    Multifamily Housing: Effects of HUD's Portfolio Reengineering Proposal
    (Chapter Report, 11/01/96, GAO/RCED-97-7).

    GAO reviewed the Department of Housing and Urban Development's (HUD)
    proposals to reengineer its portfolio of insured Section 8 multifamily
    rental housing properties, focusing on the: (1) problems affecting the
    properties in the HUD insured Section 8 portfolio and HUD plans for
    addressing them; (2) results and reasonableness of a study performed by
    Ernst & Young to assess the effects of the HUD proposal on the
    portfolio's properties; and (3) key issues facing Congress in assessing
    the HUD proposal.

    GAO found that: (1) the HUD insured Section 8 portfolio suffers from
    high subsidy costs, high exposure to insurance loss, and the poor
    physical condition of some properties; (2) under the HUD mark-to-market
    proposal, property owners would set rents at market levels, and HUD
    would reduce mortgages as necessary to achieve positive cash flows,
    terminate Federal Housing Administration (FHA) mortgage insurance, and
    replace Section 8 project-based rental subsidies with portable
    tenant-based subsidies; (3) the Ernst & Young study concluded that under
    the reengineering proposal, about 80 percent of the properties would
    need to have their mortgages reduced to some degree and that between 22
    and 29 percent of the properties would have difficulty sustaining
    operations even if their mortgages were totally written off; (4) the
    study data indicated that the cost to the government of writing down
    mortgages and addressing deferred maintenance needs at reengineered
    properties would be high; (5) based on Ernst & Young's assumptions, FHA
    insurance fund claims would be between $6 billion and $7 billion in
    present value over the next 10 years and subsidy costs would be
    comparable to the existing program's subsidy costs if all of the
    properties were reengineered when their Section 8 contracts expire; and
    (6) Ernst & Young's financial model was generally reasonable, but some
    assumptions about the properties' deferred maintenance needs were
    questionable and some financing assumptions may not reflect the way in
    which insured Section 8 properties would actually be affected by
    portfolio reengineering.

    --------------------------- Indexing Terms -----------------------------

     REPORTNUM:  RCED-97-7
         TITLE:  Multifamily Housing: Effects of HUD's Portfolio
                 Reengineering Proposal
          DATE:  11/01/96
       SUBJECT:  Housing programs
                 Rent subsidies
                 Mortgage protection insurance
                 Cost control
                 Housing repairs
                 Insurance losses
                 Reengineering (management)
                 Rental rates
                 Disadvantaged persons
                 Rental housing
    IDENTIFIER:  HUD Section 8 Portfolio Reengineering Program
                 HUD Insured Section 8 Multifamily Rental Housing Portfolio
                 Federal Housing Insurance Fund
                 HUD Mark to Market Program
                 HUD Section 8 Loan Management Set-Aside Program
                 HUD Section 8 New Housing Construction Program
                 HUD Section 8 Substantial Rehabilitation Program
                 FHA Multifamily Loan Insurance Program

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    Cover
    ================================================================ COVER

    Report to Congressional Committees

    November 1996

    MULTIFAMILY HOUSING - EFFECTS OF
    HUD'S PORTFOLIO REENGINEERING
    PROPOSAL

    GAO/RCED-97-7

    Effects of Portfolio Reengineering

    (385496)

    Abbreviations
    =============================================================== ABBREV

      DSCR - Debt service coverage ratio
      FHA - Federal Housing Administration
      GAO - General Accounting Office
      HFAs - Housing Finance Agencies
      HUD - Department of Housing and Urban Development
      IREM - Institute of Real Estate Management
      LTV - loan-to-value
      OIG - Office of Inspector General

    Letter
    =============================================================== LETTER

    B-274000

    November 1, 1996

    The Honorable Alfonse M.  D'Amato
    Chairman
    The Honorable Paul S.  Sarbanes
    Ranking Minority Member
    Committee on Banking, Housing
     and Urban Affairs
    United States Senate

    The Honorable Jim Leach
    Chairman
    The Honorable Henry B.  Gonzalez
    Ranking Minority Member
    Committee on Banking
     and Financial Services
    House of Representatives

    This report presents the results of our review of proposals by the
    Department of Housing and Urban Development (HUD) to reengineer its
    portfolio of insured Section 8 multifamily rental housing properties.
    We are providing the report to you because you are responsible for
    authorizing housing programs and overseeing HUD's activities.

    We are sending copies of this report to congressional committees and
    subcommittees interested in housing, the Secretary of Housing and
    Urban Development, and other interested parties.  We will make copies
    available to others upon request.

    If you or your staff have any questions about this report, please
    call me at (202) 512-7631.  Major contributors to this report are
    listed in appendix VII.

