The FHA-242 Financing Program

The FHA-242 Financing Program Background FHA-insured hospital mortgages were made possible by the Housing and Urban Development Act of 1968, which added a new section, Section 242, to Title II of the National Housing Act. This section authorized the Secretary of Housing and Urban Development ( HUD ) to insure mortgage loans used to finance the construction or rehabilitation of both for-profit, publically owned and not-for-profit hospitals and the purchase of major movable equipment. Under this program, hospitals may borrow up to 90% of the appraised value of assets pledged as security for a period of up to 25 years following construction. FHA mortgage insurance for hospitals was introduced by the federal government to induce private lenders to increase their capital investment in the hospital industry. The FHA 242 program provided an insurance mechanism whereby the federal government would repay the lender 99% of the loan principal and mortgage interest in arrears subsequent to a hospital default on an insured loan. Thus, the federal insurance replaced the credit of the individual hospital and induced greater private investment into the health care capital market. Taxable or Tax Exempt Mortgage Funding Under the FHA 242 program, an FHA approved mortgagee applies for FHA mortgage insurance on a hospital s proposed loan. Once the insurance commitment is received by the FHA mortgagee, it can fund the loan either on a taxable or tax-exempt basis. FHA loans are placed on a taxable basis in whole or divided into participation certificates or by issuing taxable GNMA securities based on the insured mortgage. Funds are drawn monthly under this loan as construction progresses to pay project costs and capitalized interest. Following construction the loan is amortized over a 25 year term by equal monthly payments of principal and interest. In a tax exempt funding, the tax-exempt issuing authority sells bonds up front in an amount sufficient to fund the mortgage loan and to provide for a Debt Service Reserve Fund. The FHA loan closing and bond closing then take place simultaneously and the issuer deposits the bond proceeds to fund the insured loan in a Construction Financing Account. Each month, as construction progresses, mortgage advances are made from this account to the hospital to pay project expenses until the project is complete and the full amount of the mortgage has been drawn. The monies in the Construction Financing Account are invested, historically through an investment agreement, and the interest from these investments, together with the mortgage interest payments, are used to pay interest on the bonds during construction. Following construction, the equal monthly payments of principal and interest on the mortgage, together with the interest earnings on the Debt Service Reserve Fund, are used to fully amortize the bond issue over 25 years. Since 2008, investments in the construction fund for a tax exempt funding have earned interest at a rate less than the tax exempt bond s interest rate which causes negative arbitrage. In a taxable Revision Date: January 19, 2012 Page 1

funding the loan proceeds are not delivered up front but obtained monthly as needed from the end lender such that taxable fundings have no negative arbitrage. The hospital s FHA mortgage banker should monitor both the tax exempt and taxable funding options and provide the hospital with the information it needs to choose a funding option. Loan Amount and Equity Requirements FHA regulations permit the mortgagor to borrow up to 90% of the replacement value of the hospital assets pledged as security for the loan. FHA specifically excludes any assets pledged under other debt instruments and historically has used net book value as a proxy for replacement value. The calculation of value includes not only the project assets and eligible expenses brought on line due to the capital project, but also the value of the hospital s existing assets in place prior to the project, reduced for any assets that have prior liens. Thus, if the existing asset value is sufficiently large, the regulations technically permit 100% financing of project costs. All costs normally associated with the hospital capital program are eligible for funding under the FHA insurance program including: architect fees, program planners fees, clerk of the works fee, equipment, building insurance, title and recording fees, legal fees, financial feasibility study fees, and (based on a specified formula) interest capitalized during construction. In addition, the program permits borrowing up to 5.5% of the loan amount for financing and placement fees and 2% of the loan for working capital, and it funds from mortgage proceeds fees charged by FHA during the construction process. Many non-profit hospitals using the FHA 242 program choose to post a letter of credit at the beginning of construction to meet their equity requirement. This allows them to spend their equity on project costs at the end of the construction period, thus giving them more time to raise equity and allowing them to earn additional interest on equity funds on hand throughout the construction period. Putting equity in the project prior to mortgage proceeds will reduce the project s capitalized interest component, but this benefit may be offset by the lost investment earnings. FHA Fees To participate in this program, FHA charges a one-time, front-end fee equal to 0.8% of the principal amount of the loan (consisting of a 0.5% inspection fee and a 0.3% application fee). Additionally, once the commitment has been obtained, FHA charges an annual insurance premium equal to 0.5% of the outstanding principal amount of the loan. During the construction period FHA s 0.5% annual insurance premium is charged on the full amount of the approved mortgage and is capitalized in the loan for the full construction period. Following construction, HUD calculates what would have been due during construction based on the actual amounts drawn each month and the overpayment by the hospital is used as a credit towards insurance premiums the hospital owes following construction. Security, Refunding and Additional Debt Provisions The FHA program requires that an FHA-insured mortgage be secured by a first mortgage lien on all of the properties of the hospital essential to the operation of the facility as a health care provider. The purpose of this is to assure that FHA has an operational foreclosable entity in the event of the hospital s default on the loan. Revision Date: January 19, 2012 Page 2

