1. HOME Multi-Family Rental Underwriting Workshop NCDA Winter Conference Washington, D.C. January 20, 2016

2. Trainer – Steve Gartrell- sgartrell@ncdaonline.orgsgartrell@ncdaonline.org Welcome 2

3. What HUD Wants From the PJ – Statutory & Regulatory Requirements Definition of Underwriting Terms HOME Financial Underwriting Requirements: – General Underwriting Requirements – Determining Project Costs are Reasonable Reviewing the Development Budget (Sources & Uses) Subsidy Layering Review Reviewing the Long Term Operating Costs – Determining the Level of Subsidy Agenda 3

4. WHAT HUD WANTS ( CPD NOTICES 15-11 – HOME UNDERWRITING REQUIREMENTS & 15-09 – HOME COMMITMENT REQUIREMENTS):

5. National Affordable Housing Act of 1990 (NAHA) – PJ must certify that it will not invest any more HOME funds in combination with other governmental assistance than is necessary to provide quality affordable housing that is financially viable for the period of affordability STATUTORY REQUIREMENTS 5

6. 24 CFR 92.250(b) – PJ must adopt and evaluate projects according to written underwriting and subsidy layering guidelines for all HOME activities to determine the appropriate HOME investment. §92.254(f) – PJ must adopt and follow written underwriting standards for assistance to homebuyers, including analysis of housing and family debt, monthly family expenses, assets available to acquire the housing, resources needed to sustain homeownership, including the terms of planned mortgages. Except direct homebuyer assistance not part of a project: – No Market analysis – No evaluation of developer capacity Homeowner Rehab. – above two and only if HOME loan is amortizing REGULATORY REQUIREMENTS 6

7. What HUD Wants from PJ (review CPD 15-11 – Underwriting Requirements & 15-09 - Commitment Requirements): – Screening HOME Eligibility & Requirements Meets Housing Goals – Market Risk Whether project marketable over time – Borrower Risk Assessment of developer/developer team capacity – Project Financial Risk, Feasibility and Viability Costs are Reasonable Sufficient funds to complete project – firm commitments Sufficient funds to manage property over time Underwriting for Rental MF 7

8. UNDERWRITING DEFINITIONS

9. HOME Commitment Underwriting – For Developer/owner – For Bank – For PJ Subsidy Layering Analysis Project Development Budget – Sources & Uses Operating Budget – Pro-Forma – Debt Service Coverage Ratio – “Cash on Cash” Analysis Definitions 9

10. PJs may not commit HOME funds to a project consisting of new construction or rehabilitation until: – All necessary financing is secured – A budget and production schedule is established – Underwriting and subsidy layering analysis is completed – Construction is expected to start within 12 months See CPD-15-09, Attachment A – Commitment Checklist HOME Commitment (§92.2 & CPD 15-09) Slide 10

11. Underwriting for Developer: – Creates Development Budget – Determines all costs to produce project Determines Sources to cover these costs – Creates Operating Pro-Forma Projects long-term costs to manage & operate project Projects long-term sources of income to cover costs (and make a profit or return on investment) Underwriting for Rental MF 11

12. Underwriting for Banker: Reviews – Development Budget – Operating Pro-Forma To determine whether requested debt can/should be provided Underwriting for Rental MF 12

13. HUD – “PJs are encouraged to undertake sustainable underwriting—that is, underwriting that is based on realistic financial projections to minimize risks and enhance the project’s long-term success.” Underwriting for Rental MF 13

14. Subsidy Layering Analysis PJ Looks at project financing to: – Ensure appropriate HOME subsidy Is based on need in Con Plan Is reasonable to the project – Make sound investments over long term Underinvestment cannot sustain unexpected costs – Higher risk of failure Overinvestment uses more public funds than are needed – Developer windfall Protects against duplication from multiple public sources Essentially is basic underwriting Slide 14

15. SourcesUses Equity$163,920Acquisition$250,000 Private Loan$250,000Design Services$50,000 Public Loan$100,000Legal Fees$25,000 CDBG$324,000Other Soft Costs$25,000 HOME$800,000Demolition$50,000 Site Improvements$24,000 Construction$1,000,000 Developer’s Fee$113,920 Total Sources$1,537,920Total Uses$1,537,920 TDC/Unit$192,240 Project Development Budget (Sources & Uses - Simplified) 15

16. Project Development Budget (Sources & Uses - Simplified) 16 Sources & Uses must include: – All Sources (both private and public) of funds with dollar amount(s) and timing of availability for each source, and – All Uses of funds (for example acquisition costs, site preparation and infrastructure costs, rehabilitation/or construction costs, financing costs, professional fees, developer fees and other soft costs) associated with the project. – See CPD 15-11 for details

