab. Altogether, the property owner hopes to pull together financing from a combination of sources to accumulate about $4.6 million for the rehabilitation. Those funds will come from soft loans, 9 percent Low Income Housing Tax Credits, and deferred developer’s fees. This will be used to replace an inefficient heating system and install new windows, doors, and insulation, which will significantly lower operating and maintenance costs.
Wagner also noted that separately from the NOFA, RHS is permitting rent increases in some markets and will consider deferring existing Section 515 payments so that a property will generate enough income to cover payments on a new Section 538 loan.
Interest in Section 538 Loans Expected to Increase
Encouraged by the changes in the Section 538 loan program, Lancaster Pollard expects to increase its loan volume under the program in 2006, Wagner said. Last year, it underwrote two Section 538 loans, one for a property in Oklahoma property, and the other in Ohio, totaling $1.62 million.
“We could do many times that volume this year,” he said.
Richard Price, a partner at the Washington, D.C., office of Nixon Peabody LLP, has worked with both lenders and property owners on Section 538 and 515 financings. He said that the NOFA should help bring in banks that have been reluctant to underwrite 538 loans.
Price also said that increased use of Section 538 loans to preserve Section 515 properties could help convince Congress to appropriate more for the Section 538 program than the $99 million currently allocated for FY2006.
“There are a lot of the older rural properties with Section 515 loans that need recapitalization, and the use of Section 538 loans for this purpose will increase interest and support for both programs,” he said.
RHS said that it will review and score all NOFA applications received by June 16, 2006, but will continue to accept applications after that date until funds run out.
