THE FEDERAL HOUSING Administration (FHA) has become the most prolific and popular construction debt source since the advent of the credit crunch. But the agency will soon tighten up the underwriting criteria of some key programs.

The FHA dropped a bombshell at the Mortgage Bankers Association's Commercial Real Estate Finance (MBA/CREF) Conference in February when it unveiled proposed changes to its Sec. 221(d)(4) and Sec. 223(f ) programs that could make it harder for developers to gain access to those loans. During a contentious session with Carol Galante, HUD's deputy assistant secretary of multifamily housing, a packed room of FHA lenders expressed their disapproval of the changes, which will be implemented through a mortgagee letter the first week of May.

Most notably, the FHA wants to raise the debt service coverage ratio (DSCR) for the popular Sec. 221(d)(4) program, which has become the only game in town for construction capital throughout the recession. The program has always offered some of the most generous loan terms in the industry, such as a 1.11x DSCR. But under the proposed changes, market-rate deals seeking 221(d)(4) loans would be underwritten to a minimum 1.20x DSCR. Projects with subsidy levels of 95 percent or greater would still enjoy a 1.11x DSCR, but low-income housing tax credit (LIHTC) deals would be bumped up to a minimum 1.15x.

Loan-to-cost (LTC) ratios would also be adjusted under the new rules. Projects with rental assistance, however, would still qualify for 90 percent LTC, but LIHTC deals would tap out at 87 percent and market-rate deals at 83.3 percent.

And that's not all. Another proposed change would increase the minimum required amount of working capital funds. In the past, developers had to put up 2 percent of the total loan amount in a working capital escrow fund, but that figure will be 4 percent under the proposed rules. That signals a big change: On a $10 million loan, a developer will have to come up with an additional $200,000. Another change would increase the required operating deficit reserves from three months of debt service to four months.

“It might make it tougher for weaker borrowers to get deals done because they're not going to be able to come up with the extra funds,” says Phil Melton, a senior vice president and head of FHA production at Charlotte, N.C.-based Grandbridge Real Estate Capital. “But what that does is provide cash and liquidity to help those projects weather the storm if it takes them a little longer to lease up.”

Modest changes were also proposed to the Sec. 223(f ) program for refinancings or acquisitions. That program, another key source of liquidity, would also see higher DSCRs. Tax-credit deals and Housing Assistance Payments contract deals would stay at the program's current level of 1.1765x DSCR, but market-rate deals would be bumped up to 1.20x.

The Long Run

FHA lenders question why the FHA would fundamentally change the program's terms rather than employ more incremental modifications, such as increasing the Mortgage Insurance Premium. Other lenders point out that HUD shouldn't try to time the market.

The Mortgage Bankers Association has worked closely with the FHA on the changes, hoping that the agency would take a more targeted approach. “We agree that they have to take prudent steps, but if anything, those should be applied market by market,” says Doug Moritz, the MBA's associate vice president of multifamily.

But at the MBA/CREF Conference, Galante said that HUD was concerned with the weaknesses seen in its existing portfolio of 221(d)(4) loans. Hundreds of millions of dollars in losses are expected in 2010 through that program alone. The broader issues of overbuilding and market weaknesses also bolster the case for changes to be made, she said.

The fear is that the agency is setting itself up for more losses over the next 24 months since it has become the predominant lender of new construction throughout the past year or so.

“Broadly, this is ensuring that FHA in the long run can be a consistent partner, and that we are strengthening FHA's balance sheet,” adds HUD Secretary Shaun Donovan. “We felt it was important from a risk management point of view to ensure that we are protecting the FHA fund and developing housing that is sustainable in the long term.”

The irony is a good portion of those troubled loans may have been made when the FHA was still a “lender of last resort,” to smaller developers for smaller properties. Since the credit crisis began, the FHA has become a lender of choice to some of the industry's biggest and most wellcapitalized firms. Some lenders now argue that those premier developers, many of whom are using the FHA for the first time, will now be penalized for the sins of a less well-heeled borrower base.

Still, since the terms of the FHA's programs are substantially better than what's available in the market, many felt it was just a matter of time before the agency tightened up.

“It's prudent for HUD to look at whether underwriting guidelines need to be modified and not just keep their eyes closed and continue lending as if we're not in a recession,” says Clay Sublett, national production manager for Cleveland-based FHA lender KeyBank Real Estate Capital. “They're still very attractive, still very good executions, and the market just needs to learn to adjust to the changing standards.”

Biggest Concerns

One of the lending community's main concerns is the “grandfathering” issue, or the impact the proposed changes will have on deals currently filtering through the pipeline. At CREF, Galante made a point of saying that the FHA is sensitive to the potential impact of deals already in process. The MBA has proposed that firm commitments issued within 120 days of the mortgagee letter should be grandfathered in under the old terms.

But perhaps of equal concern to lenders is the FHA's separate push to require increased disclosure of the fees that lenders charge their borrowers. FHA lenders make money on the origination fee and servicing, but also potentially when they go to sell the Ginnie Mae securities. If investors will pay 5.25 percent for the securities but the loan was originated at a 5 percent interest rate, then the lender can make money off that excess 25 basis point premium.

In the past, lenders were not required to disclose the pricing premium to the borrower, but that may change under a separate proposed rule. The FHA's contention is that since the programs are clearly superior to what's available elsewhere, some lenders may have been taking advantage by charging significant premiums. FHA lenders argue that there's an equal possibility that the market shifts in the other direction, and they're left holding the bag.

“The originators are saying that it can go both ways,” Sublett says. “If I'm on the right side of the trade and have profits, the FHA is upset with me. And if I'm on the wrong side of the trade, then the FHA says, ”˜well, that's just the risk of the business.'”

But the proposed changes—both in underwriting and disclosure—reflect HUD's mission to support affordable housing and not the luxury high-rises that have increasingly sought FHA funds.

“The program wasn't meant to be the market-rate construction lending arm of the U.S. government,” Melton says. “That's probably why they made small or no changes to Sec. 8 and LIHTC deals, things that really fit their primary mission.”