Jeff Gray thought his project was a homerun.

He wanted to build a workforce deal amid luxury apartments in the shadows of a Houston employment engine—The Texas Medical Center. And, he had a REIT, Houston-based Camden Property Trust, as a sponsor. But when the market turned in 2007, he put on the brakes. Then, seeing great demand potential for 2012 and beyond, Gray revisited doing the deal under the FHA 221(d)(4) program in 2009.

"We thought why don’t we try (d)(4) at a much more modest leverage than it calls for,” says Gray, founder and president of  Houston-based Gracyco. “We were going to do a much more conventional loan—25 percent of the total cost of capital and a 1.3 debt service coverage ratio (DSCR).”

So, last fall, with what Gray characterized as encouragement from the FHA, he submitted his application. And, two weeks ago, he received an answer. No.

“It basically said that in spite of the fact that my sponsorship was outstanding with Camden, and I was at a leverage point that they never see, I was denied,” he says. “It tripped a signal to me that although the program might still be alive on paper, in any practical application, it was dead.”

While HUD disagrees with Gray’s assertion that the (d)(4) program is dead, it has become much harder to secure an FHA construction loan. Don't believe that? Ask Steve Brady, senior vice president for Evanston Financial Corp., a lender based in Raleigh, N.C. Brady has been doing FHA loans for the past 18 years but hadn't recieved a rejection letter until the past few weeks. He's now received a total of three. "We're seeing the rejection notices come in more frequently," he says.

In fact, the fatality rate on new 221(d)(4) applications is around 43 percent. The agency is giving much more scrutiny to market studies to determine whether it has an appetite for a project, according to FHA lenders. But the agency is also changing its underwriting standards on 221(d)(4) loans, making it tougher for market-rate developers to procure the funds.

“These changes are in response to changes in real estate and financing markets and are intended to mitigate the department’s risk, while ensuring the continued availability of FHA financing,” says Lemar C. Wooley, a spokesperson for HUD. “Given the tremendous demand for FHA products, the new requirements are not expected to cause a decline in volume of new loans insured.”

The Slowdown

The increased scrutiny, combined with an overworked, understaffed agency—the FHA’s volume is up 450 percent this fiscal year to reach its highest point in the past decade— has conspired to slow things down considerably. “HUD has always had a great financing product and a terrible delivery system,” says Tom Booher, who leads the multifamily platform for Pittsburgh-based PNC Real Estate, which originated $639 million in FHA debt last year. “Unfortunately, its delivery process is even more problematic at the moment given that their product is so attractive. They’re just completely constipated at the moment.”

Developers have noticed this as well. KWA Construction, a builder out of Addison, Texas, has used the (d)(4) program in the past, starting a project in Ft. Worth, Texas, last December. KWA is also working with another owner on getting a tax credit deal in South Dallas through the program. Both of those deals took longer than expected. And one deal, a senior housing development in Plano, Texas, is still in limbo.

Likewise, Birmingham, Ala.-based Doster Construction Co. will submit one application in May and is working on seven additional deals with other lenders and developers that are waiting on invitations. John Rooney, business development manager at Doster, attributes the backlog to "too many developers chasing the same markets, or markets that are overbuilt and have no room for added capacity in the near term.” 

“HUD has become overburdened with too many developments that lack the proper team members, architects, and general contractors with limited or no multifamily experience,” he says. “Lastly, the financial capacity of many of the developers is inadequate.”

But part of the problem with FHA rests with HUD’s dysfunctional family tree. Lenders have complained for years about the inconsistency between HUD’s different regional offices—some of them impose slightly different processes and requirements. And now that the agency is on the verge of changing the underwriting standards on (d)(4) loans for the first time in decades, that disconnect has grown worse.

“There are some offices who have jumped the gun and been imposing these requirements on their own,” Booher say. “It’s my understanding that the central office will be telling those offices that those are not the current requirements yet.”


The Changes

Developers applying for 221(d)(4) deals won’t just have to deal with lag time anymore. They’ll have to deal with stricter standards in the future. The program has always offered some of the most generous loan terms in the industry, such as a 1.11x DSCR and 90 percent loan-to-cost (LTC). 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.

LTC ratios would also be adjusted under the new rules. Projects with rental assistance 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’s 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.

If HUD tightens the reins on 221(d)(4), where will development financing come from? Sure, some banks are putting their toes back in the market, but it’s probably not enough to meet the demand required in the next few years.

“A lot of the development activity was with regional and local banks,” says Doug Bibby, president of the National Multi Housing Council. “They’re still working their way through their own balance sheet issues. Until that point where they can feel more comfortable, I don’t think we’ll see a flood of construction lending. Without FHA, everything would stop.”