FHA 242 Loan Insurance: Background & General Characteristics

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1 FHA 242 Loan Insurance: Background & General Characteristics FHA Insurance Programs (Numbers reference sections of National Housing Act) FHA 242: for acute care hospitals with > 50% acute care days FHA 232: for long term care facilities: assisted living and nursing homes FHA 223f: for pure refinancing of non-fha debt when no new money is borrowed (pending for hospitals) FHA 223(a)(7): for refinancing of existing FHA -insured loans (permits maturity extension) FHA 241: for supplemental loans for facilities with existing FHA loans FHA 242 vs. FHA 232 Financings Both programs now processed on a national level by HUD s Office of Insured Health Care Facilities FHA 232 applications instituted processing using an expedited ( Lean ) process Both programs allow GNMA taxable funding but only FHA 232 allows GNMA tax exempt funding FHA 242 applications require full financial feasibility study by an independent third party while FHA 232 applications are reviewed based on market need analysis and financial projections underwritten by FHA mortgagee FHA 242 loans amortize over 25 years; FHA 232 loans amortize over years Basic Structure FHA insures 99% of the mortgage principal to lender in event of a hospital default replacing hospital credit with that of Federal Government. Insured mortgage can be pledged as collateral for tax-exempt or taxable securities. Loan funded by: Tax-exempt Bonds, GNMA Securities, or Mortgage Participation Certificates (MPCs). Rate and prepayment provisions of loan to hospital a function of which funding source is used. Letters of Credit (LOCs) plug holes in FHA Insurance Payout Tax-Exempt Bonds: 1% Note + 1 month s Note interest + 30 Days Bond Interest MPCs: 1% Note + 1 month s Note interest + 6 months difference between Note rate and debenture rate GNMA s: no LOCs required Interim and permanent financing - 25 year amortization following construction Tax-exempt bond structure funds entire loan up front producing negative arbitrage in certain markets. Taxable options fund monthly as advances are made -- no negative arbitrage. Cash or FHA debenture payout for insurance claims: Debenture Lock used primarily in refinancings in 1990s. Cash Lock replaced commercial insurance on new money deals in recent years. Events of Insurance Cancellation Failure to pay FHA mortgage insurance or hazard insurance premiums.

2 Loan Amount, Equity and Letter of Credit Requirements Loan limited to 90% of appraised value - Net book value of PP&E used as proxy for appraised value. Refinancing cannot exceed 80% of loan for projects with construction under FHA 242 & 241. All project costs eligible, including working capital allowance. Interest capitalized for two months longer than construction period with commencement of amortization on the first day of the third month following construction completion Pure refinancing of non-fha debt not yet allowed under FHA 223 (f) Cost of issuance allowance of up to 3.5% for taxable funding and 5.5% for tax exempt funding All legal and consulting fees allowed other than Certificate of Need fees Not for profit hospitals can post a Letter of Credit evidencing equity allowing equity in after loan proceeds FHA Fees 0.3% Application fee 0.5% Inspection fee 0.5% Annual Mortgage Insurance Premium Eligibility Requirements For-profit, not-for-profit and municipally owned hospitals are eligible. Must be licensed and regulated by the state or another political subdivision of the state. CON required in States where CONs exist except for critical access hospitals. Acute Care Only - Greater than 50% patient days in acute categories. Ability to grant first lien on assets and accounts receivable - land can be leased. First and only lien requires refinancing of existing secured debt. 90% loan to value limit. 20% of loan must be for rehabilitation costs - maximum 80% refinancing if new money is involved- Straight refunding of non-fha debt under 223(f) not yet allowed by FHA. Three year average operating margin of 0 or better - turnaround exception; will accept application with 1 year positive margin but 2 years positive margin required for approval FHA does not allow one time revenue events, other operating or investment income in calculation. Three year average historical debt coverage of 1.25x - turnaround exception with 1.4x most recent year and can assume refinancing has occurred when calculating maximum annual debt service. Projects already under construction generally not allowed though HUD will approve almost immediate start after application is submitted. Design build projects over $60 million not permitted.