    Judy A.  England-Joseph
    Director, Housing and Community
     Development Issues

    EXECUTIVE SUMMARY
    ============================================================ Chapter 0

       PURPOSE
    ---------------------------------------------------------- Chapter 0:1

    About 8,600 privately owned multifamily properties with federally
    insured mortgages totaling $17.8 billion receive federal rental
    subsidies for some or all of their apartments under HUD's Section 8
    program.  For subsidized apartments, HUD pays the difference between
    the rent and 30 percent of the household's income.  The rents at many
    properties exceed market levels, resulting in high subsidies.  To
    reduce these costs and address other problems, HUD has proposed to
    adjust the rents to market levels and write down the mortgages as
    needed to allow the properties to operate at market rents.  In
    essence, HUD's proposal recognizes a reality that has existed for
    some time, namely, that many of the properties in the insured Section
    8 portfolio are worth far less than their mortgages suggest.

    To assist the Congress in evaluating HUD's proposal, this report
    examines the (1) problems affecting the properties in HUD's insured
    Section 8 portfolio and HUD's plans for addressing them, (2) results
    and reasonableness of a study performed by Ernst & Young LLP to
    assess the effects of HUD's proposal on the properties in the
    portfolio, and (3) key issues facing the Congress in assessing HUD's
    proposal.  In addition, appendix I discusses the characteristics of,
    and the effects of HUD's proposal on, 10 of the properties included
    in Ernst & Young's study, which GAO independently reviewed.

       BACKGROUND
    ---------------------------------------------------------- Chapter 0:2

    Mortgage insurance provided by HUD's Federal Housing Administration
    (FHA) protects commercial lenders from financial losses stemming from
    borrowers' defaults.  When a default occurs on an insured loan, a
    lender may "assign" the mortgage to HUD and receive payment for an
    insurance claim from FHA's insurance fund.  HUD's Section 8 program
    provides rental subsidies for low-income families.  These subsidies
    are linked to either the apartment (project-based) or the resident
    (tenant-based).

    The insured Section 8 portfolio--the subject of HUD's
    proposal--consists of 8,636 properties containing just under 859,000
    apartments.  These properties are insured by FHA and receive
    project-based Section 8 assistance, much of which was provided under
    long-term contracts executed in the 1970s.  The properties provide
    housing for a diverse population, including families, single adults,
    elderly persons, and disabled residents.  HUD estimates that the
    contracts for buildings containing about 69 percent of the
    portfolio's apartments will expire by the end of the year 2000.

    To obtain information about how its proposal would affect properties
    in its portfolio, HUD hired Ernst & Young LLP to study a randomly
    selected sample of 558 properties.  GAO selected 10 of the properties
    included in Ernst & Young's study as case studies and hired three
    licensed real estate appraisal firms to help assess the effects of
    HUD's proposal on them.  While Ernst & Young's findings can be
    applied to the entire insured Section 8 portfolio, the results of
    GAO's case studies cannot be generalized.

       RESULTS IN BRIEF
    ---------------------------------------------------------- Chapter 0:3

    HUD's insured Section 8 portfolio suffers from three basic
    problems--high subsidy costs, high exposure to insurance loss, and
    the poor physical condition of some properties.  To correct these
    problems, HUD introduced a "mark-to-market" proposal in 1995.  Under
    this proposal, property owners would set rents at market levels and
    HUD would reduce mortgages as necessary to achieve positive cash
    flows, terminate FHA's mortgage insurance, and replace project-based
    Section 8 subsidies with portable tenant-based subsidies.  In April
    1996, one month before Ernst & Young completed its study, HUD renamed
    the proposal "portfolio reengineering" and modified it in several
    ways in response to concerns raised by industry officials and
    resident groups about various issues, such as the elimination of
    project-based subsidies and the termination of FHA insurance.  Under
    HUD's modified proposal, state and local governments would decide
    whether to continue Section 8 project-based rental subsidies at
    individual properties and owners could apply for FHA insurance on the
    newly restructured loans.

