Don’t Overlook HUD for Project Funding
With a nationwide shortage of affordable multi-family units, many municipalities have enacted inclusive housing ordinances requiring market rate developers to set aside 10-30% of new construction units for affordable housing.
While some of the orders provide mechanisms to offset the cost of delivering units and lost revenue, many do not, and the project’s capital stacks are disorganized as banks “properly carve” construction loans for project cash flow. Mortgages insured by the U.S. Department of Housing and Urban Development can be an attractive alternative to traditional bank financing with higher loan size and lower debt coverage thresholds, making apartments more economically viable at market rates and with mixed income.
As a federal agency, HUD directs national policy and programs that meet our country’s housing needs and provides mortgage insurance on loans made by FHA-approved multifamily lenders. This includes a variety of loan programs for new construction projects. Most market rate developers are familiar with Freddie Mac and Fannie Mae and thought of HUD primarily as a niche lender for affordable projects. However, nearly two-thirds of HUD-insured mortgages are secured by traditional apartments at market rates, and HUD is very active. It insured about $31.8 billion in 2021, an increase from $26.5 billion in 2020. That means its annual inceptions are on par with the historical annual multifamily inceptions of life insurance companies.
While many inclusive developments will not be classified as “affordable” under HUD’s definition, HUD views the inclusion of all affordable units favorably, and affordability is not a prerequisite for funding. HUD funds many projects that are 100% market rate.
HUD vs Traditional Funding
For market rate construction loans, HUD can underwrite at the lesser of 85% LTC or a debt coverage ratio of 1.18, compared to 75% LTC for banks. So, from an SLD perspective, the HUD provides an immediate benefit.
However, most projects using bank financing with inclusive and affordable units are limited by cash flow, not cost. Banks typically use an artificial interest rate and amortization to accentuate their exit underwriting, effectively limiting loan proceeds to around 60% LTC. The HUD, however, uses the real interest rate, a 40-year amortization, and a DCR of 1.18. Current all-inclusive rates, including a mortgage insurance premium, assuming the property meets HUD green building standards, are approximately 3.35%, fixed for the term of the loan. On the net, this can result in 25% more loan proceeds than a bank can achieve. From an equity perspective, the higher leverage and lower interest rate combined with the long amortization period can also make inclusive projects with low cost returns acceptable to investors, as the cash yield is always attractive.
Also note: HUD construction loans are non-recourse and subject to standard exclusions. HUD also offers attractive prepayment flexibility with a sliding penalty starting in the first year and no penalty after the 10th year.
Why don’t all developers use the HUD? There are a few downsides to browsing:
- HUD loans for new construction at market rate take about 12 months to process, compared to three to four months for a typical bank loan. Developments that meet HUD’s definition of affordable can be closed in as little as seven months.
- HUD requires prevailing wages. In cities without a strong union presence, or on smaller projects, this requirement can increase costs by 10% or more.
- Finally, for new HUD developers, HUD will require some HUD experience on the development team – a general contractor who has completed HUD transactions or a construction consultant – and an experienced HUD property manager for the first year.
If a developer doesn’t have 12 months or is constrained by labor costs, they could also use HUD as a take-out lender when stabilizing. HUD will advance 80% LTV on a cash refinance with a DCR of 1.18. Current refinance rates are 2.75% (assuming a green project) for a term and amortization of 35 years.
A developer considering HUD for a construction loan should contact the HUD lender early, and they should consider using a GC and architect who has prior HUD experience. HUD has nuanced rules about what it will count for mortgage project costs versus market-rate lenders, and it’s also more concerned about FHA affordability compliance. Ensuring that the project meets these requirements early in the design process will save considerable time.
Inclusive zoning policies can create significant capital holes in development projects, as reduced cash flow limits lending and equity returns to the point that many projects are no longer financially viable. HUD financing—with its higher LTC, competitive rates, long amortization, and tighter debt coverage requirements—presents a solid alternative to traditional bank financing for market-rate and mixed-income apartments. Sponsors can talk to credit providers, including HUD-approved direct lenders and mortgage bankers, to determine if a HUD loan is the right choice for them.
Matthew Wurtzebach is Senior Vice President of the Commercial Finance Group of Draper and Kramer.