17. Operating Budget (Year 1) 17 Simplified Operating Budget Gross Potential Rent$180,000.00 Rent Loss (7%)-$12,600.00 Other Income$1,800.00 Effective Gross Income (EGI)$169,200.00 Marketing$3,000.00 Payroll$45,000.00 Property Admin. & Mgmt$10,152.00 Utilities$6,000.00 Security$4,500.00 Maintenance$9,750.00 Taxes$15,000.00 Insurance$6,000.00 Reserves for Replacement$12,000.00 Operating Costs$111,402.00 Net Operating Income (NOI=EGI-Costs)$57,798.00 Debt. Service-$50,259.00 Cash Flow$7,539.00

18. Operating Budget Proforma (Years 1 – 5 of 20) 18 Year 1Year 2Year 3Year 4Year 5 Effective Gross Income (EGI) = 1% Increase/year $169,200$170,892$172,601$174,327$176,070 Operating Costs - 3% Increase/year-$111,402-$114,744-$118,186-$121,732-$125,384 Net Operating Income$57,798$56,148$54,415$52,595$50,686 Debt. Service-$50,259 Cash Flow$7,539$5,889$4,156$2,336$427

19. Debt Service Coverage Ratio Analysis 19 Debt Service Coverage Ratio [s/b 1.11 (aff.) to 1.4 -2.0 (mkt.) ] Year 1Year 2Year 3Year 4Year 5 Effective Gross Income (EGI) = 1% Inc. $169,200$170,892$172,601$174,327$176,070 Operating Costs - 3% Inc.-$111,402-$114,744-$118,186-$121,732-$125,384 Net Operating Income$57,798$56,148$54,415$52,595$50,686 Debt. Service-$50,259 Cash Flow$7,539$5,889$4,156$2,336$427 Debt. Service Coverage Ratio1.151.121.081.051.01 DSCR = Net Operating Income / Total Debt Service

20. Cash Flow as a % of Operating Costs & Debt Service 20

21. Used to help determine how much equity (owner/developer’s own money) should be in project – Annual Cash Flow  Equity = X% Cash on Cash Return – Example: ($10,000 Cash Flow  $100,000 Equity) = 10% cash-on-cash return – Higher for for-profit developers, lower for non-profits – HUD to develop standards “Cash on Cash” Analysis 21

22. HOME FINANCIAL UNDERWRITING GENERAL REQUIREMENTS

23. But First -- HOME Timing Requirements 23 Specific HOME timing requirements: – Construction or demolition must be started within 12monts; Acquisition of housing within six months of agreement – Completed within 4 years of contract & – Complete project in IDIS w/in 120 days of final draw – Rental units not occupied: w/in 6 months – report to HUD status & marketing efforts w/in 18 months must repay HOME funds – Homebuyer units not sold in 9 months become rental units

24. PJs must ensure long-term sustainable projects by establishing guidelines for: – Subsidy layering and underwriting assessment – Market assessment – Assessing developer qualifications, experience & financial capacity – Verifying that there are firm financial commitments Applies to rental projects and homebuyer development projects (some exceptions) Analysis must be done prior to funding commitment Certify compliance in IDIS at project set-up HOME Underwriting & Subsidy Layering – PJs to Establish Guidelines - §92.250 Slide 24

25. Additionally Subsidy Layering & Underwriting Guidelines must: – Ensure amount of HOME funds invested no more than necessary to provide quality, financially viable affordable housing – Determine reasonable level of profit/return to owner/developer for size, type, complexity of project – Examine Sources and Uses & Operating Proforma for cost reasonableness – Verify financial commitments are firm HOME Subsidy Layering & Underwriting Guidelines §92.250 (b) Slide 25

26. Determine whether Sufficient funds to complete project – Review Development Budget - Sources & Uses Determine whether Sufficient funds to manage property over time – Review Operating Budget Pro-Forma Debt Service Coverage Ratio Analysis Cash on Cash Analysis Use both to determine the level of subsidy needed to complete the project Project Financial Risk, Feasibility and Viability 26

27. DEVELOPMENT BUDGET (SOURCES & USES)

28. SourcesUses Equity$163,920Acquisition$250,000 Private Loan$250,000Design Services$50,000 Public Loan$100,000Legal Fees$25,000 CDBG$324,000Other Soft Costs$25,000 HOME$800,000Demolition$50,000 Site Improvements$24,000 Construction$1,000,000 Developer’s Fee$113,920 Total Sources$1,537,920Total Uses$1,537,920 TDC/Unit$192,240 Development Costs Sources & Uses (Simplified) 28

