HOME Multi-Family Rental Underwriting Workshop

NCDA Winter ConferenceWashington, D.C.

January 20, 2016

• Trainer– Steve Gartrell- sgartrell@ncdaonline.org

Welcome

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• What HUD Wants From the PJ– Statutory & Regulatory Requirements

• Definition of Underwriting Terms• HOME Financial Underwriting Requirements:– General Underwriting Requirements– Determining Project Costs are Reasonable• Reviewing the Development Budget (Sources & Uses)• Subsidy Layering Review• Reviewing the Long Term Operating Costs

– Determining the Level of Subsidy

Agenda

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WHAT HUD WANTS(CPD NOTICES 15-11 – HOME UNDERWRITING

REQUIREMENTS & 15-09 – HOME COMMITMENT REQUIREMENTS):

• National Affordable Housing Act of 1990 (NAHA)– PJ must certify that it will not invest any more

HOME funds in combination with other governmental assistance than is necessary to provide quality affordable housing that is financially viable for the period of affordability

STATUTORY REQUIREMENTS

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• 24 CFR 92.250(b) – PJ must adopt and evaluate projects according to written underwriting

and subsidy layering guidelines for all HOME activities to determine the appropriate HOME investment.

• §92.254(f) – PJ must adopt and follow written underwriting standards for

assistance to homebuyers, including analysis of housing and family debt, monthly family expenses, assets available to acquire the housing, resources needed to sustain homeownership, including the terms of planned mortgages.• Except direct homebuyer assistance not part of a project:

– No Market analysis– No evaluation of developer capacity

• Homeowner Rehab. – above two and only if HOME loan is amortizing

REGULATORY REQUIREMENTS

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• What HUD Wants from PJ (review CPD 15-11 – Underwriting Requirements & 15-09 - Commitment Requirements):– Screening

• HOME Eligibility & Requirements• Meets Housing Goals

– Market Risk• Whether project marketable over time

– Borrower Risk• Assessment of developer/developer team capacity

– Project Financial Risk, Feasibility and Viability• Costs are Reasonable• Sufficient funds to complete project – firm commitments• Sufficient funds to manage property over time

Underwriting for Rental MF

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UNDERWRITING DEFINITIONS

• HOME Commitment• Underwriting

– For Developer/owner– For Bank– For PJ

• Subsidy Layering Analysis• Project Development Budget

– Sources & Uses• Operating Budget

– Pro-Forma– Debt Service Coverage Ratio– “Cash on Cash” Analysis

Definitions

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PJs may not commit HOME funds to a project consisting of new construction or rehabilitation until:– All necessary financing is secured– A budget and production schedule is established– Underwriting and subsidy layering analysis is

completed– Construction is expected to start within 12 months

• See CPD-15-09, Attachment A – Commitment Checklist

HOME Commitment (§92.2 & CPD 15-09)

Slide 10

• Underwriting for Developer: – Creates Development Budget – • Determines all costs to produce project• Determines Sources to cover these costs

– Creates Operating Pro-Forma• Projects long-term costs to manage & operate project• Projects long-term sources of income to cover costs

(and make a profit or return on investment)

Underwriting for Rental MF

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• Underwriting for Banker: Reviews– Development Budget – Operating Pro-Forma

• To determine whether requested debt can/should be provided

Underwriting for Rental MF

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• HUD – “PJs are encouraged to undertake sustainable underwriting—that is, underwriting that is based on realistic financial projections to minimize risks and enhance the project’s long-term success.”

Underwriting for Rental MF

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Subsidy Layering Analysis

• PJ Looks at project financing to:– Ensure appropriate HOME subsidy

• Is based on need in Con Plan• Is reasonable to the project

– Make sound investments over long term• Underinvestment cannot sustain unexpected costs

– Higher risk of failure• Overinvestment uses more public funds than are needed

– Developer windfall

• Protects against duplication from multiple public sources

• Essentially is basic underwriting

Slide 14

Sources Uses

Equity $163,920 Acquisition $250,000

Private Loan $250,000 Design Services $50,000

Public Loan $100,000 Legal Fees $25,000

CDBG $324,000 Other Soft Costs $25,000

HOME $800,000 Demolition $50,000

Site Improvements $24,000

Construction $1,000,000

Developer’s Fee $113,920

Total Sources $1,537,920 Total Uses $1,537,920TDC/Unit $192,240

Project Development Budget (Sources & Uses - Simplified)

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Project Development Budget (Sources & Uses - Simplified)

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• Sources & Uses must include:– All Sources (both private and public) of funds with

dollar amount(s) and timing of availability for each source, and

– All Uses of funds (for example acquisition costs, site preparation and infrastructure costs, rehabilitation/or construction costs, financing costs, professional fees, developer fees and other soft costs) associated with the project.

