As published in Scotsman Guide’s Commercial Edition, March 2013.
In today’s tough marketplace, commercial mortgage brokers must develop an extensive knowledge of available financing alternatives to be able to find the best fit for their clients’ deals. Funding possibilities generally include bank financing, bond financing and various government-loan programs. In particular, the Federal Housing Administration (FHA) can offer viable alternatives for developer clients who wish to build a multifamily apartment property or an assisted-living property.
Working with their clients, commercial mortgage brokers should evaluate the pros and cons of each funding possibility to make a decision that fulfils the borrower’s requirements. For example, if you have clients who are looking to secure conventional construction loans from a bank, they should be aware that the current market ranges between 70 percent and 75 percent loan to cost (LTC), with interest rates in the range of 4.5 percent and 5.5 percent, depending on the bank and the credit of the developer.
Borrowers also should be prepared to sign a guaranty of completion and a guaranty of payment. Most banks will want the developer to have a net worth equal to the loan and liquidity. If the developer has objections regarding the requirement to sign a guaranty of payment, pursuing a bank construction loan may not be possible.
Commercial mortgage brokers who work with conventional market-rate deals can consider funding through bond financing, which provides borrowers with the opportunity to secure nonrecourse financing. These loans are generally 80 percent LTC, but the process typically is complicated and time-consuming.
The big advantage to bond financing is its high probability of closing and that the loans are nonrecourse, while the disadvantages include a higher cost, complex closing requirements and more time to close than conventional financing. Added to the cost is the fact that the entire loan is funded upfront and that the borrower must pay interest on the entire loan during construction instead of paying interest only on the borrowed money. In this scenario, the borrower is paying at least a 7 percent rate and investing the proceeds at, for example, 1 percent — a negative arbitrage of roughly 6 percent on the outstanding balance. In addition, because these loans are nonrecourse, there are a number of large reserves required to offset that risk.
With these costs in mind, government-backed programs have become a more viable option for many borrowers. FHA programs in particular have one strong disadvantage and many advantages. The big disadvantage is the significant time it typically takes to process a loan. That is largely offset by the advantages, however, including:
- The lowest rates available for construction or refinance loans;
- The longest amortization periods; and
- The nonrecourse nature of the loans.
In addition, the extra costs of FHA programs are not as large as they are in bond financing, and there is no requirement for affordability or selling to a nonprofit organization.
The two programs that are used most often for new construction or for substantial rehabilitation of existing properties are the Section 221(d)(4) program for rental and cooperative multifamily housing and the Section 232 program for assisted- living, intermediate-care and nursing-home facilities. Commercial mortgage brokers should understand the basic guidelines and processes for each of these programs to guide their clients to take advantage of their attractive terms.
Commercial mortgage brokers who are working with developers of market-rate apartments can find a good funding option in the FHA Section 221(d)(4) program. The program underwrites to the lower of the following:
- 83.3 percent of replacement cost (development cost plus as-is value of land) for market-rate deals; 87 percent for affordable housing; and 90 percent for projects with 90 percent or greater rental assistance
- 1.20 percent debt-service-coverage ratio (DSCR) for market-rate deals; 1.15 percent for affordable transactions; or 1.11 percent for projects with 90 percent or greater rental assistance
- Federal statutory mortgage limits as adjusted to the high-cost factor for the marketplus the value of the land — the adjustment factor allows the FHA to insure loans in high-cost areas like New York, Los Angeles and San Francisco
To apply for a 221(d)(4) loan, commercial mortgage brokers must work with an FHA Multifamily Accelerated Processing (MAP) lender. The application involves three basic steps:
- Concept meeting: In this meeting, the development team and the proposed development are presented to the FHA field office staff.
- Pre-application stage: The focus in this stage is mostly on the market study, income and expense numbers.
- Firm-commitment application: This step includes a thorough review of the architectural drawings, the projected construction costs, the final land value and a mortgage credit review.
Although the process is often timely, the developer does control the time between the stages and will receive three distinct “green lights” along the way, culminating in the FHA issuing a firm commitment. Once this commitment is issued, the loan is rate-locked and can move to closing. Construction must start within 10 days of closing.
Commercial mortgage brokers should bring several additional benefits of this FHA program to their clients’ attention.
- The debt is nonrecourse with the exception of “bad boy” provisions — i.e., anything related to bad faith, bankruptcy or other serious breaches of the fundamental basis on which the deal was struck.
