Following the example of the U.S. Department of Housing and Urban Development (HUD)/Federal Housing Administration (FHA), the United States Department of Agriculture (USDA) is now offering note modifications—a low-cost alternative for housing owners to reduce annual debt service and thereby increase the overall financial performance of the property.
What are Note Modifications?
The key benefits of USDA-insured financing include long-term fully amortizing debt, reasonable transaction costs, nonrecourse and minimal covenants. With its new note modification program, USDA is trying to add to that list of benefits. Currently, the 538 program cannot be utilized for a pure refinance unless it is taking out a construction loan. Since a refinance is not allowed, one option is to reduce the interest rate while keeping all the other covenants of the loan untouched. Although the borrower does not have the option of pulling equity out of the deal, it does allow for debt service savings and the agency can provide a faster turnaround by focusing on one loan parameter—the interest rate. Like any other government agency financing program, the key for the borrower will be to fit into the programmatic requirements.
On July 30, 2015, Tony Hernandez, administrator of the Housing and Communities Facilities Program, issued an unnumbered letter (UL) titled “Guidance on Loan Modifications in the Section 538 Guaranteed Rural Rental Housing Program (GRRHP).” The letter explains that the request to make the modification can only come from the incumbent lender and should include the following:
- A summary of the transaction detailing the projected change in the interest rate debt service savings and confirmation the project will have a debt service coverage ratio (DCR) in excess of 1.15:1
- The most recent and interim financial statements and lender analysis
- Sources and uses statement disclosing all fees
- Certification from the lender stating that:
- The original term of the guaranteed loan will not be modified
- Outstanding principal balance will not be modified
- There is no negative impact to the tenants
- The borrower is in compliance with all program requirements
- There are no asset management issues
- The modification meets state law requirements
- Any out-of-pocket costs incurred by the lender or the owner related to the modification cannot be paid from project funds.
If the note modification is approved new lockout terms and prepayment terms may be added to allow the mortgage to be re-securitized with Ginnie Mae. USDA has established a 30 business day timetable to respond to a written request. Requests approved by the state office must receive national office concurrence. The state office will review and approve all closing documents as applicable.
Current Note Modification Status
Once USDA instituted the note modification program, its first step was working with Ginnie Mae to allow for the releases of the loan guaranty from the securitized pool. The next step consisted of USDA documenting the change to the interest rate in the loan note guaranty (LNG). On September 1, 2015, USDA agreed to review existing loans for approval of note modifications. This was the final step to consummate the loan modification program.
As of December 1, 2015, USDA had approved 26 loan modifications across 10 states, according to USDA leadership during a Section 538 Guaranteed Rural Rental Housing Program Industry Forum on Dec. 1. The average interest rate before the loan modification was 6.2% and the average rate after the modification was 5.03%, a 19% reduction. Further, many additional loans are engaged and packages are being submitted to a number of state offices across the country, giving borrowers nationwide the benefit of debt service savings and increasing the safety of the overall portfolio for USDA and its lenders.
In one example, the Texas Housing Foundation completed a note modification of San Gabriel Crossing, a 76-unit affordable housing complex in Liberty Hills, Texas. The successful transaction reduced San Gabriel’s interest rate by 21% and provides the facility annual savings of approximately $30,500, with total savings over the remaining term of approximately $1 million. Those savings can be used to maintain and improve the facility for the residents of San Gabriel Crossing (pictured below).
Should You Seek a Lower Rate?
Although there are some significant benefits to lowering interest rates through the note modification program, there are some items that the borrower should consider before initiating the process. Chief among them are the lockout provisions and prepayment penalties associated with a USDA loan. These provisions could dilute the benefits of lowering the rate for the borrower, who may have to consider paying the existing investor(s) a pre-payment penalty. For some borrowers, modifying the note rate may be cost prohibitive as the prepayment penalties could erode the debt service savings. Moreover, the revision of the rate will put the facility into another lockout period with new provisions for prepayment. All costs are eligible to be included in the revised interest rate, including: prepayment penalties, lender’s financing fee, lender’s counsel fee, borrower’s counsel fee and title expenses.
A quick review of the existing loan could easily address the eligibility and costs associated with the loan modification. Compared to other options for lowering interest rates, such as a full-fledged refinancing of a loan, these costs are still a bargain. Other benefits include:
- The time it takes to modify the interest rate is much less than the time it takes to refinance. The whole process could take less than eight weeks from when the lender is engaged. Considering the volatility in interest rates and impending decline in the Federal Reserve’s bond buying program, this quick turnaround can reduce interest rate risk associated with longer processes.
- Another benefit of a note modification is that it does not require credit approval from USDA as these facilities are already in USDA’s portfolio and are being monitored on a regular basis.
- The out-of-pocket costs of the note modification are less than the cost of a traditional refinancing program because there are no third-party costs and all costs of the loan modification are built into the new interest rate.
Like any other refinancing, timing is important. Interest rates have increased from historic lows in 2012 and 2013, but are still well below historical averages. Borrowers with USDA Sec. 538 loans who want a lower interest rate should consider the note modification program as they can lower their cost of capital without investing significant money or time.
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