8.1 Subordinate Debt

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1 8.1 Subordinate Debt Table of Contents Page Introduction Uses and Types of Subordinate Finance... 1 A. Uses... 1 B. Types Basic Terms and Conditions Required HUD Approvals Subordinate Financing by Federal Home Loan Banks for Section 202 and 811 Projects... 4 A. Introduction... 4 B. Background... 5 C. Policy Guidance... 5 D. Memorandum of Understanding Rent Increases and Additional Debt Service for Capital Needs... 7 A. Budget-Based Rent Increases for Non-Profit Owners... 7 B. Mark Up tp Market Rent Increases Approval of Debt Service for Subordinate Financing... 7 A. Unsecured Financing... 7 B. Secured Financing Subordination of Section 202 Direct Loans... 8 A. Subordination with LIHTC Equity... 8 B. Programmatic Requirements... 9 C. Application Threshold Requirements... 9 D. HUD Review of Applications... 10

2 8.1 1 Introduction This chapter discusses the uses and types of subordinate financing in general terms and provides a general overview of the basic requirements applicable to use of subordinate debt in HUD programs. The specific terms and conditions for HUD approval and processing of Federal Housing Administration (FHA) insured transactions which include subordinate or secondary financing are set forth in the MAP Guide, Chapter 8.9, pages Subordinate financing is a loan obtained in the name of the project ownership which ranks after the first mortgage held by the lender in terms of the legal priority in collecting amounts owed. In multiple loans involving more than a 1st and 2nd mortgage, the collection order is determined by priority in time or by a specific agreement among the creditors. A subordinate loan may be unsecured, ranking behind other secured creditors. A secured loan treats the project as collateral; a lien is placed on the project. Unsecured debt does not create a lien on the project but relies upon the borrower s promise to pay as evidenced by its signature on a promissory note. The proposed documents must not conflict with the FHA-insured or HUD-held first mortgage or the FHA Regulatory Agreement. The terms secondary or subordinate are often used interchangeably; secondary is not limited to second mortgage. If project debt consists only of a 1st and 2nd mortgage, the second mortgage is also the subordinate mortgage. This chapter uses the term subordinate as the generic inclusive term for debt not secured by the project 1st lien Uses and Types of Subordinate Finance A. Uses Subordinate debt may be used for the following purposes: 1. Essential property repairs or rehabilitation, 2. Energy upgrades, 3. Release of liens, 4. Curing of delinquencies, 5. Avoid prepayment penalties, 6. Deferral of purchase price of the subject property, 7. Keep affordability restrictions in place, 8.1 Subordinate Debt 1 February 18, 2014

3 8. Increase leverage to create larger tax benefits without losing favorable existing financing, or 9. Convert equity in the property into tax-free capital which can finance property improvements. B. Types 1. Conventional types of subordinate finance include: a. Second mortgages, b. Wrap-around mortgages, c. Purchase money mortgages, d. Subordinated land lease-backs, and e. Installment land leasebacks. 2. FHA insurance programs: a. Section 241 Supplemental Loans for Multifamily Projects. FHA insured loans for the purpose of financing improvements or additions to projects in which the first mortgage is insured by FHA or held by HUD or is not FHA insured. b. Section 223(d) Two-Year Operating Loss Loans. FHA insured loan may not exceed the amount by which the mortgage insurance premium, taxes, insurance, and interest on the first mortgage exceeds project income during the first two years of operation. 3. HUD-held: Second mortgages held in connection with the following: a. Partial Payment of Claim, b. Mark-to-market restructuring, c. Flexible Subsidy Loan, or d. Section 202 or Section 811 Loan. 8.1 Subordinate Debt 2 February 18, 2014