3 Overview of Application Process Preliminary eligibility package submitted for screening applicants. Pre-application meeting with HUD staff allows HUD to tell client if loan meets approval criteria. Preparation of application - long lead time items are feasibility study, environmental review, CON, reliable construction cost estimates. Initial HUD approval based on estimated costs within days of submission of complete application. Final HUD approval based on availability of Guaranteed Maximum Price Contract ( GMP ) (based on 80% architectural drawings) being less than amount in initial application. Approximately 30 days from receipt of GMP to receive FHA Insurance Commitment Availability of GMP at end of process generally determines overall timing Construction Process Considerations No projects where construction has already begun. Once application is received by HUD, site work can commence with HUD s approval/ Once application is deemed complete, limited construction can begin with HUD oversight: Pre Commitment Work. Once commitment is received, full construction allowed: Early Start. HUD must approve contracts to be used with CM and architect. Lump sum or CM contract/ No Design Build over $60 million. Specific requirements for liquidated damages, retainage and performance and payment bonds. Wages must be in compliance with Davis Bacon requirements. Security Provisions/Covenants First-and-only mortgage and AR lien, as well as collateral mortgages on non-essential properties. After- acquired clause in new covenants covers future property as well. Mortgage Reserve Fund requirement: two years debt service funded over ten years following commencement of amortization. Mortgage, Note, Regulatory Agreement and operating covenants define limitations on hospital. Standardized covenants (see web page on FHA program for link) Problem covenants are Parent non-interference, all current or future property & revenue on or off mortgage parcel subject to FHA documents, consultant reports for significant negative variances including reimbursement changes Certain actions must have HUD permission Mergers, creation of new subsidiaries, changes to organizational documents Affiliate transactions, distribution of assets, additional debt can be done without HUD permission subject to certain limits if certain terms and ratios are met Project complete, mortgage payments are current, MRF is funded, DSC 1.5x, Days AR & AP less than 80,current ratio 1.5X, days cash 21 days, positive margin requirement and unrestricted fund balance greater than zero

4 Refunding Provisions of FHA 242 Program FHA refunding of existing FHA debt Debenture Lock Refunding High-to-low interest rate refinancing creates escrow premiums & Non -Asset Bonds Existing FHA loan & debenture rate survives Today s low debenture interest rate precludes this as an option. Taxable GNMA refunding of FHA loans funded by tax exempt bonds produces savings in today s ( ) market conditions. GNMA proceeds defease tax exempt bonds and mortgage remains intact and is assigned to GNMA Issuer. FHA 223 (a)(7) refunding Up to 12 Year maturity extension New FHA loan & debenture rate New loan principal can be increased up to refinanced note s original principal amount No non-asset bonds created as new note principal equals all costs FHA 242/223 (f) Refinancing of Existing Debt Not Insured by FHA Section 242/241 insured financings for hospitals require at least 20% of mortgage proceeds to be used for new construction, renovation or other capital purchases. No pure refinancing of non FHA debt has been allowed. HUD realized that the current credit crisis has made it increasingly difficult for many Hospitals to access traditional forms of capital. In addition many hospitals had existing credit enhancement products which either expired or created situations where an institution was paying substantially more in interest expense with no available means of refinancing. The purpose of the pending 223(f) regulations is to allow Hospitals to obtain FHA insurance for refinancing non-fha insured debt without a requirement for a new capital component. FHA 223 (f) refinancing can allow up to 20% of the requested loan for financing costs and new capital expenditures. Proposed rules were published in July of 2009 and revised January 29, Final rules are expected late in The 223(f) refinancing option for Hospitals is being enacted through modification to the FHA 242 regulations and thus all FHA 242 provisions apply unless specifically modified by FHA 223 (f).