29. Verify that all sources are committed Funding Sufficient to complete project Timing of availability is appropriate to need Are other funds compatible with HOME? Reviewing Sources of Funds 29

30. Reviewing Development Costs PJ must determine that: – All costs are necessary, and reasonable (2CFR Part 200) Cost of comparable projects in same area Qualifications of cost estimators Comparable with industry standard cost indexes – Proposed costs are sufficient to achieve all program requirements, for at least the affordability period including: All HOME Requirements (including Property and Rent standards) Cross Cutting Federal Requirements – Supporting documentation (see CPD 15-11) Slide 30

31. OPERATING COSTS REVIEW FOR RENTAL PROJECTS

32. Rental Projects Operating Budget At minimum should cover: – Projected income and vacancies – Operating expenses – Contributions to reserves – Debt service – Cash flow and payments of deferred fees Slide 32

33. Slide33

34. Operating Budget Expenses – Summary All cash expenses should be shown Reflect: – Type and location of project – Number of units – Physical characteristics of property – Cost environment for this project Trend expenses realistically given history – Always higher than income growth Look at comparable properties – Some PJs keep database Slide 34

35. Operating Budget Reserves for Replacements Deposits for future capital expenditures PJs have often used standard rule of thumb – Better to do property-specific capital needs assessment – §92.251(b)(1): Capital Needs Assessment required when rehabbing projects with 26 or more total units Research shows wide range of capital needs with average of $650 per unit per year Slide 35

36. Evaluating the Operating Pro- forma Ensure: – Income is sufficient to cover expenses and debt service for all years of affordability period – Expense cushion does not drop below threshold during affordability period – Adequate positive cash flow each year Slide 36

37. Evaluating the Operating Pro- forma (cont) Are rent assumptions realistic? – Most HOME rents only grow by 1-3% annually – Market rents should be based on comparable history – Vacancy estimated at no lower than 5% Are expense assumptions realistic? – Base on comparable properties – Controllable vs. Non-Controllable Expenses – Expenses should always trend higher than income DSCR useful for evaluation – Recent HOME rent study found that PJs underestimate expense increases Slide 37

38. Operating Budget Proforma (Years 1 – 5 of 20) 38 Year 1Year 2Year 3Year 4Year 5 Effective Gross Income (EGI) = 1% Increase/year $169,200$170,892$172,601$174,327$176,070 Operating Costs - 3% Increase/year-$111,402-$114,744-$118,186-$121,732-$125,384 Net Operating Income$57,798$56,148$54,415$52,595$50,686 Debt. Service-$50,259 Cash Flow$7,539$5,889$4,156$2,336$427

39. Cash Flow Analysis 39 Debt Service Coverage Ratio [s/b 1.11 (aff.) to 1.4 -2.0 (mkt.) ] Year 1Year 2Year 3Year 4Year 5 Effective Gross Income (EGI) = 1% Increase/year $169,200$170,892$172,601$174,327$176,070 Operating Costs - 3% Inc./year-$111,402-$114,744-$118,186-$121,732-$125,384 Net Operating Income$57,798$56,148$54,415$52,595$50,686 Debt. Service-$50,259 Cash Flow$7,539$5,889$4,156$2,336$427 Debt. Service Coverage Ratio1.151.121.081.051.01 Cash Flow as % of OC + DS 4.66%3.57%2.47%1.36%0.24% DSCR = Net Operating Income / Total Debt Service

40. Cash Flow Goal: Positive Cash Flow over Life of Project – Means that expenses can be covered with cushion – Provides Owner with income Remaining cash (if distributable) after payment of debt service Analyze using both DSCR review & CF as % of Costs + DS Analyze Equity Investment -“Cash-on-cash” return to measure – Annual Cash Flow  Equity = X% – Example: ($10,000 Cash Flow  $100,000 Equity) = 10% cash-on-cash return Since cash flow changes over time, average over the affordability period Slide 40

41. Developers Can and Should Make Money Many sources of potential $$ – Developer Fees – Property Management Fees – Appreciation and other equity increases – Net cash flow Compare returns to other similar investment Appropriate level of return depends on: – Project risk – Returns available elsewhere OK for non-profit developers to earn revenue Slide 41

42. PUTTING IT ALL TOGETHER - DETERMINING LEVEL OF SUBSIDY

43. SUBSIDY LAYERING

44. Subsidy Layering Requirements HOME Final Rule at 92.250(b) – Always been required (including having SL Policy) CPD Notice 98-01 provides guidance PJ must establish written guidelines Carry out prior to committing $$$ to project Certify in Consolidated Plan and in IDIS (together with Underwriting) Slide 44