    In May 1996 Ernst & Young reported on the results of its study
    analyzing the effects of HUD's original mark-to-market proposal on
    insured Section 8 properties.  Ernst & Young determined that if the
    insured Section 8 portfolio were reengineered, about 80 percent of
    the properties--with a current estimated unpaid principal balance
    ranging from $12.6 billion to $14.5 billion--would need to have their
    mortgages reduced to some degree.  Furthermore, between 22 and 29
    percent of the properties would have difficulty sustaining operations
    even if their mortgages were totally written off.  GAO's analysis of
    Ernst & Young's data indicates that the cost to the government of
    writing down mortgages and addressing deferred maintenance needs at
    reengineered properties would be high.  Using Ernst & Young's
    assumptions, GAO estimated that reengineering costs would generate
    claims of between $6 billion and $7 billion (in present value terms)
    against FHA's insurance fund over the next 10 years.  Furthermore,
    Ernst & Young's data indicate that although portfolio reengineering
    would eventually reduce the Section 8 program's subsidy costs, the
    subsidy costs over the next 10 years would be comparable to the costs
    of the current program if all of the properties were reengineered
    when their current Section 8 contracts expire.  The program's subsidy
    costs would not decline immediately because the contracts for
    properties with below-market rents will generally expire earlier
    during the 10-year period than the contracts for properties with
    above-market rents.  GAO believes that the financial model Ernst &
    Young used in the study provides a generally reasonable framework for
    studying the results of portfolio reengineering.  However, GAO
    questions some of Ernst & Young's assumptions about the properties'
    deferred maintenance needs.  In addition, some of the financing
    assumptions used in the financial model may not reflect the way in
    which insured Section 8 properties would actually be affected by
    portfolio reengineering.

    The Congress faces a number of key issues in considering HUD's
    portfolio reengineering proposal.  These include (1) whether FHA
    should insure restructured loans and, if so, under what conditions;
    (2) whether HUD should continue to offer project-based assistance,
    convert entirely to tenant-based assistance, or use some mix of the
    two subsidy types; (3) what kind of protection HUD should provide for
    current residents if it converts to tenant-based assistance; and (4)
    who should pay for needed repairs to HUD's properties and how much.

       PRINCIPAL FINDINGS
    ---------------------------------------------------------- Chapter 0:4

          PROBLEMS AFFECTING THE
          PORTFOLIO AND HUD'S PLANS
          FOR ADDRESSING THEM
    -------------------------------------------------------- Chapter 0:4.1

    The high costs of subsidies for insured Section 8 properties stem, in
    part, from incentives such as above-market rents, introduced in the
    1970s to encourage the production or maintenance of affordable
    housing.  As the long-term contracts providing these subsidies
    expire, HUD's annual Section 8 contract renewal costs are expected to
    increase dramatically.  Other major problems affecting HUD's insured
    Section 8 portfolio are (1) the risk to HUD of insurance losses
    resulting from defaults on loans--a risk that would increase
    significantly if the Section 8 contracts on projects in the portfolio
    were not renewed or were renewed at substantially lower funding
    levels and (2) the failure of many properties to provide physically
    and financially sound housing.

    To address these problems, HUD in 1995 proposed a "mark-to-market"
    strategy designed to subject Section 8 properties to the forces and
    disciplines of the commercial market.  Initially, HUD proposed to (1)
    eliminate project-based subsidies as contracts expired; (2) let the
    market set rents and restructure mortgages as necessary, offsetting
    write-offs with payments to affected lenders from FHA's insurance
    fund; (3) terminate FHA insurance on refinanced mortgages; and (4)
    provide assisted residents with portable tenant-based subsidies
    enabling them to stay in their current apartments or move elsewhere.
    Industry officials and resident groups expressed concerns about the
    mark-to-market strategy, indicating, among other things, that
    project-based subsidies and FHA insurance would still be needed.  In
    April 1996, HUD revised the proposal, renaming it "portfolio
    reengineering." The revised proposal would, among other things, give
    priority to reengineering properties with above-market rents, allow
    state and local governments to choose to continue project-based
    subsidies at individual properties, and allow property owners to
    apply for FHA insurance on restructured loans.

          ERNST & YOUNG'S STUDY AND
          GAO'S EVALUATION
    -------------------------------------------------------- Chapter 0:4.2

    Ernst & Young grouped the sample properties it evaluated into four
    categories reflecting the effects of HUD's proposal on them:
    "performing," "restructure," "full write-off," and "nonperforming."
    Ernst & Young's study estimated that if the insured Section 8
    portfolio were reengineered, 17 to 23 percent of the properties (in
    the performing class) could cover their current debt, operating
    expenses, and maintenance and capital needs without mortgage
    write-downs.  About 50 to 58 percent of the properties (in the
    restructure class) could cover their new debt and other expenses if
    their mortgage debt were reduced.  However, the remaining properties
    would have difficulty sustaining operations.  Approximately 11 to 15
    percent (in the full write-off class) could cover their operating
    expenses if their mortgages were entirely written off but could not
    meet their deferred maintenance or capital needs.  Still another 11
    to 15 percent (in the nonperforming class) could not cover even their
    operating expenses if their mortgages were fully written off.

    According to the study, 60 to 66 percent of the properties in the
    insured Section 8 portfolio receive above-market rents.  The study
    also estimated that expenditures of between $9.2 billion and $10.3
    billion would be required to address deferred maintenance and future
    capital needs at the properties if they were to compete in the
    marketplace without project-based subsidies.

