Compared to what’s being offered in the private sector, the rates and terms of the Federal Housing Administration’s (FHA) Sec. 221(d)(4) program for new construction loans are more than attractive. Loan-to-cost ratios can reach up to 90 percent; the loan has a 40-year amortization; and the rates currently being offered are in the low-6 percent range.
Sounds great, right? Here’s the bad news: The fatality rate of new Sec. 221(d)(4) applications is now hovering at about 50 percent. So managing your expectations as you begin the loan approval process is key. The following are five tips from FHA lenders on how to navigate the process effectively and position your deal for approval.
1. HUD Doesn’t Trend Rents.
Even though new construction is inherently forward-looking, the FHA doesn’t see things that way. Many borrowers don’t realize that FHA is only concerned with the here and now when it comes to a project’s feasibility. “Many borrowers will say that two years from now, the market is going to come back,” says Phil Melton, who runs the FHA division of Charlotte, N.C.-based Grandbridge Real Estate Capital. “But HUD wants to make sure there’s a market there today, not projecting that there will be demand two years from now.”
2. Invitation Letters Are No Guarantee.
The approval process begins with a third-party market study that determines the feasibility of the project and whether there’s demand. HUD then reviews they study and, if they agree there is demand, they’ll issue an invitation letter. Unfortunately, an invitation letter guarantees little. It's more akin to entering a race where the odds are about even. In short, HUD invites more projects than it is able to fund.
“HUD will in some instances invite numerous projects in the same market, knowing that not all of them will come together,” says Clay Sublett, national production manager for Cleveland-based KeyBank Real Estate Capital. “One deal may fall apart, the other two may get their plans and specs, and then the first one in the door is going to get the nod.”
3. Don’t Wait for a Quote.
Pulling together the reports, appraisals, and environmental studies needed for a full application submission is often a race against time. While the (d)(4) program goes up to 90 percent loan-to-cost, you still need to make up that other 10 percent in the capital stack. This is a chicken or egg issue. Many borrowers want to make sure they have a loan quote before going out and raising equity, but this will not do in HUD’s estimation. The agency wants to see the equity on hand.
The same goes for having all your plans and specs in order. Some borrowers are reluctant to shell out $10,000 to do their plans and specs without knowing whether the loan will go through. But lining up all your ducks in a row will help accelerate the deal cycle time. "The more that you have all these things banked—that you own the land, you’ve got your plans and specs done, you’ve done the environmental work—the higher the probability that there’s going to be momentum,” Sublett says. “So, have your act together, and be ready to deliver.”
4. The FHA Doesn’t Negotiate.
Sometimes, there’s a gap between what borrowers request in proceeds and what the FHA is willing to do. But the FHA doesn’t think like a private lender. For instance, if you ask for a $20 million loan, and the FHA comes back with an offer of $19 million, it is what it is and there’s no room for negotiation. “HUD has absolutely no motivation to negotiate to help you make your deal,” Sublett says. “This is not the private market.”
The same goes for the possibility of speeding up the deal processing timeline. FHA lenders will do their best to push an application to the finish line, but they have limited options. The FHA runs on its own clock and the staff's bandwidth is limited with the increased demand for new construction loans that have funneled through their doors since they became, for most parts, the only game in town.
5. FHA Lenders Don’t Like Small Deals.
Many FHA lenders will tell you that the economics of making and servicing a 221(d)(4) loan preclude them from making smaller loans (i.e. anything under $2 million). Lenders basically have a three-year window for every loan: nine months to a year to get a loan closed, another 12 to 14 months to get the deal built, and up to an additional year before the deal is stabilized.
“Everybody thinks the deal closes in nine months, that you get your fee and it’s great, but you’ve got the servicing aspect behind that for two years when you do the construction monitoring and draws,” Melton says. “It’s a pretty costly execution from a corporate overhead perspective.”