4 8.1.3 Basic Terms and Conditions HUD must approve both secured and unsecured loans since both either encumber the project or incur a liability to the ownership. HUD Handbook , Section 2-23D., states: Loans for the purpose of paying current operating expenses can be paid back without HUD approval as long as the project is not in default. A reduction in loans and notes payable for purposes other than current operating expenses must have the prior approval of HUD. Owner advances may only be repaid from surplus cash unless prior HUD approval is obtained. The Code of Federal Regulations (CFR) Part 24, Section Liens, states that the project must be free and clear of all liens other than the insured mortgage, except that the property may be subject to an inferior lien as provided by terms and conditions established by the Commissioner for an inferior lien: 1. Made or held by a Federal, State, or local government instrumentality; 2. Required in connection with: an operating loss loan insured pursuant to section 223(d)of the Act; a supplemental loan insured pursuant to section 241 of the Act; or a mortgage to purchase or refinance an existing project pursuant to section 223(f) of the Act; or 3. As otherwise provided by the Commissioner. 24 CFR states the following: 1. The mortgage shall contain a covenant against the creation by the mortgagor of liens against the property superior or inferior to the lien of the mortgage except for such inferior lien as may be approved by the Commissioner in accordance with the provisions of ; and 2. A covenant against repayment of a Commissioner approved inferior lien from mortgage proceeds other than surplus cash or residual receipts, except in the case of an inferior lien created by an operating loss loan insured pursuant to section 223(d) of the Act, or a supplemental loan insured pursuant to section 241 of the Act Required HUD Approvals Subordinate financing includes all deferred financing: financing secured by the project, financing secured by collateral other than the project, or unsecured financing. HUD approval of subordinate financing transactions requires: 1. Field Office determination that the proposal does not jeopardize HUD's security, conflict with HUD's legal or programmatic interests, or unduly burden the project with debt. 8.1 Subordinate Debt 3 February 18, 2014

5 2. Compliance with the underwriting criteria of the applicable Section of the Act and related MAP Guide instructions. 3. Prior legal review. The legal prerequisites to approval of subordinate financing proposals are set forth in the Daly memo, Appendix of this Handbook. Field Counsel must review all subordinate financing to determine legal compliance before the Field Office will grant approval. 4. Field Offices will approve the use of subordinate financing only when the following conditions are met: a. First mortgagee approval in writing of any subordinate financing secured by a lien against the project. HUD shall not approve such proposals without this written mortgagee approval. If the subordinate financing is not secured by the project, the owner should try to obtain consent to the financing from the holder of the first mortgage. Failure to obtain mortgagee consent when the subordinate financing is not secured, however, does not bar HUD consent: if the mortgagee does not respond to the request for consent, HUD will accept owner certification that an attempt was made to obtain mortgagee consent. b. A finding that approval of the subordinate financing will not increase HUD's exposure to financial risk or loss; and c. Approval of the proposal would not compromise the Department's obligation to provide housing at the least cost to the Federal government. 5. Upon consent of the first mortgagee to allow subordinate financing, the original signed document must be transmitted immediately to the Office of Asset Management at HUD Headquarters for inclusion in the project's safe instruments file. All approved subordinate financing documents must be transmitted to Headquarters upon final approval of the proposal Subordinate Financing by Federal Home Loan Banks for Section 202 and 811 Projects A. Introduction This section provides information on HUD policy for the use of Federal Home Loan Bank (FHLB) System Affordable Housing Program (AHP) funds for subordinate financing of Section 202 and Section 811 projects. It also transmits the Memorandum of Understanding (MOU) between HUD and the Federal Housing Finance Board which sets forth the policy for such financing as well as the legal documents that must be used (Appendix ). 8.1 Subordinate Debt 4 February 18, 2014

6 B. Background Sponsors of Section 202 and 811 projects may have recourse to AHP subordinate financing to satisfy front end cash requirements and cash requirements related to project management. Previously, each such request was submitted to Headquarters, with the proposed mortgage documents, for approval on a case-by-case basis. To decentralize and simplify the process for approving subordinate financing with AHP funds, HUD and the Federal Housing Finance Board entered into a Memorandum of Understanding (MOU). The MOU establishes the framework for the use of such financing and outlines HUD's responsibilities, including monitoring, in connection with Section 202 and Section 811 projects receiving the financing. C. Policy Guidance Subordinate financing by FHLB's in Section 202 and 811 projects may be used for project related purposes allowed under the AHP Regulation and as provided in the project's approved AHP application. Examples of acceptable expenses are: excess land costs, unusual off-site costs, additional amenities and the cost of major structural repairs. HUD would not permit not permit subordinate loans for amenities that would raise project operating expenses, such as swimming pools (unless the owner is prepared to pay such operating expenses out of its own or other non-hud funds). To expedite processing, the Multifamily Hub or Program Center Director with jurisdiction for Section 202 and Section 811 operations, has the delegated authority to review and approve subordinate financing requests. The HUD Counsel for that Office reviews the subordinate financing documents for legal sufficiency and recommends to the Director any modifications to the documents as appropriate. Once determined to be legally acceptable and approved by the Director, the documets and exhibits are included in the AHP subordinate financing documents and HUD capital advance financing documents. HUD review and approval for subordinate financing for Section 202 and 811 projects requires determination that: 1. The subordinate mortgage holder imposes no requirements which conflict with HUD's requirements concerning the project development or operation, or which would in any way jeopardize the continued operation of the project on terms at least as favorable to existing as well as future tenants. (FHLB AHP projects utilizing the legal documents in Appendix will meet the test.); 2. The subordinate financing does not become due and payable in whole or in part until the Section 202 or 811 capital advance (mortgage and note) is fully amortized, except in the following cases: a. Payments may be made on the subordinate mortgage prior to full amortization from Residual Receipts to the extent available after approval by the local HUD Office (In the event of a default in the subordinate mortgage based on noncompliance with AHP covenants and regulations, HUD shall approve 8.1 Subordinate Debt 5 February 18, 2014