    GAO's analysis of Ernst & Young's data indicates that portfolio
    reengineering would eventually reduce the costs of providing Section
    8 assistance.  However, the costs of subsidies over the next 10 years
    would be comparable to the current program's costs if all of the
    insured Section 8 properties were reengineered when their current
    Section 8 contracts expire.  Because the contracts for many of the
    properties with below-market rents will expire during the first part
    of the 10-year period and would therefore be reengineered early in
    the process, the program's costs would increase during the early
    years but would then begin to decrease as the contracts for more
    projects with above-market rents were reengineered in the later
    years.  If HUD were able, as it is now proposing, to reengineer the
    contracts for projects with above-market rents before they expire and
    to delay reengineering the contracts for properties with below-market
    rents, the Section 8 program's costs would decrease faster.

    GAO believes that, for the most part, the methodology and assumptions
    used in Ernst & Young's study were reasonable, given the study's
    overall scope.  However, for most of the 10 properties that GAO
    reviewed, the study estimated substantially higher deferred
    maintenance needs than did the property owners or managers and GAO's
    contract appraisers.  Also, the lenders contacted by GAO believed
    that some of the study's financing assumptions may be more favorable
    than those that would actually be available.

          KEY ISSUES FACING THE
          CONGRESS
    -------------------------------------------------------- Chapter 0:4.3

    The Congress faces many issues in assessing HUD's portfolio
    reengineering proposal.  One of the most important is which
    properties should be subject to the proposal--only those with
    above-market rents or those with below-market rents as well.  Other
    issues concern the reengineering process itself--how it should be
    carried out, the extent to which FHA should insure restructured
    loans, whether rental assistance should be linked to the unit or the
    tenant after restructuring, and the extent to which the government
    should finance the costs of rehabilitation.  In addition, the
    Congress will need to decide how to deal with HUD's problems in
    managing the insured Section 8 portfolio.  Addressing these and other
    issues will require trade-offs among actions that may achieve
    progress in one area at the expense of another or benefit one group
    of stakeholders more than another.  How these issues are resolved
    will, to a large degree, determine how effectively the problems that
    have long plagued the portfolio are permanently corrected and how
    extensively the reengineering process results in savings to the
    government.

       RECOMMENDATIONS
    ---------------------------------------------------------- Chapter 0:5

    This report contains no recommendations.

       AGENCY COMMENTS AND OUR
       EVALUATION
    ---------------------------------------------------------- Chapter 0:6

    GAO provided a draft copy of this report to HUD for its review and
    comment.  In commenting on the draft, HUD said the report provided an
    excellent summary of the portfolio reengineering proposal and its
    likely impact on the insured multifamily portfolio.  HUD also noted,
    among other things, that differences in the estimates of deferred
    maintenance and capital needs developed by Ernst & Young and by GAO's
    contract appraisers are due to differences in the methodologies used.
    While agreeing that the differences in the estimates are due, in
    part, to differences in methodologies, GAO continues to question
    certain aspects of Ernst & Young's approach, including the (1)
    assumption that working systems and components will be replaced if
    their estimated useful lives have expired and (2) inclusion in the
    capital needs estimates of the cost of work that is under way but not
    yet completed.  The fact that Ernst & Young's estimates for 7 of the
    10 case study properties that GAO reviewed were based on inspections
    of fewer than 10 percent of each property's units also adds to the
    uncertainty of the estimates.  HUD's comments and GAO's evaluation of
    them are discussed in more detail in chapter 2 and in appendix VI.

    INTRODUCTION
    ============================================================ Chapter 1

    The Department of Housing and Urban Development (HUD), through the
    Federal Housing Administration (FHA), insures mortgages on both
    single-family homes and multifamily rental housing properties for
    low- and moderate-income households.  In addition to mortgage
    insurance, many FHA-insured multifamily properties receive some form
    of direct assistance or subsidy from HUD, such as below-market
    interest rates or Section 8 rental subsidies tied to some or all
    units (Section 8 project-based assistance).

    In an effort to resolve long-standing problems with the segment of
    the insured multifamily portfolio that both has mortgages insured by
    FHA and receives project-based Section 8 rental subsidies (the
    insured Section 8 portfolio), HUD during 1995 proposed a major
    restructuring process that it called "mark-to-market." In early 1996,
    HUD made several key changes to its proposal in response to concerns
    raised by various stakeholders and changed its name for the process
    from mark-to-market to "portfolio reengineering." HUD left most of
    the basic thrust of the original mark-to-market proposal intact,
    however.