To this end FHA normally will not allow any other mortgage liens on the property (other than chattel liens on equipment), thus necessitating refunding of any outstanding debt secured by a mortgage lien. In certain circumstances, FHA may require collateral mortgages on hospital properties not essential to operation of the facility as a health care provider if it is not satisfied with the fiscal strength of the institution. Future secured debt issues may only be incurred with the permission of FHA, although FHA is fairly generous in allowing additional debt insured by FHA on a parity basis without refinancing existing FHA-insured debt. FHA places few restrictions on future unsecured debt but does require approval of new leases and equipment loans that in aggregate exceed a negotiated ceiling in any one calendar year if the hospital s financial performance does not meet certain benchmark ratios. In addition to the mortgage security required, FHA loans are further secured by a reserve fund equal in amount to two years mortgage debt service which amount is contributed by the hospital over a 10-year period following construction. The FHA 242 loan insurance program has a standard set of covenants for applicants that can be modified to fit a particular hospital s situation but they are called standard covenants for a reason and HUD is reluctant to allow wholesale changes. One of the benefits of the program is that the covenants are between HUD and the hospital so changes in, or relief from, the covenants are negotiated between two parties and not an infinite set of bondholders. A second benefit is that violation of a non-payment covenant will not result in acceleration of the loan. HUD has no interest in paying out a loan insurance claim unless the hospital fails to make its required debt service payments. The covenants restrict certain actions of the hospital without HUD permission such as mergers, changes in organization documents, guarantees of debt etc. It also restricts other actions unless certain benchmark financial tests are met such as debt service coverage, day s cash, days in receivables and payables etc. A link for the current set of FHA 242 financial covenants is on our web page entitled The FHA 242 Program. Loan Repayment Terms and Interest Rates The FHA-insured mortgage program provides for both interim and construction financing and permanent financing. During construction, the hospital draws on a monthly basis the funds required to pay construction costs, equipment purchases, fees and capitalized interest. At the end of construction, the total amount drawn is converted into a permanent loan. During construction, the hospital pays interest only on the outstanding balance of the loan on a monthly basis in arrears. Following construction, the loan is amortized in 300 equal monthly payments of principal and interest. Eligibility for FHA-242 Program Although FHA s review process is designed to fully assess a hospital s future financial strength based on many factors including a financial feasibility study, there are an initial set of eligibility criteria which FHA applies. Revision Date: January 19, 2012 Page 3

