With a national shortage of affordable multifamily units, many municipalities have enacted inclusionary housing ordinances requiring market-rate developers to set aside 10 percent to 30 percent of new-construction units for affordable housing.
While some of the ordinances provide mechanisms to offset the cost of delivering the units and loss of income, many do not, and project capital stacks are thrown into disarray as banks “right size” construction loan dollars to the project cash flow. U.S. Department of Housing and Urban Development-insured mortgages can provide an attractive alternative to traditional bank financing with higher loan to cost and lower debt coverage thresholds, making more market-rate and mixed-income apartments economically viable.
As a federal agency, HUD leads national policy and programs that address our country’s housing needs and provides mortgage insurance on loans made by FHA-approved multifamily lenders. This includes a variety of loan programs for new construction projects. Most market-rate developers are familiar with Freddie Mac and Fannie Mae and have thought of HUD primarily as a niche lender for affordable projects. Nearly two-thirds of HUD-insured mortgages, however, are secured by traditional market-rate apartments, and HUD is very active. It insured about $31.8 billion in 2021, an increase from $26.5 billion in 2020. This means its annual originations are on par with historical annual life company multifamily originations.
While many inclusionary developments will not be categorized as “affordable” per HUD’s definition, HUD looks favorably on the inclusion of any affordable units, and affordability is not a precondition of financing. HUD finances many projects that are 100 percent market-rate.
HUD vs. Traditional Financing
For market-rate construction loans, HUD can underwrite to the lesser of 85 percent LTC or a 1.18 debt coverage ratio, compared with 75 percent LTC for banks. So, from an LTC perspective, HUD provides an immediate advantage.
Most projects utilizing bank financing with inclusionary and affordable units, however, are constrained by cash flow, not cost. Banks typically use an artificial interest rate and amortization to stress their exit underwriting, which effectively constrains loan proceeds to around 60 percent LTC. HUD, however, uses the actual interest rate, a 40-year amortization and a 1.18 DCR. Current all-in rates inclusive of a mortgage insurance premium, assuming the property meets HUD’s green building standards, are about 3.35 percent, fixed for the term of the loan. On net, this can result in loan proceeds 25 percent greater than what a bank can achieve. From an equity perspective, the higher leverage and lower interest rate combined with the long amortization can also make low yield-on-cost inclusionary projects palatable to investors because the cash-on-cash return is still attractive.
Also of note: HUD construction loans are non-recourse and subject to standard carve-outs. HUD also offers attractive prepayment flexibility with a step-down penalty beginning in year one and no penalty after year 10.
Why don’t all developers use HUD? There are a few downsides to navigate:
- Market-rate new construction HUD loans take about 12 months to process, compared to three to four months for a typical bank loan. Developments that meet HUD’s definition of affordable can close in as quickly as seven months.
- HUD requires prevailing wages. In cities without a strong union presence, or on smaller projects, this requirement can increase costs by 10 percent or more.
- Lastly, for first-time HUD developers, HUD will require some HUD experience on the development team—a general contractor that has completed HUD transactions or a construction consultant—and a HUD-experienced property manager for the first year.
If a developer doesn’t have 12 months or is constrained by labor costs, it could also use HUD as the take-out lender at stabilization. HUD will advance 80 percent LTV on a cash-out refinance with a 1.18 DCR. Current refinance rates are 2.75 percent (assuming a green project) for a 35-year term and amortization.
A developer considering HUD for a construction loan should approach the HUD lender early, and it should consider using a GC and an architect that have prior HUD experience. HUD has nuanced rules about what it will count toward mortgageable project costs relative to market-rate lenders, and it is also more concerned about FHA compliance for accessibility. Making sure the project meets those requirements early in the design process will save tremendous time.
Inclusionary zoning policies can create large capital stack holes in development projects because the reduced cash flow constrains loan dollars and equity returns to the point that many projects are no longer financially viable. HUD financing—with its higher LTC, competitive rates, long amortization and tighter debt-coverage requirements—presents a strong alternative to traditional bank financing for market-rate and mixed-income apartments. Developers can talk to debt providers, including direct HUD-approved lenders and mortgage bankers, to determine if a HUD loan is the right choice for them.
Matthew Wurtzebach is senior vice president in the Commercial Finance Group of Draper and Kramer.