       BACKGROUND
    ---------------------------------------------------------- Chapter 1:1

    FHA insurance protects private lenders from financial losses stemming
    from borrowers' defaults on mortgage loans for both single-family
    homes and multifamily rental housing properties.  When a default
    occurs on an insured loan, a lender may "assign" the mortgage to HUD
    and receive payment from FHA for an insurance claim.  According to
    the latest data available from HUD, FHA insures mortgage loans for
    about 15,800 multifamily properties.  These properties contain just
    under 2 million units and have a combined unpaid mortgage principal
    balance of $46.9 billion.\1 These properties include multifamily
    apartments and other specialized properties, such as nursing homes,
    hospitals, student housing, and condominiums.

    HUD's Section 8 program provides rental subsidies for low-income
    families.  These subsidies are linked either to multifamily apartment
    units (project-based) or to individuals (tenant-based).  According to
    HUD's latest available data, about 1.4 million units at about 20,400
    multifamily properties receive Section 8 project-based subsidies.
    Under the Section 8 program, residents in subsidized units generally
    pay 30 percent of their income for rent and HUD pays the balance.
    According to HUD's data, monthly Section 8 payments to HUD-insured
    properties average about $300 to $500 per unit.

    --------------------
    \1 These data do not include properties with "HUD-held" mortgages, or
    those for which HUD has paid an insurance claim and is now, in
    effect, the lender.  According to its data, HUD holds the mortgages
    on 1,609 properties that have a combined unpaid principal balance of
    $5.4 billion.

          THE INSURED SECTION 8
          PORTFOLIO
    -------------------------------------------------------- Chapter 1:1.1

    According to HUD, its restructuring proposals apply to 8,636
    properties that both have mortgages insured by FHA and receive
    project-based Section 8 rental subsidies for some or all of their
    units.  In this report, we refer to these properties as HUD's insured
    Section 8 portfolio.  Data provided by HUD show that, together, these
    properties contain 859,000 units and have unpaid principal balances
    totaling $17.8 billion.

    For various reasons, HUD chose to exclude from its restructuring
    proposals properties with project-based Section 8 assistance that are
    insured under its "moderate rehabilitation" program.  HUD estimates
    that about 167 properties containing about 16,800 units are insured
    under this program.  Figure 1.1 shows how the insured Section 8
    portfolio fits into HUD's overall multifamily housing portfolio.

       Figure 1.1:  HUD's Multifamily
       Housing Portfolio

       (See figure in printed
       edition.)

    \a Excludes properties with HUD-held mortgages.

    \b Excludes 167 properties and about 16,800 units with project-based
    assistance provided under the Section 8 "moderate rehabilitation"
    program.

    Source:  GAO's presentation of data from HUD.

    According to HUD's data, about 45 percent of the insured Section 8
    portfolio (3,859 properties) consists of "older assisted" properties.
    These were constructed beginning in the late 1960s under a variety of
    mortgage subsidy programs, to which project-based Section 8
    assistance (Loan Management Set-Aside) was added later, beginning in
    the 1970s, to replace other subsidies and to help troubled properties
    sustain operations.  About 55 percent of the insured Section 8
    portfolio (4,777 properties) consists of "newer assisted" properties.
    These were built after 1974 under HUD's Section 8 New Construction
    and Substantial Rehabilitation programs and received project-based
    Section 8 subsidies calculated on the basis of formulas with
    automatic annual adjustments, which, according to HUD, tended to be
    relatively generous to encourage the production of affordable
    housing.  Figure 1.2 provides additional data on the insured Section
    8 portfolio.

       Figure 1.2:  The Insured
       Section 8 Portfolio

       (See figure in printed
       edition.)

    Note:  The older assisted properties were constructed beginning in
    the late 1960s under various mortgage subsidy programs to which
    project-based Section 8 assistance was added later, beginning in the
    1970s.  The newer assisted properties were built after 1974 under the
    Section 8 New Construction and Substantial Rehabilitation programs.

    Source:  GAO's presentation of data from HUD.

          EXPIRING SECTION 8
          ASSISTANCE
    -------------------------------------------------------- Chapter 1:1.2

    The project-based Section 8 assistance for properties in the insured
    Section 8 portfolio is covered by contracts, many of which are for
    long terms.  Under these contracts, property owners agreed to house
    lower-income tenants for specified periods in exchange for guaranteed
    rental subsidies for specified units.  In the next few years, many of
    these contracts will expire.  According to the available data from
    HUD, contracts covering about 69 percent of the project-based Section
    8 units in the insured Section 8 portfolio will expire by the end of
    the year 2000 and contracts covering about 98 percent of the units
    will expire by the end of the year 2006.  (See fig.  1.3.) In the
    early 1990s, most expiring contracts were renewed for 5-year periods,
    but the terms of Section 8 contracts have been gradually shortened
    since then.  To improve its budgeting for contract renewals, HUD
    proposes to renew all contracts for 1-year terms, beginning in fiscal
    year 1997.