Debt to Value: An FHA loan may not exceed 90% of the replacement value of property, plant and equipment, ordinarily based on net book value, plus costs of the new project, less net book value of leased assets and those assets subject to other financing arrangements. HUD may consider appraised value if the net book value test does not work. Historical Operating Margin: Hospitals with an aggregate operating margin of less than 0.00 when calculated from the three most recent annual audited financial statements are not eligible for Section 242 insurance, unless HUD determines, based on the financial data in those statements, that the hospital has achieved a financial turnaround resulting in a positive operating margin in the most recent year, calculated using classifications of items as operating or non-operating in accordance with guidance that shall be provided in written directives by HUD. In any event, HUD shall not issue an insurance commitment for any hospital in a turnaround situation that has not achieved 2 consecutive years of positive operating margin immediately prior to issuance of the commitment. HUD s written guidelines mandate that operating margins be calculated without consideration of investment income, gains or losses from investments, income from related entities and unrestricted gifts. However, at HUD s discretion, that revenue that has historically been received reliably and is expected to continue to be received may be considered operating revenue for underwriting purposes. Historical Debt Service Coverage: Hospitals with an average debt service coverage ratio of less than 1.25 in the 3 most recent audited years are not eligible for Section 242 insurance, unless HUD determines, based on the audited financial data, that the hospital has achieved a financial turnaround resulting in a debt service coverage ratio of at least 1.40 in the most recent year. In cases of refinancing at a lower interest rate, HUD may authorize the use of the projected debt service requirement in lieu of the historical debt in calculating the debt service coverage ratios for each of the prior 3 years. In cases where HUD authorizes the use of the projected debt service requirement in lieu of the historical debt to determine the debt service coverage ratio, hospitals must have an average debt service coverage ratio of 1.40 or greater. A hospital under investigation by any state or federal agency for statutory or regulatory violations is not eligible until the investigation is resolved unless HUD determines that it is minor in nature. A hospital must be able to grant a first lien on its assets and accounts receivable. Land can be leased if lease meets certain terms. Whole facility leases only allowed by exception from HUD. Maximum 80% of the loan can be for refinancing. Projects under construction not allowed. Design build projects over $60 million not yet allowed. Greater than 50% of patient days must be for acute care except for critical access hospitals. Must be licensed and regulated by the state or other political subdivision. CON approval required in states with CON programs. Revision Date: January 19, 2012 Page 4

Refinancing Under Pending Section 223(f) 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, 2010. Final rules are expected late in 2012. 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). 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. Revision Date: January 19, 2012 Page 5

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. Overview of the FHA Application Process There are three process steps that comprise the application process: Preliminary Review, Pre- Application Meeting and Submission & HUD Review of a complete Insurance Application. Preliminary Review: The Preliminary Review is a general overview of the acceptability of a potential mortgagor performed by HUD to identify any factors that would likely cause an application to be rejected, should an application be submitted before the potential mortgagor or mortgagee expends resources to prepare one. The hospital s FHA mortgagee submits a preliminary information package to HUD that provides evidence of statutory eligibility, market need, financial strength, and such other documentation as HUD may require. If HUD does not identify any factors that would cause an application to be rejected, HUD shall issue a Preliminary Review Letter advising the potential applicant that there appears to be no bar to the applicant's proceeding to the next step in the application process. This process requires 2-3 weeks to assemble the pre-application package and two weeks for HUD to review and rule on it. Pre-Application Meeting: The next step in the application process is the pre-application meeting. At HUD's discretion, this meeting may be held at HUD Headquarters in Washington, DC or at another site agreeable to HUD and the potential applicant. The preapplication meeting is an opportunity for the potential mortgagor to summarize the proposed project, for HUD to summarize the application process, and for issues that could affect the eligibility or underwriting of the project to be identified and discussed to the extent possible. Following the meeting, HUD may: (i) Advise the potential applicant that there appears to be no bar to submitting an application for mortgage insurance; or (ii) Identify issues that must be resolved before a full application should be submitted for processing. The Pre-Application meeting process generally takes a month to prepare the presentation, arrange for a meeting and receive the results. Submission & HUD Review of Application: The application for mortgage insurance shall include exhibits that follow such guidance as to content and format that HUD shall provide from time to time. The application shall include: 1) A description of the proposed sources and uses of funds; Revision Date: January 19, 2012 Page 6

