Preservation and Recapitalization of Section 236 Properties
The Section 236 Program was created by Congress in 1968 and was designed to involve the private sector in the creation of affordable rental housing. Market rate lenders provide loans that are either HUD or FHA insured, and in some cases financing is provided by State Housing Finance Agencies (HFAs). HUD also provided Interest Reduction Payments (IRP) that subsidized the loans down to a one percent interest rate with a 40-year term. Tenant income limits are set at 80% of the median income and rents are capped at HUD-approved, cost-based Section 236 Basic Rents. Rents for higher income residents are capped at the Section 236 Market Rent Level (the rent needed to amortize the market rate of the loan). Project-based rental assistance (PBRA) was also included for many projects.
There are currently 550 Section 236 projects at risk with more than 100,000 units. All of these will required preservation and recapitalization in the next few years. HUD has developed a complete program to assist owners of Section 236 projects with this process; this article is designed to introduce owners to the process and explain how and where to seek assistance.
Assessing options will require a strategy that will involve refinancing, possible restructuring of the Section 236 subsidy, renewal of rental assistance contracts, and possible participation in the RAD 2 program and/or the Low-Income Housing Tax Credit (LIHTC) Program.
There are five steps required for a successful preservation action:
- Know the property;
- Set your preservation goals;
- Choose your preservation options;
- Apply for financing and HUD approvals; and
- Secure long-term stability.
Know the Property – The first step in the process is the gathering of documents – a lot of documents. These documents relate to the financing of the project, its rental assistance, and information on the capital needs and reserves of the property.
Documents to gather regarding financing:
*Section 236 Mortgage Note;
*Section 236 Regulatory Agreement;
*Interest Reduction Payment Amortization Schedule;
*Flexible Subsidy documents;
*ELIHPA or LIHPRHA Plan of Action and Use Agreement (if any);
*Other financing documents; and
*Financial statements
>>When does the Section 236 loan mature? How many months are left on the IRP? These critical questions must be answered by the documents.
Documents to gather regarding rental assistance:
*Project-Based Section 8 Contract;
*Rent Supplement (Rent Supp) and/or Rental Assistance Payment (RAP) contract; and
*Rent roll
>>When do the rental assistance contracts expire? What is the mix of subsidized and unsubsidized rents? What are the rents?
Documents to gather regarding capital needs and reserves:
*Review the latest REAC report for capital and repair needs, know your score, and understand the issues;
*Know the current balances in your reserves for replacement and residual receipts accounts; and
*You will need a Capital Needs Assessment (CNA) that evaluates your property’s upcoming capital replacement needs.
Set Preservation Goals – After gathering all required information, the next step is to set preservation goals. Primary goals should be:
*Safeguard long-term rental assistance;
*Improve and modernize the property through capital repairs; and
*Stabilize the property by placing on a sound financial footing.
Typical capital improvement goals:
*Major repairs;
*Modernization of older units and common areas;
*Conversion of efficiencies to one-bedroom units;
*Energy efficiency upgrades; and
*Accessibility improvements.
Choose Preservation Options
Preservation options fall into two categories – financing and rental assistance. With regard to financing owners will need to raise capital, examine prepayment options, consider IRP decoupling, and look into Flexible Subsidy loan deferral. Rental assistance options include Section 8 contracts, vouchers, and RAD 2.
Raise Capital
Capital will need to be raised in order to address capital needs and get access to accumulated equity. Sources of capital may include:
>Refinancing – New First Mortgage Debt
*FHA-insured, Fannie Mae, Freddie Mac or State HFA
>Equity
*Low-Income Housing Tax Credits (LIHTC)
*Cash-on-cash
>Subordinate debt
*HOME, CDBG, State housing trust funds, National Housing Trust Fund
>Grants (mainly available to non-profits)
Prepayment
Prepayment of the Section 236 loan will usually be required in order to refinance a property and to trigger the issuance of Tenant Protection Vouchers (TPVs). Some properties need HUD permission to prepay. These include:
*Nonprofits, properties with Flex Sub Loans, and certain FHA loans with Rent Supplement Contracts.