       Figure 1.3:  Number of Units in
       FHA-Insured Multifamily
       Properties Whose Existing
       Project-Based Contracts Will
       Expire Each Year, 1996-2006

       (See figure in printed
       edition.)

    Note:  Contracts covering a total of 689,150 units will expire during
    the period.

    Source:  GAO's presentation of data from HUD.

       PROBLEMS AFFECTING THE INSURED
       SECTION 8 PORTFOLIO
    ---------------------------------------------------------- Chapter 1:2

    The insured Section 8 portfolio suffers from three basic
    problems--high subsidy costs; high exposure to insurance loss; and,
    in the case of some properties, poor physical condition.

    A substantial number of properties in the insured Section 8 portfolio
    now receive subsidized rents above market levels.  Many of these
    rents substantially exceed the rents charged for comparable
    unsubsidized units.  This problem is most prevalent in (but not
    confined to) the newer assisted segment of the portfolio, where it
    stems from the design of the Section 8 New Construction and
    Substantial Rehabilitation programs.  The government originally paid
    to develop these properties under the two Section 8 programs by
    establishing rents above market levels and then raising them
    regularly through the application of set formulas that, according to
    HUD, tended to be generous to encourage the production of new
    affordable housing.

    The high cost of Section 8 subsidies is reflected in the cost of
    renewing the existing project-based contracts for the properties in
    the insured Section 8 portfolio as they expire.  HUD is requesting
    $863 million in budget authority for fiscal year 1997 to renew
    expiring contracts covering almost 293,000 insured Section 8 units.
    As its long-term Section 8 contracts expire and its 1-year contracts
    are renewed annually, HUD estimates that its annual renewal costs
    will increase steadily in each of the following 9 fiscal years,
    resulting in an estimated annual renewal cost of about $6.7 billion
    by the year 2006 and a 10-year cumulative renewal cost approaching
    $45 billion.

    A second key problem affecting the insured Section 8 portfolio is the
    high risk of insurance loss.  Under FHA's insurance program, HUD
    bears virtually all the risk in the event of a loan default.
    According to a recent HUD-contracted study of the Department's
    capacity to manage the assisted multifamily portfolio's financial
    risk,\2 HUD's multifamily insurance program depends upon the actions
    of private parties whose share in the risk and stake in the
    properties' financial success may be limited.  The study points out
    that instead of bearing the financial risk of default, private
    lenders may have a more limited stake in the continuation of
    mortgages through their servicing rights.  Rather than having
    substantial equity invested in the properties, the owners may possess
    indirect interests that are hard for HUD to evaluate.  Borrowers are
    often structured into partnerships in which the general partners, who
    are responsible for the properties' day-to-day management, may have
    interests in property management fees through affiliated firms.

    HUD's fiscal year 1994 loan loss reserve analysis\3 evaluated the
    risk of default and insurance loss for a sample of multifamily
    properties on the basis of a set of financial, physical, and
    management data.  The properties were categorized as excellent, good,
    standard, substandard, or doubtful, and degrees of risk were assigned
    on the basis of these categories.  According to the analysis, 48
    percent of the older assisted properties and 20 percent of the newer
    assisted properties had a medium to high risk of default.  This risk
    could increase substantially if the properties' Section 8 contracts
    are not renewed or are renewed at substantially lower levels.

    Poor physical condition is a third key problem affecting many
    properties in the insured Section 8 portfolio.  A 1993 study of
    multifamily rental properties with FHA-insured or HUD-held mortgages
    found that almost one-fourth of the properties were "distressed." The
    properties were considered to be distressed if they failed to provide
    sound housing and lacked the resources to correct their deficiencies
    or if they were likely to fail financially.\4

    --------------------
    \2 Thomas H.  Stanton, Institutional Capacity to Manage Financial
    Risk:  An Essential Consideration for the Future of the HUD
    Multifamily Assisted Loan Portfolio (Apr.  2, 1996).

    \3 HUD's loan loss reserve analysis is a multistep process used to
    estimate FHA's future losses on insured multifamily housing mortgage
    loans.

    \4 Abt Associates, Inc., Assessment of the HUD-Insured Multifamily
    Housing Stock (Sept.  1993).

