The HUD 223(f) multifamily loan is a pretty special product. In certain ways, it is more competitive and advantageous to the borrower than any other commercial loan available on the market. Today we'll discuss the advantages and disadvantages of these loans.
1. High Loan to Value Ratio (LTV)
The first advantage of the HUD 223f loan is the LTV, or the loan-to-value ratio. For market rate properties in the HUD loan, it can go up to as high as 83%, or even higher in the case of affordable housing or subsidized housing. Properties of Section 8 or Section 202 can get as much as 90% on their LTV.
2. Low Debt Service Coverage Ratio (DSCR)
The next advantage is the debt service coverage ratio requirement. The HUD loan is set at a
very generous minimum, and for market rate properties the DSCR can be as low as 1.18x relative to the net income. Affordable housing and subsidized housing can have debt service coverage ratios as low as 1.15x or even 1.11x for Section 8 or Section 202.
3. Low Fixed Interest Rate
The HUD rate is typically lower than other agency loans or conventional loans, sometimes by as much as a full percentage point. Obviously, the lower interest rate means lower payments and more cash flow to the investor.
4. Extended Term & Amortization
The amortization on the HUD multifamily loan can be as far as 35 years, and that is atypical compared to other loans on the market. Most standard loans are 25 to 30 years, but with a 35 year amortization, that extends the amount of time that the principal needs to be repaid. When you combine that with the lower interest rate, the longer amortization creates significantly lower monthly payments than other loan products.
5. Non-Recourse Loans
The HUD loans are non-recourse loans, which means that the borrower does not have to personally guarantee the loan, and it doesn't show up on their balance sheet as a contingent liability.
6. Fully Assumable
The HUD loan is also fully assumable, meaning that if the borrower decides down the road that they want to sell the property, it is possible that the new buyer could come in and assume the existing loan at the same rate and terms for the remaining life of the loan. This could be a huge competitive advantage in the market if interest rates rise significantly. If the property has a long-term fixed-rate low interest rate HUD loan on it that can be assumed, then the property might be more desirable to buy relative to other properties that are on the market.
7. No Geographic Restrictions
The HUD loan has no geographic restrictions -- it can be applied to multifamily properties anywhere in the United States and the U.S. territories. There are no population requirements. Unlike other agency and conventional loans, and certain lenders who won't go into rural markets or small markets, the HUD loan can be obtained on a multifamily property anywhere in the U.S. or territories.
8. Additional Funds/Cash-Out
The HUD allows for additional funds to be taken out, so if there are capital projects or major systems that have deferred maintenance, the HUD loan can accommodate that by adding additional funds to the loan that are specifically used to improve the property.
9. Prepayment Penalty
The prepayment penalty on the HUD loan is predictable. Typically it's a ten-year prepayment penalty, as opposed to a yield maintenance or a defeasance prepayment penalty, which is subject to change due to market interest rates. The HUD prepayment penalty is predictable and therefore can be analyzed in advance. The HUD loan also allows for supplemental financing, so in an event that the borrower wanted to expand the property or do some major improvements to the property, there are additional loans that can be taken out to be joined. Basically a second that can be joined with the original HUD loan -- and HUD allows this -- so that properties may be further developed down the road. Not all other loans allow for secondary financing.
As you can see, the HUD loan has quite a few advantages relative to other loans on the market. Now, let's talk about the disadvantages.
1. Documentation Requirements
Because this is a government guaranteed loan, the documentation requirements are pretty significant, and that can be an arduous process. Having to go and collect and compile all of the information that HUD requires in order to originate this loan can be really frustrating for some borrowers, especially if they're not organized, or maybe they're self-managing and they don't have advanced reporting systems or all of their financials in place. Typically a good commercial mortgage broker (like Evergreen Capital!) can help with that process, and reduce the frustration that the borrower may incur by originating the HUD loan.
Typically it takes several months just to complete the package for formal application, and once formal application is made it's usually about five or six months before the loan is approved and funded. The whole process can take eight or nine months or even longer from beginning to end before the loan actually funds and closes.
The origination costs on the HUD loan and the ongoing costs are a little bit higher. Typically you would pay a financing fee and a placement fee, which is effectively the origination fee, but that can add up to 1.5-2.5%. Additionally, HUD requires initial mortgage insurance premium payments, and then there are a variety of other costs that the borrower must incur in advance or during the application process -- such as inspection fees, legal fees and other
costs -- that can add up. Make no mistake, the HUD loan is more expensive to originate on the front end, but the longer amortization and the lower interest rate and the lower payments typically make up for that additional cost pretty quickly.
4. Mortgage Insurance
The HUD loan requires mortgage insurance to be paid both upfront and each month throughout the life of the loan, regardless of the loan-to-value ratio.
5. Property Inspections
HUD requires property inspections both at origination and annually. HUD can come out once or twice a year to inspect the property; obviously this takes time and resources from the owner, and of course they do an initial inspection prior to closing. Now, some owners that I've worked with in the past who do a great job of maintaining their properties don't see the HUD inspectors very often -- sometimes they don't even come out every year. But certainly properties that have more deferred maintenance or aging systems should expect a formal HUD inspection of the property each year.
6. Audited Financials
HUD requires audited financials to be submitted every year. As opposed to just submitting the borrower's own financials, they must be submitted to a tax or finance professional for audit before being submitted to HUD. This process usually costs between $2,000-3,000 and is something that needs to be factored in to the operating costs of the property going forward while the HUD loan is in place. Now this may seem like a disadvantage; however, owners should note that audited financials reduce their risk of any sort of misappropriation of funds or anything going wrong with the bookkeeping. There's a certain peace of mind that comes with having your financials audited every year.
7. Replacement Reserves
HUD also requires replacement reserves to be set aside at closing. This is in addition to tax and insurance escrows, but HUD will require an initial deposit into the replacement reserve account and usually an ongoing deposit into that account, especially in the case of distressed properties or properties that have a lot of deferred maintenance or capital needs. These reserves can be as little as $250 per unit per year, but in the case of properties that need more work it can be as much as $1,000 per unit per year or even higher. The age and condition of the property will affect the amount of replacement reserves that HUD requires both at closing and annually ongoing.
8. Cash-Out Restrictions
The borrower can usually take up to 80% or higher on their loaned value, but typically if they're getting cash out back to them at closing, that cash needs to be earmarked for capital projects or other items that are being used to improve the property. Often HUD will require that those funds be held back until that work is done.
9. Owner Distributions
HUD only allows two owner distributions per year -- once after the annual audited financials have been submitted, and then one other time during the year. Borrowers cannot take monthly distributions or quarterly distributions; they can only be semi-annually. That's just for the net cash flow and does not apply to capital projects or other needs. Owners can certainly request that they draw funds that are going to be used on the property at any time, but typically owner distributions are limited to twice per year.
When is the HUD 223(f) loan the best option for a borrower? Although the upfront costs and documentation can be a bit arduous, the advantages (especially long-term) certainly outweigh the disadvantages -- particularly from a cash flow perspective and from an investor's IRR perspective.
Give us a call at (503) 704-4999 or email firstname.lastname@example.org to find out if the HUD loan is the best option for you.