2) A description of the mortgagor entity, its ownership structure, and its directors and managers; 3) A description of the project, the business plan of the hospital, and how the project will further that plan; 4) Historical audited financial statements and interim year-to-date financial results (for existing hospitals); 5) A study of market need and financial feasibility with assumptions and financial forecasts clearly presented, prepared by a certified public accounting firm acceptable to HUD; 6) Architectural plans and specifications in sufficient detail to enable a reasonable estimate of cost (if applicable); 7) Evidence that the hospital is located in a state or political subdivision of a state with reasonable minimum standards of licensure and methods of operation for hospitals and satisfactory assurance that such standards will be applied and enforced with respect to the hospital; 8) If the state has an official procedure for determining need for hospitals, evidence that such procedure has been followed and that need has been established under that procedure; 9) A Phase I environmental report; and 10) Such other exhibits as HUD shall require based upon the facts pertaining to the particular case. HUD s policy has been to allow 90 days for processing of an application. Recently, in an effort to further enhance the program s reputation, HUD has committed to expedite its 90 day review by accepting certain application items during the processing. HUD will assign one individual as the Project Executive and form a joint project team from its personnel which reviews the programmatic, architectural and financial feasibility aspects of the insurance application and will recommend approval or disapproval with various conditions to be met by the applicant. Generally, these first levels of review are based on estimated project costs. The key long lead time items required to start the loan process are a feasibility study and good estimates of project scope and costs. Once an application for loan insurance is deemed approvable, the timing for completion of the process depends on when the hospital can deliver the following documents which transform the initial application based on estimated costs into a final application. 1) Guaranteed Maximum Price Contract 2) Construction Management Contract 3) Evidence of Available Payment and Performance Bonds 4) Building Permit 5) Contractor s Certification re: prevailing wages 6) Evidence of Zoning Compliance 7) Owner/Architect Agreement 8) Assurance of Utilities from Providers 9) Final Plans and Specifications Revision Date: January 19, 2012 Page 7

The revised final application is reviewed and generally, as long as the total costs have remained the same as in the initial approval, final approval is granted. This final approval forms the basis for submission to HUD of the request for mortgage insurance. HUD reviews the mortgage budget, legal documentation and creditworthiness of the construction parties. Review of the final application generally takes one month after which the FHA Commitment is issued and arrangements are made to fund the insured loan by tax-exempt bonds, GNMA securities or mortgage participations. Closing of the transaction and thus loan proceeds availability takes place 3-4 weeks thereafter. Construction Process Considerations The FHA-insured financing program entails involvement of federal representatives in many aspects of the architectural, engineering and construction processes. All work funded by government insured loan programs must be in compliance with federal guidelines involving construction standards, civil rights, and area prevailing wage requirements. All architectural plans and contracts must be submitted to officials at HUD s Division of Architecture and Engineering ( OED ) for review and approval prior to implementation. All contracts must be competitively bid although Construction Management Agreements ( CM Agreements) can be negotiated and subcontractors can be prequalified. Working drawings must be in substantially complete (70-80%) form prior to commencement of construction and there must be a legal separation of the architect and contractor to assure that the owner retains control over design and construction. Although federal government involvement appears to be extensive, it is not prohibitive or costly if coordinated in a proper fashion at the onset of the project. Knowledge of the various requirements and selection of project team members who meet government criteria and are familiar with the process will ensure a smooth development of the project. The government s involvement serves to protect the hospital s interests in the construction process as well as its own. Construction can be undertaken with either a guaranteed maximum price ( GMP ) CM Agreement from a CM or via bidding the project through a lump sum contract. The majority of hospitals using the FHA insurance program utilize the CM Agreement. A CM Agreement can give a GMP based on 70-80% complete working drawings and specifications. A lump sum approach requires 100% complete working drawings and specifications and a competitive public bidding procedure that normally requires one month completing. As it generally takes an architect 3-5 months to finalize the last 25% of working drawings and specifications and to prepare bid packages, the CM Agreement approach generally saves 4-6 months for the hospital. Under either process, a firm construction price is prerequisite to receiving final HUD approval and the normal time frame for processing those final stages is two months. Design / build and turnkey approaches to construction have been prohibited in the past but are currently allowed for projects under $60 million of construction. Revision Date: January 19, 2012 Page 8