          PRINCIPAL CAUSES OF THE
          PROBLEMS
    -------------------------------------------------------- Chapter 1:2.1

    The problems affecting HUD's insured Section 8 portfolio have several
    causes.  These include (1) program design flaws that have contributed
    to high subsidies in the Section 8 program and have put virtually all
    the risk on HUD in the insurance program; (2) HUD's dual role as both
    the mortgage insurer and the rental subsidy provider, which has
    resulted in the federal government's averting claims against FHA's
    insurance fund by supporting a subsidy and regulatory structure that
    has masked the true market value of the properties; and (3)
    weaknesses in HUD's oversight and management of the insured
    portfolio, which have allowed physical and financial problems at a
    number of HUD-insured multifamily properties to go undetected or
    uncorrected.  According to a September 1995 paper prepared by the
    Affordable Housing Preservation Tax Policy Group,\5 a related problem
    is that the limited-partner investors in many of the properties no
    longer have an economic incentive to invest, or an interest in
    investing, additional capital to pay for improvements, such as new
    roofs, boilers, and updated appliances, which many properties are now
    starting to need.

    --------------------
    \5 Reorganization of HUD-Assisted Multi-Family Housing Projects--The
    Tax Obstacles (Washington, D.C., Sept.  1995).

       HUD'S PROPOSALS TO ADDRESS
       PROBLEMS WITH THE INSURED
       SECTION 8 PORTFOLIO
    ---------------------------------------------------------- Chapter 1:3

    In May 1995, HUD proposed to address the key problems affecting the
    insured Section 8 portfolio through a process that it called
    "mark-to-market." The principal steps in this process were to reset
    rents to market levels and reduce mortgage debt if necessary to
    permit a positive cash flow, terminate FHA's mortgage insurance, and
    replace project-based Section 8 subsidies with portable tenant-based
    subsidies.

    The basic idea behind HUD's mark-to-market proposal was to address
    the three key problems and their causes by decoupling HUD's mortgage
    insurance and project-based rental subsidies and subjecting the
    properties to the forces and disciplines of the commercial market.
    HUD originally proposed to do this by (1) eliminating project-based
    Section 8 subsidies as existing contracts expired (or sooner if the
    owners agreed), (2) allowing owners to rent their apartments for
    whatever amounts the marketplace would bear, (3) facilitating the
    refinancing of FHA-insured mortgages with smaller mortgages if needed
    for the properties to operate at the new rents, (4) terminating FHA's
    insurance on the mortgages, and (5) providing the residents of
    assisted units with portable Section 8 rental subsidies that they
    could use to either stay in their current apartment or move to
    another one in accordance with their wishes or financial needs.

    HUD recognized that many owners could not cover their expenses and
    might eventually default on their mortgages if their properties were
    forced to compete in the commercial marketplace without their
    project-based Section 8 subsidies.  The mark-to-market proposal
    therefore included several alternatives for restructuring the
    program's FHA-insured mortgages to bring properties' income and
    expenses into line.  These alternatives included selling the
    mortgages, engaging third parties to work out restructuring
    arrangements, and paying full or partial FHA insurance claims to
    lenders to reduce the mortgage debt and monthly payments.  Each of
    these alternatives would likely expose HUD to claims against FHA's
    insurance fund, but HUD estimated that over the long term this
    approach would cost the government less than maintaining the status
    quo.

    The proposed mark-to-market process would likely affect properties
    differently, depending on whether their existing rents were higher or
    lower than market rents and whether they needed funding for capital
    items, such as deferred maintenance.  If the existing rents exceeded
    market value, the process would lower the mortgage debt, thereby
    allowing the property to operate and compete effectively at lower
    market rents.  If the existing rents were below market value, the
    process would allow the owner to increase the rents, potentially
    providing more money to improve and maintain the property.  HUD
    recognized, however, that some properties would not be able to
    generate enough income to cover their expenses even if their mortgage
    payments were reduced to zero.  In these cases, HUD proposed using
    alternative strategies, including demolishing the property and
    subsequently selling the land to a third party, such as a nonprofit
    organization or government entity.

    Although both the Senate and the House held hearings on the
    mark-to-market proposal, no consensus was reached as to whether it or
    some other approach should be adopted.  No action was taken, in part
    because reliable information was not available on the properties and
    their surrounding commercial rental markets.  Potential stakeholders
    raised questions about the proposal that could not be answered,
    including the following:  (1) What are the physical and financial
    conditions of the properties that make up the insured Section 8
    portfolio?  (2) What different effects would the proposal have at
    different types of properties?  (3) Would the government realize net
    savings or incur additional costs in the long run?  (4) To what
    extent would low-income residents be displaced or have to pay higher
    rents?  (5) To what extent could such residents find suitable and
    affordable alternative housing if they chose to or had to?  (6) To
    what extent would possible income tax consequences\6 and other
    negative effects on owners cause them to oppose the proposal and
    hamper HUD's efforts to implement it?  and (7) To what extent would
    owners with substantial time left on their Section 8 contracts
    disinvest and let their properties deteriorate?  Without this
    information, it was difficult to predict the overall effects of HUD's
    mark-to-market proposal on the properties, their owners, the
    residents, and the federal government.  HUD contracted with Ernst &
    Young LLP in 1995 to obtain up-to-date information on market rents
    and the physical condition of properties in the insured Section 8
    portfolio, develop a financial model to show how HUD's proposal would
    affect the properties, and estimate the subsidy and insurance claims
    costs associated with the proposal.  (See ch.  2 for our analysis of
    Ernst & Young's study.)

