The only game in town for construction debt is tightening its underwriting of market-rate deals. And while borrowers aren’t happy about it, the U.S. Department of Housing and Urban Development (HUD) says it’s a matter of survival.

The Federal Housing Administration (FHA) has proposed changes to its popular Sec. 221(d)(4) program, raising the debt service coverage ratio (DSCR) to 1.20x for market-rate deals, and lowering the maximum loan-to-cost (LTC) ratio to about 83 percent.

HUD Secretary Shaun Donovan, who noted the “substantial vacancy rates” affecting the multifamily market, said the changes will be necessary to ensure the long-term viability of the program.

“Broadly, this is ensuring that the FHA, in the long run, can be a consistent partner, and that we are strengthening the FHA’s balance sheet,” Donovan says. “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.”

When the proposed changes were announced in early February, HUD representatives said the agency was concerned about the weaknesses in its existing portfolio of 221(d)(4) loans, and expected to rack up hundreds of millions of dollars in losses this year through that program alone.

Another proposed change to the (d)(4) program 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 double to 4 percent under the proposed rules. The new rules would also increase the program’s 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.”

Still, the rates and terms of the FHA’s programs are so much better than what’s otherwise available in the market that 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 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.”

Notably, the proposed changes don’t affect affordable housing deals much. Projects with subsidy levels of 95 percent or greater will still enjoy a 1.11x DSCR and 90 percent LTC, but low-income housing tax credit (LIHTC) deals would be bumped up to a minimum 1.15x and 87 percent LTC.

The changes reflect HUD’s public 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 Section 8 and LIHTC deals, the things that really fit their primary mission.”

Additional reporting by Donna Kimura