HUD 223 (f) Pros and Cons-updated

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Borrowers who never considered FHA/HUD are now being told they need a FHA/HUD 223 (f) loan.  However, most borrowers, and brokers who are selling this product, don’t understand the issues relating to these loans.   The 223 (f) is FHA/HUD’s acquisition/refinance program for conventional apartment projects.  With limited sources for apartment financing today, this program is being pushed by most mortgage brokers and bankers as the way to refinance your apartment project.

To get a complete, but very dry, description of the program visit the HUD web site at http://www.hud.gov/offices/hsg/mfh/progdesc/purchrefi223f.cfm.   The summary of this program states that “Section 223(f) insures mortgage loans to facilitate the purchase or refinancing of existing multifamily rental housing.”  So first things first, this is not an FHA/HUD loan, because HUD does not lend money, FHA provides insurance on the loan allowing the lender to sell a security to fund the loan.  So while FHA/HUD underwrites and approves the loan they do not fund it.  It’s really the original conduit loan.

FHA/HUD underwriting, loan terms and restrictions are not like conventional loans.  They look at the numbers differently and limit loans based on things other than just LTV and DSC.   Because of this you really need to deal with someone who has experience in HUD lending and knows how to process your loan.  There are many approved FHA/HUD lenders and a list can be found at the HUD web site.  Some lenders are just small shops and some are FHA/HUD departments of national or regional mortgage bankers.  As long as they are a lender who annually processes a large number of FHA/HUD multifamily loans you should be OK, but make sure they are active lenders because some approved lenders only dabble in multifamily lending and only do a few loans a year.   If you don’t know of a good FHA/HUD lender give me a call (847-421-2217).

So why is everyone pushing the 223 (f) loan.  There are two main reasons, first is that FHA/HUD is actively lending, unlike conduits and most life companies; second, and more importantly, it’s the leverage.  At a time when other lenders are cutting back on LTV levels and increasing DSC levels this program is still an 80%-85% LTV program (80% on cash out refinances and 85% on acquisitions or cash in refinances) with a minimum DSC of 1.175.   This is the only program today that can get borrowers even close to the leverage they were able to get a few years ago.  For many borrowers that is the most important factor given their loans are coming due and other lenders cannot get to their existing loan balance.

In addition to the high level of leverage these loans also offer a longer term and amortization than conventional loans.   These are 35 year fully amortizing loans with the rate fixed for the full term.  The rates are very good, but the rate calculation is a little strange.  You have a fixed rate on the amortizing basis plus an additional mortgage insurance premium (MIP) which does not amortize.  Today the full rate is approximately 5.75%, including the MIP which is favorable when compared to other lenders.  Other positive factors of the loan are that it is a fully non-recourse loan and has a more borrower friendly step-down prepayment premium vs. a 10 year yield maintenance for most other long term lenders.  The 223 (f) is available in all markets compared to loans from some lenders who only like major markets and/or limit LTVs in certain markets.

This sounds like a great loan, sign me up.  But before you sign on the dotted line there are a number of things you need to know about the loan.

The first thing that most people mention is that these loans have significant document requirements and the process is onerous.   This is a big issue when compared to traditional bank loans, but is not really that big when compared to other institutional loans.  Freddie, Fannie and other institutional lenders all have document requirements and in today’s environment even banks are getting document heavy.   While FHA/HUD is very specific on what they require and how the forms are completed that’s what you pay your lender for.  A good lender will help you manage the process and make it relatively easy.

The second issues are the costs.  FHA/HUD loans cost more than conventional loans.  The fees are higher, the upfront reserves are higher and the costs of maintaining the loan are higher.  On a 223 (f) loan you pay a loan placement fee and a financing fee instead of the typical origination fee.  This can run up to 3½% of the loan amount, but is usually between 1 1/2% and 2%, combined (unless your loan is less than $2 million where higher fees are not unusual).  In addition to this FHA collects an application fee (30 Bps) and an inspection fee ($30 per unit).    Make sure you negotiate the placement fee, this is a competitive business and if you are paying more than 2% you are probably being overcharged.

Next you must consider the reserves and escrows.  Like most loans, FHA/HUD loans require tax and insurance escrows, but HUD loans also require a replacement reserve and repair escrow.   At closing FHA/HUD requires a deposit for replacement of capital items during the loan term and monthly funding of the reserve account.  Initial funding is usually much higher than on conventional loans sometimes as high as $1,000 per unit.  You can get funds out of the account on a quarterly basis after submitting paid receipts for the work you have done.  In addition to replacement reserves you will be required to fund a repair escrow at closing for items that are identified in the engineering report as immediate repairs.

Some unique issues are the required audits and bi-annual limits on investor returns.  HUD requires all ownership entities to have an annual audit.  This usually adds about $2,500 to your annual operating costs.  While FHA/HUD does not limit the amount of return an investor can get on their investment they do limit the borrower to taking returns only twice a year, once after the audit and a second time after a certification signed by the borrower.

Finally, the biggest issue on a 223 (f) loan is the timing.   To process and close the loan it takes 3-4 months, assuming there are no issues or problems.  Your rate is not locked until after a HUD commitment which makes the rate an unknown for most of the 3-4 months.  In a stable rate environment this is not a big issue, but today is not a stable environment.   I believe there is significant risk that the rate you eventually get will be higher than today’s rate.  The overall timing of the loan and of locking rate is a month or two longer than with Freddie or Fannie.

On balance the FHA/HUD 223 (f) loan is a great loan.  It’s the best leverage with the lowest payment available today.  You may not like all the restriction, but these are not hard issues to live with.  Just make sure you know what you are getting into before you sign up for the loan.   Also, if you need leverage this is really your only option.

This article was written in late 2009.  Since then HUD has updated their program.  See out blog post http://mfloan.net/2010/07/23/hud-issues-new-rules-finally/ for more info about the changes.

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