No work on the project can be undertaken without specific HUD permission. Projects that have already commenced construction are generally not eligible for acceptance into the project. The following three major contract provisions must be highlighted to potential CMs and GCs other than the monthly construction payment cycle as these provisions will affect their pricing. 1) Performance & Payment Bonds: The FHA-242 Program requires that the GC or CM post a 100% Performance and Payment Bond for its contract. In prequalifying CMs and/or GCs, the hospital should ask for a letter from their surety company attesting to their ability to obtain the required bonding. 2) Liquidated Damages: The FHA-242 Program provides that any delay caused by the CM or GC in final completion of the construction project past the date established in the contract for completion shall obligate the CM or GC to pay daily liquidated damages in an amount equal to $.09/$1000 of GMP daily. This potential liability must be factored into the estimated construction period in the construction contract, usually by stipulating a date that exceeds the expected completion date. 3) FHA Retainage on Construction: The FHA-242 Program requires retainage of 10% of each advance for construction until the entire project is 50% complete, at which point retainage on all further advances can be reduced to 0%. Thus, upon construction completion, the balance retained equals 5% of construction and is released to the CM or GC upon cost certification of the project and final endorsement of the loan. Final loan endorsement can take place anywhere from five to ten months following construction completion if proper documentation is kept during construction. A problem can arise with respect to payments to subcontractors, particularly those performing early work on the project, in that FHA retainage is based on the overall project without recognition of individual subcontractor schedules and contract provisions. If a subcontractor completes its contract prior to completion of 50% of the overall contract, the CM or GC may have to use its own funds to release the subcontractor s retainage. The potential need for doing so creates costs that the CM or GC may seek to pass back to the hospital in the contract price. This is generally a problem on projects with a construction period exceeding three years where major subcontractors will finish their work (and expect release of their retainage) prior to the GC s or CM s reaching the 50% completion point of their contract with the hospital. On projects of 18 months or less, the problem is not as severe. The GC or CM must be aware of this provision so that it can adjust its subcontractor retainage provision to minimize any negative effects. Revision Date: January 19, 2012 Page 9

FHA 242 Program Advantages and Disadvantages Advantages The program offers unlimited access to capital financing for hospitals that meet FHA s approval criteria. Unlike the commercial insurers that dominated the hospital financing scene from 2000-2008, the federal government does not have capacity limitations and will not disappear as the commercial insurers have. Once in the program, the FHA 241 supplemental loan program allows hospitals continuing access without market dislocation. The program offers access to capital rated AA and the interest rate for hospitals using the program reflect this quality rating. Changes to, or waivers of, covenants are negotiated between two parties; the hospital and HUD. The lenders are not parties to the covenants in the Regulatory Agreement between HUD and the hospital and there is no need to be able to contact all the lenders for their consent to changes. HUD has no incentive to accelerate a loan for a non-payment default. They are the ones who would then have to pay out the insurance contract. If you violate a non-payment provision you have the opportunity to work the issue out. FHA s criteria for approval are less stringent than other financing alternatives which give its hospital s both greater access to capital and increases their debt capacity significantly. An A rated hospital revenue bond requires a debt service coverage ratio of approximately 3.5X. A 1.5X debt coverage ratio is acceptable to FHA. As shown below, this difference in required debt coverage dramatically increases the debt capacity allowed for each $1,000,000 of available cash flow. 3.5X Coverage (A Rating) 1.5X Coverage (FHA) EBIDA $1,000,000 $1,000,000 Maximum Debt Service $285,715 $666,666 30 Yr. at 5% for A; 25 Yr. at 5% for FHA $6,435,861 $9,503,335 Disadvantages The program has suffered with a reputation for having a cumbersome approval process. The problems in this are being addressed with consolidation of the program in Washington, DC and a stated objective of acting on an application within 60-90 days of receipt. Limits on design build projects, prohibition against insuring projects that have already commenced and requirement for paying Davis Bacon wage rates makes the program uncompetitive in certain areas of the country. Revision Date: January 19, 2012 Page 10

FHA does not allow variable rate debt and in most cases swaps or other synthetic financing mechanisms. The program has always been based on single purpose facility financing and has not yet evolved into a financing alternative that is used for an obligated group structure. There are published eligibility criteria but no published approval criteria. The after acquired property lien covenant causes many hospitals concern that there future flexibility will be limited by HUD. Revision Date: January 19, 2012 Page 11