– See CPD 15-11 for details

Operating Budget(Year 1)

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Simplified Operating BudgetGross Potential Rent $180,000.00Rent Loss (7%) -$12,600.00Other Income $1,800.00Effective Gross Income (EGI) $169,200.00 Marketing $3,000.00Payroll $45,000.00Property Admin. & Mgmt $10,152.00Utilities $6,000.00Security $4,500.00Maintenance $9,750.00Taxes $15,000.00Insurance $6,000.00Reserves for Replacement $12,000.00Operating Costs $111,402.00 Net Operating Income (NOI=EGI-Costs) $57,798.00Debt. Service -$50,259.00Cash Flow $7,539.00

Operating Budget Proforma(Years 1 – 5 of 20)

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Year 1 Year 2 Year 3 Year 4 Year 5Effective Gross Income (EGI) = 1% Increase/year $169,200 $170,892 $172,601 $174,327 $176,070Operating Costs - 3% Increase/year -$111,402 -$114,744 -$118,186 -$121,732 -$125,384Net Operating Income $57,798 $56,148 $54,415 $52,595 $50,686Debt. Service -$50,259 -$50,259 -$50,259 -$50,259 -$50,259Cash Flow $7,539 $5,889 $4,156 $2,336 $427

Debt Service Coverage Ratio Analysis

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Debt Service Coverage Ratio [s/b 1.11 (aff.) to 1.4 -2.0 (mkt.) ]

Year 1 Year 2 Year 3 Year 4 Year 5Effective Gross Income (EGI) = 1% Inc. $169,200 $170,892 $172,601 $174,327 $176,070Operating Costs - 3% Inc. -$111,402 -$114,744 -$118,186 -$121,732 -$125,384Net Operating Income $57,798 $56,148 $54,415 $52,595 $50,686Debt. Service -$50,259 -$50,259 -$50,259 -$50,259 -$50,259Cash Flow $7,539 $5,889 $4,156 $2,336 $427

Debt. Service Coverage Ratio 1.15 1.12 1.08 1.05 1.01

DSCR = Net Operating Income / Total Debt Service

Cash Flow as a % of Operating Costs & Debt Service

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Year 1 Year 2 Year 3 Year 4 Year 5Effective Gross Income (EGI) = 1% Inc. $169,200 $170,892 $172,601 $174,327 $176,070Operating Costs - 3% Inc. -$111,402 -$114,744 -$118,186 -$121,732 -$125,384Net Operating Income $57,798 $56,148 $54,415 $52,595 $50,686Debt. Service -$50,259 -$50,259 -$50,259 -$50,259 -$50,259Cash Flow $7,539 $5,889 $4,156 $2,336 $427

Debt. Service Coverage Ratio 1.15 1.12 1.08 1.05 1.01Cash Flow as a % of Op. Costs & DS 4.66% 3.57% 2.47% 1.36% 0.24%

• Used to help determine how much equity (owner/developer’s own money) should be in project– Annual Cash Flow Equity = X% Cash on Cash Return– Example: ($10,000 Cash Flow $100,000 Equity) = 10%

cash-on-cash return– Higher for for-profit developers, lower for non-profits– HUD to develop standards

“Cash on Cash” Analysis

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HOME FINANCIAL UNDERWRITING GENERAL REQUIREMENTS

But First -- HOME Timing Requirements

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• Specific HOME timing requirements:– Construction or demolition must be started within

12monts; Acquisition of housing within six months of agreement

– Completed within 4 years of contract & – Complete project in IDIS w/in 120 days of final draw– Rental units not occupied:

• w/in 6 months – report to HUD status & marketing efforts• w/in 18 months must repay HOME funds