7 payments to the Lender from Residual Receipts to the extent available as determined by the Multifamily Hub or the Multifamily Program Center Director.), or b. the sponsor agrees to make payments from its own funds, and such funds do not come from the Section 202 or 811 project; 3. Pursuant to Paragraph l.c. of the Rider (Exhibit A of the MOU), no default under the subordinate mortgage may be declared without HUD approval, which shall not be unreasonably withheld; and 4. HUD's approval of a Transfer of Physical Assets (TPA) also constitutes approval of the TPA by the subordinate loan holder. In the event of a transfer, such transferee shall notify the FHLB of its intent to acquire Borrower's interest in the property and shall assume Borrower's obligations under the AHP covenants. D. Memorandum of Understanding The memorandum of understanding (MOU) identifies HUD's responsibilities for monitoring projects receiving AHP funds, notifying the FHLB when there are changes in the ownership of the project and assuming the Borrower's obligations under the AHP for projects transferred to HUD, and notifying the FHLB of cases in which: 1. Tenant rents or incomes do not comply with the Section 202 or Section 811 program rent or income requirements, and/or 2. Projects are not suitable for occupancy, taking into account local health, safety and building codes. The MOU also transmits the Rider that must be attached to any Lender's Deed of Trust or Mortgage and the HUD capital advance financing documents as modified consistent with the MOU. The documents are: 1. The subordinate Lender and the Owner/Borrower shall execute the Rider to Lender's Deed of Trust or Mortgage which is attached to the MOU as Exhibit A. The Director of the Multifamily Hub or Multifamily Program Center authorized to process Section 202 and 811 projects shall execute HUD's approval of the Rider by signing on the "Approved" line. 2. The modified Capital Advance Agreement (HUD Form CA (9/92)) and Regulatory Agreement (HUD Form CA (4/92)) attached as Exhibits B and C to the MOU, must be used for all Section 202 and 811 projects receiving AHP subordinate financing. 8.1 Subordinate Debt 6 February 18, 2014

8 The Multifamily Hub or Multifamily Program Center Director authorized to process Section 202 and 811 projects shall be responsible for carrying out the requirements set forth in paragraphs (1) through (4) of the MOU. Although the MOU specifically addresses 202/811 projects, the FHLB AHP loan/grant program is available to other nonprofit sponsored projects which serve low income residents. For further information on the FHLB s programs, go to the FHLB web site at Rent Increases and Additional Debt Service for Capital Needs A. Budget-Based Rent Increases for Non-Profit Owners For nonprofit owners, a Section 8 contract rent increase may be approved for capital needs, such as lead-based paint removal, energy efficiency upgrades, and physical repairs. The debt service for a capital repair loan may be included in the budget. Rent increases are capped at the lesser of comparable market rents or 150% of the Fair Market Rent (FMR), less the interest rate subsidy adjustment factor (IRP), if applicable. For further information, please refer to the Section 8 Renewal Guide. Rent increases that request rents higher than the caps shown above require Headquarters approval. B. Mark Up to Market Rent Increases The Section 8 Renewal Guide allows certain eligible projects to mark rents up to market and increase the rents up to market without the need for a budget. The higher rents make affordable the additional debt service for financing capital improvements. The owner must submit a budget that includes the entire debt service component. The budget is used to determine that the project has sufficient income to pay all operating expenses and debt service on the first mortgage and the subordinate financing. It is not used to determine the rents Approval of Debt Service for Subordinate Financing A. Unsecured Financing Funds in the Reserve for Replacements or Residual Receipts Accounts should be used to make needed capital improvements before considering use of subordinate financing. When such funds are not adequate, the Hub or Program center Director may approve unsecured subordinate financing. The preferred resource for servicing such debt is Surplus Cash or Residual Receipts. However, if the owner cannot find a lender willing to accept a surplus cash note, Field Offices may approve servicing of the loan from project operations under the following conditions: 1. Compliance with the requirements of Sections 3 and 4 of this chapter; 8.1 Subordinate Debt 7 February 18, 2014