All owners should examine the mortgage note and other property documents to determine prepayment requirements. Prepayment is governed by Section 250(a) of the National Housing Act.
Prepayment when HUD Permission is Required
Tenant Notification Requirements
*Tenants must be notified of the prepayment at least 150-days before the expected prepayment. When the owner submits the prepayment request to HUD, tenant comments must be submitted as an exhibit to the request.
*Owners must send a copy of the tenant notification letter to the HUD field office with a signed certification that it has been delivered to the tenants.
Rehab Requirements
*Properties must be rehabbed and minimum requirements apply.
Affordability Requirements
*Properties must be maintained as affordable (with the same benefits that existing under the 236 Program) for low-income residents through whatever the original mortgage note term was.
*The owner must execute a new Use Agreement.
Resources & Tools
*Notice H 2006-11 provides information relating to prepayments.
Prepayment when Permission is NOT Required (Governed by Section 219 of the FY 1999 HUD Appropriations Act – Wellstone Amendment)
Tenant Notification Requirements (Wellstone Notice)
*Tenants must be notified at least 150 days – but no more than 270 days – before prepayment may occur.
>This requirement may be waived by HUD, but only if necessary to facilitate preservation.
There may be no rent increases for 60-days after prepayment but there are no HUD rehabilitation requirements.
Decoupling the IRP Subsidy
Owners may “decouple” the remaining IRP subsidy at prepayment and apply it to a new loan. In other words, even though the Section 236 loan is being prepaid, the interest reduction payment subsidy may remain with the property. These funds may assist in leveraging new debt capital for the project. The new lender will receive the remaining IRP payments from HUD.
Setting the Rent when Decoupling
If the project has Section 8 units, the rent will be set per the renewal options outlined in the Section 8 Renewal Guide. Owners will have to coordinate Section 8, FHA, and Section 236 rent underwriting.
Non-Section 8 units will be required to retain Section 236 rent-setting rules for five years after pre-payment. The rents will be budget-based and capped at the Section 236 required levels.
IRP Decoupling Use Agreement
The property will be required to maintain Section 236 occupancy and income restrictions. New residents may have incomes no higher than 80% of the area median income, and as noted above, the Section 236 Basic or Market Rents will have to be maintained for five years beyond the current maturity date of the loan.
There can be no involuntary displacement of current residents and Section 8 contracts must be terminated and immediately renewed for 20 years.
IRP Decoupling Distributions
Annual distributions to owners are restricted to 6% of the new adjusted equity. LIHTC equity, long-term deferred developer fees, and owner cash are considered new equity, but not grants and soft loans. If there is no new equity, return is limited to 10% of 10% of the new mortgage amount.
Distributions may be taken only from surplus cash, and for HFA-financed Section 236 deals, state or local law controls the distributions.
Flexible Subsidy Loan Deferral
Owners with a Flex Sub loan may be able to defer repayment of the loan in order to avoid a balloon payment at prepayment, maturity, or sale. In the late 1970’s, HUD provided loans for operating assistance or capital improvements. Such loans are required to be paid in full at the maturity or prepayment of the Section 236 loan, or at sale of the property. Capital improvement loans were amortized and typically have low balances. Operating assistance loans were structured as balloon payments. Owners wishing to defer the Flex Sub loans face certain requirements:
*Regulatory compliance;
*There may be no other funding sources available to repay the loan;
*The maximum deferral and re-amortization is the greater of 20 years or the term of the new first mortgage;
*Financial projections must show that repayment under the new terms is feasible; and
*The owner must enter into a new Flex Sub Use Agreement restricting rents and incomes to match the new term of the Flex Sub Loan.
Section 8 Contract Renewal
When recapitalizing a Section 236 project, lenders and LIHTC investors will insist on a new 20-year HAP contract for Section 8. Owners may be able to increase rents to market level under the new contract. Owners with existing Section 8 contracts must follow the guidance in the Section 8 Renewal Guide for available options and eligibility to renew. The main factors determining Section 8 renewal options are:
- Are rents over or under the market at the time of renewal?
- Is the debt FHA-insured?