45. What is Subsidy Layering? Looking at project financing to: – Ensure appropriate HOME subsidy – Make sound investments over long term – Accurately project income and expenses Essentially is basic underwriting Slide 45

46. When To Do Subsidy Layering Required for all projects using HOME funds – Not replaced by new underwriting requirements – document both All projects: – Includes multifamily AND single-family projects Other governmental assistance defined broadly: – Any direct or indirect assistance – Federal, State or local (can sometimes use their SL analysis) – Includes  Loan  Grant  Guarantee  Insurance  Payment  Rebate  Subsidy  Credit  Tax benefit Slide 46

47. Basics of Subsidy Subsidy is determined by measuring the gap in funds needed to undertake the project and for the project to meet the long term requirements. Market project must support itself – revenue must cover all expenses, reserves and debt coverage Affordable project has lower revenue, so it can’t cover same debt and will need a subsidy to get it built Projects unable to cover operating expenses will also need operating assistance not eligible under HOME (but can reduce debt upfront reducing debt burden) PJ is liable for HOME investment based on the project successfully completing the entire affordability period. Slide 47

48. Determination of Subsidy PJ, in determining that no more public subsidy than necessary goes into project, should encourage: – Maximum equity (that developer can afford) – Maximum loan with the lowest debt service (that cash flow can cover) Review Interest Rate and Term Slide 48

49. Determination of Subsidy How Long-Term Operating Costs help Determine Subsidy – Based primarily on capacity of project to earn revenue in excess of expenses and thus carry debt – To analyze rental subsidy PJ must evaluate long term operating budget and assumptions such as escalation of rents, expenses along with vacancy rate as well as the development budget Slide 49

50. Determine - Debt Service Coverage Ratio (DSCR) – The measure of the cash flow available to pay current debt obligations plus provide owner income. – DSCR = Net Operating Income / Total Debt Service. – DSCRs should range from a minimum of: Affordable – 1.11 Market – 1.4 + – Less than these amounts means they don’t have sufficient income to pay debts – Much more than these means they should take on more debt (and get less subsidy) How Much Debt? 50

51. How Much Debt? (1 st Determine Debt Service Amount) Slide 51 DSCR = Net Operating Income / Total Debt Service DSCR= $45,000/$40,000 = 1.125 To determine amount avail. for debt service NOI / desired DSCR = Amt. for DS $45,000/1.125=$40,000

52. How Much Debt? (Next Determine Loan Amount) Slide 52 1.Operating Budget can afford $40,000/year in Debt Service 2.Determine Best Interest Rate (7%)for Loan Period (e.g. 20 Years) 3.Determine Loan that Debt Service can carry at that Interest Rate/Loan Period

53. To Determine Debt (If Cash Flow Insufficient) Slide 53 1.Get Better Interest Rate 2.Longer Term Loan 3.Increase Equity 4.Increase outside contributions 5.Increase Subsidy

54. Summary - Underwriting Process Evaluate proposal and adjust all components for realism and accuracy – Don’t forget eligibility! Apply appropriate cushions and controls Apply HOME limits & do cost allocation Negotiate Apply the subsidy (if appropriate) or reject Later changes in scope or budget may require Underwriting/Subsidy Layering update & approval Slide 54

55. HUD Exchange - HOME & CDBG sites – https://www.hudexchange.info/programs/home/ https://www.hudexchange.info/programs/home/ – https://www.hudexchange.info/programs/cdbg- entitlement/ https://www.hudexchange.info/programs/cdbg- entitlement/ Single Family Webinar HOME 2012 Requirements – https://www.hudexchange.info/resource/2456/home- fy12-appropriations-developer-capacity-homebuyer- projects-webinar/ https://www.hudexchange.info/resource/2456/home- fy12-appropriations-developer-capacity-homebuyer- projects-webinar/ Multi-Family Webinar HOME 2012 Requirements – https://www.hudexchange.info/resource/2457/home- fy12-appropriations-underwriting-rental-projects-webinar/ https://www.hudexchange.info/resource/2457/home- fy12-appropriations-underwriting-rental-projects-webinar/ Resources 55

56. Upcoming guidance, tools, etc. – Underwriting notice – CPD 15-11 Revises the former subsidy layering notice 98-01 – Cost allocation notice Revises the former notice 98-02 – Other training and TA products related to underwriting Sign up for HUDExchange mailing list, e.g., indicate HOME as an interest area: https://www.hudexchange.info/mailinglist/ https://www.hudexchange.info/mailinglist/ Resources (cont) 56