– Homebuyer units not sold in 9 months become rental units

• PJs must ensure long-term sustainable projects by establishing guidelines for:– Subsidy layering and underwriting assessment– Market assessment – Assessing developer qualifications, experience & financial

capacity – Verifying that there are firm financial commitments

• Applies to rental projects and homebuyer development projects (some exceptions)

• Analysis must be done prior to funding commitment• Certify compliance in IDIS at project set-up

HOME Underwriting & Subsidy Layering – PJs to Establish Guidelines - §92.250

Slide 24

• Additionally Subsidy Layering & Underwriting Guidelines must:– Ensure amount of HOME funds invested no more than

necessary to provide quality, financially viable affordable housing

– Determine reasonable level of profit/return to owner/developer for size, type, complexity of project

– Examine Sources and Uses & Operating Proforma for cost reasonableness

– Verify financial commitments are firm

HOME Subsidy Layering & Underwriting Guidelines

§92.250 (b)

Slide 25

• Determine whether Sufficient funds to complete project– Review Development Budget - Sources & Uses

• Determine whether Sufficient funds to manage property over time– Review Operating Budget Pro-Forma

• Debt Service Coverage Ratio Analysis• Cash on Cash Analysis

• Use both to determine the level of subsidy needed to complete the project

Project Financial Risk, Feasibility and Viability

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DEVELOPMENT BUDGET(SOURCES & USES)

Sources Uses

Equity $163,920 Acquisition $250,000

Private Loan $250,000 Design Services $50,000

Public Loan $100,000 Legal Fees $25,000

CDBG $324,000 Other Soft Costs $25,000

HOME $800,000 Demolition $50,000

Site Improvements $24,000

Construction $1,000,000

Developer’s Fee $113,920

Total Sources $1,537,920 Total Uses $1,537,920TDC/Unit $192,240

Development CostsSources & Uses (Simplified)

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• Verify that all sources are committed• Funding Sufficient to complete project• Timing of availability is appropriate to need• Are other funds compatible with HOME?

Reviewing Sources of Funds

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Reviewing Development Costs

• PJ must determine that:– All costs are necessary, and reasonable (2CFR Part 200)

• Cost of comparable projects in same area• Qualifications of cost estimators• Comparable with industry standard cost indexes

– Proposed costs are sufficient to achieve all program requirements, for at least the affordability period including:• All HOME Requirements (including Property and Rent standards)• Cross Cutting Federal Requirements

– Supporting documentation (see CPD 15-11)

Slide 30

OPERATING COSTS REVIEW FOR RENTAL PROJECTS

Rental ProjectsOperating Budget

• At minimum should cover:–Projected income and vacancies–Operating expenses–Contributions to reserves–Debt service–Cash flow and payments of deferred

feesSlide 32

Slide33

Operating BudgetExpenses – Summary

• All cash expenses should be shown• Reflect:– Type and location of project– Number of units– Physical characteristics of property– Cost environment for this project

• Trend expenses realistically given history– Always higher than income growth

• Look at comparable properties– Some PJs keep database

Slide 34

Operating Budget Reserves for Replacements

• Deposits for future capital expenditures• PJs have often used standard rule of thumb – Better to do property-specific capital needs

assessment– §92.251(b)(1): Capital Needs Assessment required

when rehabbing projects with 26 or more total units

• Research shows wide range of capital needs with average of $650 per unit per year

Slide 35

Evaluating the Operating Pro-forma

• Ensure:– Income is sufficient to cover expenses and debt

service for all years of affordability period– Expense cushion does not drop below threshold

during affordability period – Adequate positive cash flow each year

Slide 36

Evaluating the Operating Pro-forma (cont)

• Are rent assumptions realistic?– Most HOME rents only grow by 1-3% annually– Market rents should be based on comparable history– Vacancy estimated at no lower than 5%

• Are expense assumptions realistic?– Base on comparable properties– Controllable vs. Non-Controllable Expenses– Expenses should always trend higher than income

• DSCR useful for evaluation– Recent HOME rent study found that PJs underestimate

expense increases Slide 37

Operating Budget Proforma(Years 1 – 5 of 20)

