Bar News - May 20, 2015
Real Property Law: Long-Term HUD Loans Underused as Financing Option
By: Karen S. McGinley and Rebecca S. Kane
Fixed Interest Rates and Significantly Longer Terms
Are Among the Potential Benefits
Those seeking to acquire, construct, rehabilitate or refinance certain commercial property often fail to consider a financing option that could be advantageous for nonprofit or for-profit owners. Some healthcare facilities or multifamily properties with affordable units could reap significant benefits by securing a mortgage loan insured by the US Department of Housing and Urban Development (HUD) through the Federal Housing Administration (FHA).
One major caveat is that the affordable units on multifamily properties must meet very specific requirements for rental rates, which vary based on the city or town.
Because these loans are insured by HUD, meaning HUD will pay the lender in the event of a default by the borrower, lenders can offer borrowers terms that are typically well below market rates for long-term loans because the risk to the lender is reduced by the HUD insurance.
These terms include competitive fixed interest rates, longer terms (30-40 years), a higher loan-to-value ratio, and other more favorable financial covenants. In the current market, where there is significant speculation regarding interest rates and when they will rise, advising clients that there are loans available at fixed interest rates of less than 4 percent for terms of up to 40 years, with a maximum loan-to-value ratio of 95 percent, offers borrowers stability in an ever-changing market.
Similar to traditional commercial lending, the application process includes detailing the historical and current success of the business operations, showing a solid financial track record and providing the credentials and experience of the management team. The application process will also require the submission of a market study, appraisal, environmental study and a survey of the property to be mortgaged.
If there is to be new construction or significant rehabilitation, the application must also include the plans and specifications for the project, the architects and contractors to be used, and a pro forma setting out all costs associated with the design and construction of the project. These additional submissions will have to be finalized by the borrower and approved by HUD before it will issue a commitment.
The principal asset secured by these loans is the real estate and the income stream from operations. For tax and liability purposes, real estate with multiple facilities frequently has owners that are different from the facility operators. In these loans, HUD will require that the properties be “tied” together to insure that the income from each property is available to support the other properties, in the event that the income stream of one is reduced. Where commercial lenders will require cross guaranties among the parties, HUD’s requirements are more complicated.
For multiple properties, the only acceptable structure is all land owners/borrowers shall lease to one new single-purpose entity, referred to as a “master tenant,” which will lease all of the real properties from the land owners/borrowers, using a HUD-approved form. The term for this lease is five-10 years longer than the term of the loan. The master tenant then leases the real properties back to the operators. This structure enables the lender to apply rent paid by one of the operators to service the debt of a land owner/borrower, if the income from a property is reduced and is not sufficient to pay the debt service.
This structure also enables the holder of the HUD-insured loan to use funds generated by one property to pay the portion of the debt associated with another property.
Due to the intricacy of these loans and the borrower’s obligation to ensure that the properties are or will be compliant with all HUD requirements, the closing costs for these loans can be quite high, but HUD allows for these costs to be rolled into the principal of the loan and, therefore, amortized over the term of the loan.
As a result, borrowers will not need to deplete their operating accounts to pay for these costs, and even with these higher-than-average closing costs, borrowers will still see a significant decrease in their monthly payments.
HUD loans also typically take longer to close than traditional institutional lending, and so it is important to choose a lender and other professionals who are familiar with the intricacies of the process to ensure that the process is as efficient as possible.
Many institutional lenders will not offer these types of loans, due either to their lack of capacity or experience, or because they are not on the FHA-approved lenders list. For borrowers wishing to maintain relationships with their current banks, this can be a difficult issue to resolve.
There are some FHA-approved lenders who specialize in HUD loans who will partner with the borrower’s current institutional lender to assist in the process, and this partnership allows the institutional lender to maintain the banking relationship with its customer, while at the same time providing its customer with below-market credit facilities.
HUD loans can be incredibly beneficial for borrowers seeking commercial loans. They provide very long terms with a fixed rate of interest, which are not available in the commercial loan market. The benefits often outweigh the difficulties of the application, and the approval and closing processes of a HUD-insured loan.
Karen S. McGinley is a shareholder of Devine Millimet and chairs the firm’s real estate practice group. She has more than 36 years of experience in real estate matters. Rebecca S. Kane is a member of Devine Millimet’s corporate department, concentrating her practice in the area of general corporate and real estate law.