- Does the project come under LIHPRHA or ELIHPA?
- Are there other regulatory agreements?
- Is the owner a nonprofit?
Vouchers
Tenant Protection Vouchers
Tenant Protection Vouchers (TPVs) may be available to owners of Section 236 projects. These vouchers provide Section 8 assistance to tenants after the loss of rental assistance or at Section 236 mortgage prepayment. TPVs protect residents from being displaced due to rent increases.
The local Public Housing Agency (PHA) issues TPVs. The vouchers are portable, but in certain circumstances may be project-based. Availability is subject to annual Congressional appropriations, and the tenants must income qualify. Units must also meet Housing Quality Standards. TPVs may be “Enhanced Vouchers (EV),” or regular Housing Choice Vouchers (HCV).
Enhanced Vouchers
Enhanced vouchers provide more protection for residents than standard TPVs, and the rent-setting requirements are more flexible. The availability of EVs is triggered when:
*A Section 236 loan is prepaid and is subject to Section 219 (Section 219 of the Departments of Veterans Affairs and Housing and Urban Development, and Independent Agencies Appropriations Act, 1999, requires an owner of preservation eligible projects to give at least 150 days, but not more than 270 days, advance notice of mortgage prepayment); or
*The prepaid property has a Flex Sub Loan; or
*The Section 8 contract is not renewed at expiration.
Discretionary TPVs for Section 236 Properties
If a Section 236 project does not meet the requirements for TPV or EV issuance, HUD has limited competitive funds for Enhanced Vouchers or Project-Based Vouchers. Certain tenants in low-vacancy areas who are at risk due to loss of affordability and not otherwise eligible for TPVs may be eligible for these discretionary vouchers.
Rental Assistance Demonstration 2 (RAD 2)
RAD 2 allows conversion of expiring non-renewable Rent Supp and RAP contracts into long-term project-based Section 8. While TPVs generated by Rent Supp or RAP expiration are tenant-based, RAD 2 allows conversion to Project-Based Vouchers (through the local PHA) or Project-Based Rental Assistance (through HUD). Applications can be submitted on a rolling basis according to the rules outlined in the Final RAD Notice from HUD.
Apply for HUD Approvals
After choosing the preservation options, owners will apply for financing and HUD approval.
Preservation Application Process
Processing of applications is centralized through the HUD Office of Recapitalization (Recap). To begin the process for a Section 236 preservation transaction, owners should go to the Multifamily Preservation Resource Desk at http://www.hudmfpreservation.net/ and click on “Submit an Application.” This begins the process of securing HUD approval and will deal with:
*Prepayment approval or permission request;
*Waivers with HFA-Financed Transactions;
*IRP decoupling;
*Flexible Subsidy Loan deferral requests;
*Request for increase in post-transaction rents;
*Issuance of TPVs;
*Nonprofit fees and sales proceeds;
*LIHPRHA – ELIHPA amendments; and
*Unit Conversion requests (combining efficiencies into one bedroom units).
Prepaying State HFA Loans
Many Section 236 loans were originated through a State HFA. All Section 236 preservation rules and incentives apply to these properties. Owners must apply for approvals through HUD like any 236 project PLUS contact their HFA about their required prepayment approvals.
Secure Long-Term Stability
The last steps in the process are to close on the new financing, secure the rental assistance, renovate the property, and stabilize the property by placing it on solid financial footing.
Owners whose loans have matured or are maturing very soon should contact HUD immediately to discuss their options. Issues that should be discussed with HUD include:
- If loan has not matured, can TPVs be obtained by prepayment?
- Would the project qualify for discretionary TPV set-aside funds?
- Are you able to renew your Section 8 rental subsidy contract to leverage new financing for capital needs?
HUD can guide you through the entire process, and the best place to start is the HUD account executive or project manager for the project. An option is to email the Office of Recap at 236Preservation@hud.gov. Ask them any questions you may have including what you need to do to get started. They can also give you suggestions on how to pay for predevelopment costs.
The key for Section 236 owners is to begin the process now. Even if you have a year or two before the loan matures, starting the process early will prevent a lot of sleepless nights down the road.