Utilizing HUD 221(d)(4) For Real Estate Development
Are you considering developing a market-rate multifamily property and are intrigued by the prospects of utilizing HUD 221(d)(4) financing? You're not alone. This FHA financing option has been popular with Tactica's commercial real estate consulting clients.
Low-interest rates, non-recourse, a 40-year amortization schedule, and more leverage are massive benefits for new construction projects or properties requiring substantial rehabilitation.
HUD 221 Contents
Disclaimer: You should verify with your lender, attorney, and accountant how to correctly account for HUD financing. This article is purely theoretical, and slightly different circumstances could significantly alter the impacts on project-level returns, partnership returns, and taxes. My interpretation may not be accurate for every scenario.
This blog post aims to show you how you must adjust your multifamily development proforma template to account for some of the unique features of HUD to ensure you are underwriting your project accurately.
In tandem with confident underwriting, a knowledgeable HUD 221(d)(4) lender should help you understand:
Required third-party reports and market studies
Pre-application process
Rate lock period
Escrows
HUD approvals process
General contractor requirements
Davis-Bacon prevailing wage standard required (could affect your budgeted construction costs)
In a typical new construction project, you'll see:
Construction Financing > Property Stabilization > Refinance > Permanent Financing
Most proforma templates are equipped to handle the sequence above (two separate multifamily loans), including the Multifamily Development Model. However, the HUD loan is unique because there is no refinance option. It's actually challenging to take money out of the project. HUD 221(d)(4) is essentially a construction loan and a permanent loan, all wrapped into one.
The lender will allow for up to 36 months of interest-only (similar to a standard construction loan) during the construction period. Once the property is constructed and stabilized, the loan will begin amortizing for the remaining loan term at a fixed interest rate.
Increased Leverage
There may be more leverage available if you qualify for grants, are developing an affordable property such as low-income housing tax credits (LIHTC), or are involved in other non-profit endeavors. I am not an affordable housing expert and can only speak for my experience analyzing market-rate properties.
Note: You could check with your lender to see if you qualify for BSPRA for a greater leverage level on market-rate developments.
Mixed-Use Qualifications
You may qualify for HUD 221 (d)(4) for a mixed-use project, but the ground-level commercial space mustn't account for more than 15% of the total adequate gross income (EGI). Agency financing will have similar stipulations.
Mortgage Insurance Premium
MIP will usually be included in the interest rate. Make sure this is the case. When I say interest is 6.15%, the actual breakdown is something like this:
Interest Rate: 5.50%
MIP: 0.65%
All-In Rate = 6.15%
These are ballpark estimates. A lender will give you something more concrete.
Conservative Debt Service Coverage
The debt service coverage ratio (DSCR) is derisked compared to instances where developers pull all their equity out at stabilization and take out permanent financing with a DSCR closer to 1.20. When we look at the "Returns Summary" tab, you'll see no refinance proceeds.
Lockout & Prepay Fees
If you're not expecting to hold the asset for the long term, it's also essential to understand the lockout period and prepayment penalties. While the loan may be assumable, it generally will exclude confident investors who prefer to put their debt on the deal and maximize their leverage. Needing a buyer to assume your financing will almost certainly reduce your asset's interest and may lead to fewer sale proceeds. I saw this frequently play out when I worked in the brokerage world.
Most people utilizing this financing are “build and hold” investors, so it will likely not be an issue. However, ensure you know the consequences of an unexpected sale effort early in the investment hold.
A good chunk of the video is dedicated to working capital and operating deficit requirements. Both are required to be funded in cash and are not mortgageable.
Working Capital
Per HUD’s Multifamily Accelerated Processing Guide (opens as a PDF document), the working capital requirement is 4% of the loan amount and is split between construction contingency for overruns and approved change orders. And separate provisions for the remaining 2% (pg 254 of linked text).
Operating Deficit
The operating deficit is cash that can help pay debt service early in lease-up when income may not be significant enough to cover all operational expenses and mortgage payments. The cash requirement will depend on the size of the loan. General guidance is the following (pg 82 of linked text)
<$25 Million: 4-6 months of debt service
$25-$75 Million: 9 months of debt service
>$75 Million: 12 months of debt service
These cash-funded reserves are reimbursable if you exceed expectations and don’t use them during construction or lease-up.
Note: While the resource link above is dated (2016), it was the only source that I could link. The more recent literature was Word docs with no direct URL.
The rest of the analysis will be like any development project where you're:
Assessing market conditions
Summarizing HUD 221(d)(4) Financing
HUD 221(d)(4) is popular because of:
Competitive interest rates
40-year amortization
More significant leverage thresholds for new construction or redevelopment projects.
If you’re a developer planning to hold the asset long-term, it could be the perfect match for your project if you’re okay with the following:
Severe prepayment penalties
More oversight/compliance/audits
More 3rd party costs/reserve requirements/MIP
Talking to a knowledgeable broker/lender about HUD, how it compares to other loan programs, and weighing the benefits and drawbacks should help you make an informed decision.