- Unlike a conventional loan, there are no lease-up requirements (90 percent occupancy for 90 days) to convert to the permanent loan. Rather, the loan will convert at a pre-set time determined upfront and is designed to give the developer time to build the property and complete cost certification.
- The interest rates for the construction loan and the permanent loan are determined at the time of rate lock. Developers, therefore, don’t have to worry about whether they’ll be able to refinance out of a construction mini-perm in three years or four years. The loan is a construction loan plus a 40-year self-amortizing permanent loan.
- Because this is a federal insurance program, the interest rates on individual mortgages typically are low and reflect the full faith and credit of the U.S. government.
In 2008, the U.S. Department of Housing and Urban Development (HUD) created the LEAN program to expedite the loan process for its Section 232 loans for senior housing with services. It also moved underwriting for these properties from its Office of Multifamily Housing to its Office of Insured Health-Care Facilities (now the Office of Healthcare Programs).
For clients who want to develop nursing homes, intermediate-care facilities, board-and-care facilities and assisted-living facilities — all of which require licensed health-care providers — the Section 232 program is a viable option. With this program, underwriting guidelines require the lower of:
- 80 percent of the market value for skilled nursing facilities (up to 85 percent for qualified nonprofit borrowers), and 75 percent for assisted-living and memory-care facilities (80 percent for qualified nonprofit borrowers);
- 90 percent of the HUD-eligible replacement costs of the facility (hard costs, soft costs and land value); or
- At least 1.45 DSCR.
There are no statutory loan limits for HUD’s Section 232 program.
The processes for applying for a Section 221(d)(4) market-rate loan and for a Section 232 loan are similar. For the 232 program, commercial mortgage brokers must work with an approved MAP lender. The health-care program includes complete mortgage credit and legal review at the pre- application stage and actually issues a conditional commitment. The final stage reviews the drawings and construction costs. Under both programs, the use of proceeds provides for up to 3.5 percent for financing fees, broker fees and placement fees.
Commercial mortgage brokers should know the steps of the loan-application process through which their clients are likely to go through:
- The developer engages with the MAP lender and pays for third-party reports, as well as a nominal processing fee to the lender. The clients then submit the architect’s basic floor plans and elevations.
- The lender then secures a market study, preliminary appraisal (not including land valuation), environmental report and preliminary architectural review. When the third-party reports come in, the lender either will receive an invitation from the FHA to apply for a firm commitment or will be turned down. The invitation could be at a client’s proposed numbers or at revised numbers.
- If your clients accept the proposal, they must pay a nonrefundable application fee of 0.3 percent of the mortgage amount, finalize the project plans to prepare them for a building-permit application and file the final plans with the FHA.
At this point, the FHA will proceed with the final appraisal (including land value), the final-plan review and the mortgage-credit review. It also will review the developer’s financials and prior FHA history. Upon completion of that process, and assuming everything is in order, the FHA will issue a firm commitment to the developer. The developer then must pay 0.5 percent of the mortgage as an inspection fee.
The lender then sells bonds to finance the project. The bonds are government-guaranteed through Ginnie Mae. The developer then proceeds to closing under an initial endorsement, which is for the construction loan. Upon the project’s completion and when the certificate of occupancy is issued, the loan goes to final endorsement — i.e., the permanent mortgage with a 40-year term.
Although these programs offer nonrecourse loans, reserves in the form of cash or a letter of credit are set aside to protect the lender. A 4 percent working-capital reserve is maintained until the project stabilizes (2 percent allocated to construction contingency and 2 percent to working capital expenses). An initial operating deposit also is established based upon the greater of:
- 3 percent of the loan amount;
- Four-month to six-month debt service (walk-up project versus elevator project); or
- The amount needed to reach a break-even point as determined by underwriting.
These funds can be drawn down as needed during construction and lease up. It must be noted that the absorption period used in estimating market demand is restricted to 18 months.
Michael Zukerman is managing director of Whitestone Realty Capital LLC, a real estate investment banker and developer, and an adjunct professor at New York University’s Schack Institute of Real Estate. Reach Zukerman at (212) 984-7836. Visitwhitestonerealty.com. Holly Bray is senior director at Love Funding. She has 30 years of experience in the financial industry and an extensive background in underwriting, secondary marketing, tax credits and loan origination. Reach her at (202) 887-1849. Visit lovefunding.com