The Right Permanent Financing Option: When FHA is Better Than Banks

An affordable housing developer stands at a crossroads. With low-income housing tax credits (LIHTCs) and plans for a construction project firmly in hand, a major decision awaits. 

To the right—permanent financing via a U.S. Department of Housing and Urban Development (HUD)/Federal Housing Administration (FHA) program. To the left—permanent financing via a traditional bank loan. Which path will lead to the better outcome? The answer is—it depends. 

When embarking upon a LIHTC new construction or substantial rehabilitation project, an affordable housing developer must carefully consider the characteristics and intricacies of the deal to decide which permanent financing option is the ideal fit. Both FHA, specifically the FHA Sec. 221(d)(4) program, and bank financing have their pros and cons. In certain circumstances, however, the benefits of the 221(d)(4) program clearly outweigh the benefits of bank financing. 

Comparing Benefits

The primary benefits of the 221(d)(4) program include its higher loan amounts due to the favorable debt service coverage ratio (DSCR) limits, 40-year term and amortization, the non-recourse provisions and the automatic conversion to a permanent loan product. The primary benefits of bank financing include the ability to offer competitive terms for construction financing, flexibility in regards to timing and in some cases the ability to serve as a “one-stop shop” with the equity investor, minimizing the administrative burden on the developer. 

FHA transactions offer a fixed rate that is locked prior to closing and which remains in place for the term of the loan. While banks can offer lower rates during construction (LIBOR + 250 basis points, for example), they lock in the permanent rate with their own interest rate hedge, resulting in higher long term rates. In the case of FHA, the rate is the same for both construction and permanent, so no hedge is necessary. Depending upon the affordability restrictions associated with the property, the FHA program allows for loan-to-cost ratios of between 87.0% and 90.0% at debt service coverage levels between 1.11x and 1.15x. The term can be up to 40 years and amortization does not begin until after the construction period, during which interest is charged only on the loan proceeds that have been drawn. This compares to commercial banks which generally offer 15- to 18-year terms with 30-year amortization. Consequently, FHA financing offers a significant advantage when it comes to term and amortization. These favorable terms, in conjunction with lower permanent interest rates, can result in more debt available to help plug funding gaps. In addition, developers who expect to keep the loan for the long term or who think the assumability feature of the FHA loan would be a valuable benefit to a prospective buyer should strongly consider FHA. 

HUD’s ability to underwrite to Section 8 Housing Assistance Payment (HAP) rents is another advantage of the FHA execution. There are also some unique attributes of the 221(d)(4) program that can allow for higher loan amounts in certain circumstances. Builder’s and sponsor’s profit and risk allowance (BSPRA) and sponsor’s profit and risk allowance (SPRA) can be used as non-cash sources and can increase the loan amount in cost-limited transactions. There is no loan-to-value limit for the 221(d)(4) mortgage, which allows equity extractions based on land values in certain markets.

Reserve requirements can also differ. Banks may require a standard $300 to $350 per unit per year, whereas FHA requires a PCNA report, which can result in a higher amount. This is less of an issue on substantial rehabilitation projects, since those tend to need more reserves regardless. Generally, there is no initial deposit to the replacement reserve with a 221(d)(4) transaction. For a new construction project, FHA does not allow for a construction contingency whereas a bank may permit a contingency. 

In regards to costs, FHA 221(d)(4) transactions require Davis-Bacon wages, thus deals that are not subject to the wage scale would find lower hard costs through a commercial bank execution. Projects that have other government funding sources like HOME or are part of the Rental Assistance Demonstration (RAD) program, or are located in bigger cities, would already be subject to these higher wage rates. In those cases, the 221(d)(4) requirements would not be an extra burden. FHA allows the ability to bridge in LIHTC equity through a third party equity bridge lender, which allows better tax credit pricing. This, coupled with the fact that FHA loans lock both construction and permanent rates at the construction closing, can reduce the permanent loan rate and save the developer money in the long term. In regards to timing, FHA transactions can be completed in approximately six months as compared to traditional bank loans which take approximately four months.  

FHA transactions require plans and specifications to be materially finished upon submission of the FHA application. In contrast, banks generally require those to be completed much closer to closing. It is a good idea to get bids to establish the schedule of values prior to the lender submitting the FHA firm application. Note that these costs can be updated during the closing process, but FHA’s review of increased costs will be thorough.  

When considering mortgageable and non-mortgageable costs, it is important to remember that FHA has strict categories and determinations that must be adhered to. The key discussion points typically surround the question of “who is paying for what?” Transactions with multiple sources of funds can get complicated but an experienced lender can guide the discussion early in the process to reduce surprises at closing. While all lenders want a strong general contractor to help shepherd a project through completion, it is extremely helpful to work with general contractors with prior FHA experience because they will know FHA’s nuances and be familiar with FHA’s minimum working capital requirements. Additionally, FHA has strict requirements regarding disability, health and safety issues, thus hiring an architect with prior FHA experience is important.

Ideal Candidates for FHA

A few key characteristics of a new construction or substantial rehabilitation project can help determine their fit with FHA. For example, projects that contain an existing HAP contract are ideal for the 221(d)(4) program because FHA is well-versed in understanding that revenue stream. In addition, nonprofit developers can benefit greatly from the FHA route since FHA does not require individual guarantors as a traditional lender would require. 

Projects with larger permanent debt, including 4% tax-exempt transactions where permanent debt is a greater percentage of total sources, will benefit from FHA financing because of the DSCR limits. Due to the programmatic lower debt service coverage and higher loan-to-cost ratios, projects that need higher loan proceeds to fill a funding gap would be wise to pursue FHA financing. In certain cases, such as the example of Oak Forest Apartments discussed below, the final interest rate can be used to request additional proceeds beyond that included in the original application underwriting. 

Oak Forest Apartments

Oak Forest Apartments is a 150-unit affordable housing complex located in Scottdale, Ga. Built in 1974,  the property was recently acquired by Herman & Kittle Properties, Inc., (HKP) one of the largest  affordable housing developers in the country. HKP sought a permanent financing solution that could be used in conjunction with 4% LIHTCs and state tax credits that would also provide funds for much-needed renovations. HKP’s lender recommended using the 221(d)(4) program as the permanent financing solution due to the program’s ability to generate the maximum amount of loan proceeds, which was due to the existing HAP contract and FHA’s DSCR limits of 1.11x for this particular transaction. 

After an efficient FHA processing time of only 47 days, the result was an $11 million insured loan that featured a low interest rate and 40-year term. The lender’s in-house trading desk was able to obtain a particularly low interest rate for a 221(d)(4) transaction, which increased the mortgage proceeds, allowing HKP to close the project’s funding gap. The successful transaction will fund significant improvements to Oak Forest Apartments, including new drywall, flooring, kitchen and bathroom cabinetry replacement, plumbing fixtures, and a new outdoor entertainment center to be added to the clubhouse and playground.

As illustrated in the story of Oak Forest Apartments, the 221(d)(4) program can be a good fit for projects with existing HAP contracts that are seeking high loan proceeds, largely because of FHA’s advantage over banks in terms of the more beneficial DSCR. For projects in need of flexibility and an especially timely execution, permanent financing via a bank may prove to be the better option. In either case, an affordable housing developer who understands both paths will be best equipped to select the right one. 

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