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Year 1 Year 2 Year 3 Year 4 Year 5Effective Gross Income (EGI) = 1% Increase/year $169,200 $170,892 $172,601 $174,327 $176,070Operating Costs - 3% Increase/year -$111,402 -$114,744 -$118,186 -$121,732 -$125,384Net Operating Income $57,798 $56,148 $54,415 $52,595 $50,686Debt. Service -$50,259 -$50,259 -$50,259 -$50,259 -$50,259Cash Flow $7,539 $5,889 $4,156 $2,336 $427

Cash Flow Analysis

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Debt Service Coverage Ratio [s/b 1.11 (aff.) to 1.4 -2.0 (mkt.) ]

Year 1 Year 2 Year 3 Year 4 Year 5

Effective Gross Income (EGI) = 1% Increase/year $169,200 $170,892 $172,601 $174,327 $176,070

Operating Costs - 3% Inc./year -$111,402 -$114,744 -$118,186 -$121,732 -$125,384Net Operating Income $57,798 $56,148 $54,415 $52,595 $50,686Debt. Service -$50,259 -$50,259 -$50,259 -$50,259 -$50,259Cash Flow $7,539 $5,889 $4,156 $2,336 $427

Debt. Service Coverage Ratio 1.15 1.12 1.08 1.05 1.01Cash Flow as % of OC + DS 4.66% 3.57% 2.47% 1.36% 0.24%

DSCR = Net Operating Income / Total Debt Service

Cash Flow

• Goal: Positive Cash Flow over Life of Project– Means that expenses can be covered with cushion– Provides Owner with income

• Remaining cash (if distributable) after payment of debt service

• Analyze using both DSCR review & CF as % of Costs + DS• Analyze Equity Investment -“Cash-on-cash” return to

measure– Annual Cash Flow Equity = X%– Example: ($10,000 Cash Flow $100,000 Equity) = 10% cash-on-cash return

• Since cash flow changes over time, average over the affordability period

Slide 40

Developers Can and Should Make Money

• Many sources of potential $$– Developer Fees– Property Management Fees– Appreciation and other equity increases– Net cash flow

• Compare returns to other similar investment• Appropriate level of return depends on:– Project risk– Returns available elsewhere

• OK for non-profit developers to earn revenue

Slide 41

PUTTING IT ALL TOGETHER -DETERMINING LEVEL OF SUBSIDY

SUBSIDY LAYERING

Subsidy Layering Requirements

• HOME Final Rule at 92.250(b)– Always been required (including having SL Policy)

• CPD Notice 98-01 provides guidance• PJ must establish written guidelines • Carry out prior to committing $$$ to project• Certify in Consolidated Plan and in IDIS

(together with Underwriting)

Slide 44

What is Subsidy Layering?

• Looking at project financing to:– Ensure appropriate HOME subsidy– Make sound investments over long term– Accurately project income and expenses

• Essentially is basic underwriting

Slide 45

When To Do Subsidy Layering

• Required for all projects using HOME funds – Not replaced by new underwriting requirements – document both

• All projects:– Includes multifamily AND single-family projects

• Other governmental assistance defined broadly:– Any direct or indirect assistance– Federal, State or local (can sometimes use their SL analysis)– Includes

Loan Grant Guarantee Insurance Payment Rebate Subsidy Credit Tax benefit

Slide 46

Basics of Subsidy

• Subsidy is determined by measuring the gap in funds needed to undertake the project and for the project to meet the long term requirements. • Market project must support itself – revenue must cover

all expenses, reserves and debt coverage• Affordable project has lower revenue, so it can’t cover

same debt and will need a subsidy to get it built• Projects unable to cover operating expenses will also need

operating assistance not eligible under HOME (but can reduce debt upfront reducing debt burden)

• PJ is liable for HOME investment based on the project successfully completing the entire affordability period.