5 Most eligibility criteria for an FHA 223(f) refinancing are the same as those for an FHA 242/241 financing except that a section 223(f) refinancing requires a 3-year historical average debt service coverage ratio of 1.40X whereas the 242/241 program requires a 3-year historical average debt service coverage ratio of 1.25X. In addition, a Hospital applying for a 223(f) refinancing must also demonstrate: that their financial health depends on refinancing their existing debt, they provide essential service to the community in which they operate, there are few affordable financing vehicles available and, the Hospital meets three of the following seven criteria: 1) The refinancing will reduce operating expenses by at least.25%, 2) The interest rate will be reduced at least.5%, 3) The rate on existing debt has increased at least 1% since January 2008 or will likely increase by 1% within one year of refinancing application, 4) The Hospital s total debt service > 3.4% of operating revenues, 5) The existing credit enhancement vehicle has been cancelled or downgraded or such is imminent, 6) The existing debt has overly restrictive or onerous covenants, 7) Other circumstances that show a refinancing is essential to viability of the hospital. As a refinancing by definition does not change the essential services a hospital provides, HUD, at its discretion, may ease some of its other requirements such as: 1. Institutions with strong historical utilization statistics may not be required to submit a study of market need. 2. Advanced architectural drawings may not be required depending on the extent of proposed capital improvements as new capital under FHA 223(f) cannot exceed 20% of the loan amount. 3. The FHA up front inspection fee may be reduced from.5% to.1% of the mortgage if there is no capital component.

6 Advantages of FHA 242 Insured Financing for Hospitals 90% interim and permanent AA rates. Supplemental loans via FHA 241 financing. Future capacity based on hospital s performance, not market changes, as with private credit enhancers (unlimited Federal capacity). Workout loans via FHA 223(a)(7) refinancing. Changes to or waiver of covenants can be renegotiated with a single party HUD. Approval criteria less stringent than for investment grade public market financing options. Maximizes debt capacity per dollar of EBIDA. 3.5X Coverage (A Rating) 1.5X Coverage (FHA) EBIDA $1,000,000 $1,000,000 Max. Debt Service $285,715 $666, % for A, 5% for FHA $6,435,861 $9,503,335 Frequent Criticisms Somewhat cumbersome process but improvements have been made and continue. Approval timeframe plus prohibition against projects that have started construction makes it noncompetitive in certain situations. Limits on design build for large construction projects, which is popular in certain parts of country. Project financing for single purpose corporation not corporate financing which to-date has prohibited obligated group financings. Offsetting this limitation is the benefit that financing of one facility within a group with an FHA insured loan is non-recourse to parent in the event of a default. No direct variable rate debt some swaps allowed with HUD permission. Unlike rating agencies, no published approval criteria. Davis Bacon Act wage requirement can be expensive in certain markets..5% annual insurance premium can be expensive, particularly in markets with compressed interest rates between rating categories.

7 FHA Financing Considerations in Today s Market Conditions Recent Dislocation of FHA Financing Markets The difference between long-term tax-exempt rates and construction fund investment rates creates prohibitive negative arbitrage in financing of new money projects on a tax exempt basis. FHA only allows capitalized interest on projected mortgage draws not the bonds less projected investment earnings. FHA tax-exempt bond ratings are a function not only of the FHA insurance but also the ratings on certain underlying letters of credit and guaranteed investment contracts ( GICs ). It has become exceedingly difficult to obtain AA rated LOCs and GICs in this market. The result is a potential FHA insured deal with a rating lower than AA which would result in a higher interest rate. The primary taxable financing alternative is the placement of GNMA securities based on the FHA mortgage. This market was virtually abandoned in 1980 with the advent of FHA tax-exempt financing. Since 2008 it has replaced tax exempt bonds as the primary source of funds for FHA 242 loans. Potential solutions to negative arbitrage in the tax-exempt financing option are: placement of debt at variable interest rates or capitalizing the negative arbitrage in the FHA loan - both of which are unacceptable to FHA. Current tax exempt rates are not sufficiently lower than taxable GNMA rates to offset the significant negative arbitrage in a tax exempt funding of an FHA loan for a new construction project. Taxable GNMA financing more efficient in today s market conditions. FHA 242 Underwriting History 401 loans insured since In excess of $17 billion. Deals done in 43 states and Puerto Rico. Many hospitals gained sufficient financial strength to refinance out of the HUD insured portfolio. Low claims rate -- program is self-sustaining 6% default rate with 2% payout rate In 1996, New York State Hospital mortgage balances represented 87 percent of total FHA Portfolio. Program has since achieved better geographic distribution.