9 2. Rents are below market and can be increased under the project s rent increase method, or rents are at are below market, but there is sufficient cash flow to afford the additional debt service; 3. Rents, at or below market, will support the full debt service on the second note without compromising financial viability; 4. The owner is in good standing with the Field Office; 5. The owner pays for the up-front loan costs of financing and pays any lender equity requirements from surplus cash, contributions, or owner advances which can only be repaid from surplus cash; 6. The interest rate on the loan cannot exceed current market; 7. The owner provides documentation of the major repairs and/or capital improvements that will be funded by the loan and HUD determines this work is necessary or will improve the project s marketability and that the work is reasonably priced; 8. The owner provides quarterly updates on the status of the repair and/or improvement work, or the Field Office completes periodic inspections, and the owner certifies to completion; AND 9. After the loan is repaid, the rents are reduced by the amount of the debt service on the subordinate financing. B. Secured Financing HUD regulations at 24 CFR prohibit secured subordinate financing (except for surplus cash loans or FHA-insured loans). Therefore, only Headquarters may approve such loans by issuance of a regulatory waiver Subordination of Section 202 Direct Loans A. Subordination with LIHTC Equity Subordination of Section 202 direct loans is permissible only for cases in which refinancing these loans under Notice H (Post-1974 Section 202 Projects) is not feasible. Subordination may prove advantageous to Section 202 owners and developers using Low Income Housing Tax Credits (LIHTC) to help finance substantial rehabilitation. The Department benefits from Use Agreements which extend affordability and the physical quality of the property. The LIHTC equity offsets the debt service demands of a new mortgage which is needed to finance the transaction. In cases requiring new debt for rehabilitation or substantial emergency repairs, the Section 202 loan is subordinated to the new first mortgage, which may be 8.1 Subordinate Debt 8 February 18, 2014

10 FHA-insured or from any third-party source. In addition, HUD permits continued subordination of any pre-existing subordinated debt which HUD had approved. See Notice H , Section 7, page 29. B. Programmatic Requirements Eligible applicants include the following types of entities: a. Single-purpose private nonprofit organizations with tax exempt status under Section 501(c)(3) or Section 501 (c) (4) of the Internal revenue Code of 1986, b. Nonprofit consumer cooperatives, or c. For-profit limited partnerships with a nonprofit entity as the sole general partner. Eligible applicants must meet the following requirements: 1. The applicant must demonstrate that the subordination will achieve long term preservation of the property and that the new capital structure (Section 202 loan and new debt)is affordable. 2. In the event of a change in control of or change in the principals of the owner entity or a transfer of ownership, all parties must be in compliance with the HUD 2530 Previous Participation process. 3. A rent increase is permitted only if no equity is taken out of the transaction and HUD finds the increase to be reasonable. 4. A Use Agreement must be recorded in first security position extending low income affordability for the longer of 20 years from the date of the original mortgage maturity, or from the date of the full repayment of the fully amortized subordinated Section 202 loan. 5. In lieu of prepayment of the Section 202 loan, HUD may permit modifications to the loan amortization schedule, as detailed in Notice , Section V.6., with appropriate modifications of the Regulatory Agreement. C. Application Threshold Requirements Each of the following conditions must be satisfied before HUD considers a request for subordination. 8.1 Subordinate Debt 9 February 18, 2014

11 1. A current 60 or above REAC PASS score or inclusion of a repair plan demonstrating that all physical needs of the project will be addressed as part of the subordination transaction, 2. Management and Occupancy Review score of satisfactory for the prior three cycles; or in the event of a unsatisfactory or below average score, evidence of the replacement of, or intent to replace, the management agent with one acceptable to HUD, 3. All financial reporting submissions current for the three prior years, 4. Mortgage payments current for at least three consecutive years prior to the subordination application, 5. No outstanding Notices of Default or Violation, 6. Current compliance with all applicable fair housing and civil rights requirements as set forth in the standard Handbook Fair Housing compliance paragraph, 7. No delinquency on any outstanding federal debt unless a negotiated repayment schedule is established and the repayment schedule is not delinquent, or 8. Other arrangements satisfactory to HUD are made prior to submission of the application. D. HUD Review of Applications Upon favorable review of the application, the Hub/Program Center Director recommends approval, with or without conditions, to the Director, Office of Asset Management, Headquarters, for final decision. In no case may the Hub/PC Director issue waivers of or grant variances from the requirements set forth herein. 8.1 Subordinate Debt 10 February 18, 2014

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