Slide 47

Determination of Subsidy

• PJ, in determining that no more public subsidy than necessary goes into project, should encourage:– Maximum equity (that developer can afford)– Maximum loan with the lowest debt service (that cash

flow can cover)• Review Interest Rate and Term

Slide 48

Determination of Subsidy

• How Long-Term Operating Costs help Determine Subsidy– Based primarily on capacity of project to earn revenue in

excess of expenses and thus carry debt– To analyze rental subsidy PJ must evaluate long term

operating budget and assumptions such as escalation of rents, expenses along with vacancy rate as well as the development budget

Slide 49

• Determine - Debt Service Coverage Ratio (DSCR) – The measure of the cash flow available to pay current debt

obligations plus provide owner income. – DSCR = Net Operating Income / Total Debt Service. – DSCRs should range from a minimum of:

• Affordable – 1.11• Market – 1.4 +

– Less than these amounts means they don’t have sufficient income to pay debts

– Much more than these means they should take on more debt (and get less subsidy)

How Much Debt?

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How Much Debt? (1st Determine Debt Service Amount)

Operating Budget Development Budget Gross Potential Rent $100,000 Hard Costs $600,000 Vacancy Loss ($10,000) Soft Costs $100,000 Net Rent $90,000 Other Costs $50,000 Other Income $5,000 TDC $750,000 Effective Gross Income $95,000 Maximum Loan ($429,000) Operating Expenses ($50,000) Equity ($50,000) Net Operating Income $45,000 Gap $271,000 Debt Service ($40,000) Public Subsidy ($271,000) Cash Flow $5,000 Remaining Gap $0

Slide 51

DSCR = Net Operating Income / Total Debt ServiceDSCR= $45,000/$40,000 = 1.125

To determine amount avail. for debt serviceNOI / desired DSCR = Amt. for DS

$45,000/1.125=$40,000

How Much Debt?(Next Determine Loan Amount)

Operating Budget Development Budget Gross Potential Rent $100,000 Hard Costs $600,000 Vacancy Loss ($10,000) Soft Costs $100,000 Net Rent $90,000 Other Costs $50,000 Other Income $5,000 TDC $750,000 Effective Gross Income $95,000 Maximum Loan ($429,000) Operating Expenses ($50,000) Equity ($50,000) Net Operating Income $45,000 Gap $271,000 Debt Service ($40,000) Public Subsidy ($271,000) Cash Flow $5,000 Remaining Gap $0

Slide 52

1. Operating Budget can afford $40,000/year in Debt Service2. Determine Best Interest Rate (7%)for Loan Period (e.g. 20 Years)

3. Determine Loan that Debt Service can carry at that Interest Rate/Loan Period

To Determine Debt (If Cash Flow Insufficient)

Operating Budget Development Budget Gross Potential Rent $100,000 Hard Costs $600,000 Vacancy Loss ($10,000) Soft Costs $100,000 Net Rent $90,000 Other Costs $50,000 Other Income $5,000 TDC $750,000 Effective Gross Income $95,000 Maximum Loan ($429,000) Operating Expenses ($50,000) Equity ($50,000) Net Operating Income $45,000 Gap $271,000 Debt Service ($40,000) Public Subsidy ($271,000) Cash Flow $5,000 Remaining Gap $0

Slide 53

1. Get Better Interest Rate2. Longer Term Loan

3. Increase Equity4. Increase outside contributions

5. Increase Subsidy

Summary - Underwriting Process

• Evaluate proposal and adjust all components for realism and accuracy– Don’t forget eligibility!

• Apply appropriate cushions and controls• Apply HOME limits & do cost allocation• Negotiate• Apply the subsidy (if appropriate) or reject• Later changes in scope or budget may require

Underwriting/Subsidy Layering update & approval

Slide 54

• HUD Exchange - HOME & CDBG sites– https://www.hudexchange.info/programs/home/– https://www.hudexchange.info/programs/cdbg-entitlemen

t/• Single Family Webinar HOME 2012 Requirements– https://www.hudexchange.info

/resource/2456/home-fy12-appropriations-developer-capacity-homebuyer-projects-webinar/

• Multi-Family Webinar HOME 2012 Requirements– https://www.hudexchange.info

/resource/2457/home-fy12-appropriations-underwriting-rental-projects-webinar/

Resources

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• Upcoming guidance, tools, etc.– Underwriting notice – CPD 15-11 • Revises the former subsidy layering notice 98-01

– Cost allocation notice• Revises the former notice 98-02

– Other training and TA products related to underwriting• Sign up for HUDExchange mailing list, e.g., indicate

HOME as an interest area: https://www.hudexchange.info/mailinglist/

Resources (cont)

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