Some investors may not know what a HUD loan is, but it is important to understand its impact on a select commercial real estate (CRE) investment. Having a HUD-insured loan can mitigate risk, provide attractive loan terms and overall help ensure the longevity of the project. In this article, we’ll dig into what a HUD loan is and its importance to a CRE investment.
Similar to other federal agencies like Freddie Mac and Fannie Mae, the U.S. Department of Housing and Urban Development (HUD) is a federal agency that primarily focuses on multifamily unit loans. However, HUD does not finance loans–they insure 100% of the loan in case there is a default, providing greater security for the lender. Since HUD is a government agency, project In commercial real estate, the sponsor is an individual or company in charge of finding, acquiring and managing the real estate property on behalf of the partnership. The sponsor is usually expected to invest anywhere from 5-20% of the total required equity capital. They are then responsible for raising the remaining funds and acquiring and managing the investment property’s day-to-day... More get to lock in the lowest interest rate available, similar to AAA bonds.
HUD doesn’t just insure loans for affordable housing developments; they also insure for market-rate multifamily development projects. These construction loans are officially referred to as 221(d)(4) loans and they provide some of the most competitive terms a developer can find, including:
- Competitive fixed rates
- 40-year term amortization
- Loan amounts up to 85% of the project cost
- Non-recourse financing
However, HUD typically only provides these ultra-competitive loans to a small pool of sponsors. According to MultiFamily.loans Capital Markets Advisors, in 2018, there were $226.4 billion in total multifamily loans issued. Of that $226.4 billion, only $6.2 billion (2.74%) were HUD 221(d)(4) multifamily construction loans.
HUD is extremely risk-averse and has an extensive vetting process that can deter many sponsors from applying. This can be attributed to:
- Tedious Screening Process: HUD 221(d)(4) loans are not readily available to most projects or In commercial real estate, the sponsor is an individual or company in charge of finding, acquiring and managing the real estate property on behalf of the partnership. The sponsor is usually expected to invest anywhere from 5-20% of the total required equity capital. They are then responsible for raising the remaining funds and acquiring and managing the investment property’s day-to-day... More teams, and proposed projects must go through an extensive pre-review process and the project must be well-positioned with an established team in place to execute. The process is advertised as taking seven to 10 months to be approved, but it can take much longer to actually close a loan; in some cases up to two years.
- Interest Rate Uncertainty: Sponsors do not know the interest rate they are locking in for 40 years until 30 days before closing. A 50 bps swing in rates can be a meaningful difference in how much equity they need. However, sponsors are often willing to take this risk due to the low benchmark interest rates of HUD loans and that, once they do lock a rate, they are now fixed for 40 years.
- Selectivity: HUD only loans to approved sponsors/developers. Further, HUD will not loan to sponsors with troubled HUD track records–one strike and you’re out. If a developer is showing their 4th HUD deal, that means they are performing on all three previous deals. Similarly, HUD requires a bonded contractor and HUD-experienced management team to supervise daily operations of the project. Therefore, the sponsor will be required to partner with HUD-approved and reputable construction, development, and management teams to facilitate the development and lease-up of their properties.
- Mortgage Insurance Premiums (“MIP”): Just as is the case with an FHA home mortgage, a borrower on a HUD 221(d)(4) construction loan must pay a mortgage insurance premium. The premium is 0.65% per annum for market-rate properties but can go as low as 0.25% if the borrower is able to obtain a green MIP reduction by incorporating energy efficiency improvements to the project.
- Prevailing Wage Requirements: Prevailing wage is the rate that contractors must offer their employees when doing business with a government agency. This wage rate is almost always higher than standard wage rates, even as much as 5 – 20% higher depending on location. Since over half of total construction costs are born from labor costs, this means total construction costs could increase by 2.5% – 10%.
- Bi-annual Cash Flow Distributions: Unlike a conventional loan that gives borrowers more flexibility in how they distribute cash flow, HUD limits distributions to twice per year and assesses the health of the property prior to approving each distribution. Investors should understand that the developer has less flexibility in issuing distributions to limited partners.
While these may seem like drawbacks to sponsors, they are also risk-mitigating factors for investors. Outside of providing attractive loan terms, HUD also requires a greater amount of reserves in comparison to a conventional loan (both interest and operating reserves during lease-up) to decrease the likelihood of default. HUD underwrites and evaluates projects using stringent criteria, and due to this outlook, HUD requires sponsors to carry additional cash in the deal. For example, HUD requires 12 months of debt service payments to be held escrow versus six months for most conventional lenders. And HUD will not release the reserves until sponsors have at least six months of at least a 1.0 debt coverage service ratio.
HUD loans, unlike most bank loans, are primarily asset-based, meaning that HUD scrutinizes the property location, the pro forma rents, expenses, and the development team to ensure its communities are successful and achievable. There are many hoops that experienced sponsors will jump through in order to obtain a highly sought after HUD loan. Ultimately, having a HUD insured project means you are working with a sophisticated sponsor with a proven track record that has taken additional precautions to improve the probability of the success of their project. As one local developer who has closed multiple HUD 221(d)(4) puts it, “If you can do a 221(d)(4) loan, you can do anything.”