    In April 1996, before Ernst & Young completed its study, HUD modified
    the original mark-to-market proposal in several ways in response to
    concerns raised by industry officials and resident groups about
    various issues, such as the elimination of project-based subsidies
    and the termination of FHA insurance, and changed the name of the
    process from mark-to-market to portfolio reengineering.  HUD left the
    basic thrust of the original proposal intact but made several key
    changes.  These included (1) giving priority attention for at least
    the first 2 years to properties with subsidized above-market rents
    while continuing to discuss approaches with stakeholders for solving
    capital needs at properties with expiring contracts and subsidized
    below-market rents; (2) allowing state and local governments to
    decide whether to continue Section 8 project-based rental subsidies
    at individual properties after their mortgages are restructured or
    switch to tenant-based assistance; and (3) allowing owners to apply
    for FHA insurance on the newly restructured mortgage loans.  HUD's
    portfolio reengineering proposal further differed from the original
    mark-to-market proposal in that it (1) put more emphasis on
    proactively using third parties to restructure and resolve problems
    with mortgages before properties' project-based Section 8 contracts
    expire; (2) better protected current residents from displacement by
    providing those in assisted apartment units with "enhanced vouchers"
    that would pay the difference between 30 percent of their income and
    the market rent for their building (even if that rent exceeded the
    normal Section 8 limits) and by providing rental assistance to
    currently unassisted residents if restructuring increased their rent
    to more than 30 percent of their income; and (3) reflected HUD's
    willingness to work with the Congress on developing mechanisms to
    take into account the tax consequences to the owners of properties
    whose mortgage debt would be forgiven as part of the restructuring
    process.  More recently, HUD has also proposed deferring action on
    properties that would not be able to generate enough income to cover
    their operating expenses after reengineering until strategies have
    been developed to address the needs of their residents and of the
    communities in which the properties are located.

    --------------------
    \6 HUD's original mark-to-market proposal could have triggered two
    different kinds of income tax liabilities for limited-partner
    investors, who typically own most of the equity interests in a
    property, without generating any cash that the investors could have
    used to pay the tax.  The first type of tax liability could have
    occurred if HUD had made a payment from FHA's insurance fund to a
    mortgage holder to reduce the mortgage principal.  This payment would
    have been considered as a "cancellation of indebtedness" and would
    have created a tax liability for the investor.  The second type of
    tax liability could have occurred if the process had led an investor
    to sell or dispose of an interest in a property.  Under certain
    circumstances, this action could have subjected the investor to an
    "exit tax."

       OBJECTIVES, SCOPE, AND
       METHODOLOGY
    ---------------------------------------------------------- Chapter 1:4

    To assist the Congress in evaluating HUD's proposal for reengineering
    the insured Section 8 multifamily housing portfolio, we examined the
    (1) problems affecting the properties in the portfolio and HUD's
    proposals for addressing them; (2) results and reasonableness of a
    HUD-contracted study carried out by Ernst & Young LLP that assesses,
    on the basis of a national sample of 558 randomly selected
    properties, the effects of HUD's proposal on the portfolio; and (3)
    key issues facing the Congress in assessing HUD's proposal.  In
    addition, as discussed in appendix I, we examined the characteristics
    of 10 properties included in Ernst & Young's study and the impact of
    HUD's proposal on them.

    To obtain information on the problems affecting the properties in
    HUD's insured Section 8 portfolio and HUD's proposals for dealing
    with them, we reviewed relevant reports issued by GAO, HUD's Office
    of Inspector General (OIG), and HUD.\7 We also reviewed HUD documents
    discussing the Department's mark-to-market and portfolio
    reengineering proposals, as well as comments on the proposals
    provided by groups representing the multifamily housing industry and
    residents.  We also discussed the proposals with HUD and industry
    officials and participated in four forums that HUD held in early 1996
    to discuss problems pertaining to the insured Section 8 properties
    and options for addressing them.

    To evaluate the results and reasonableness of Ernst & Young's study,
    we were briefed by staff from Ernst & Young and HUD on the approaches
    that Ernst & Young planned to use to carry out its study and on the
    actual methods used.  The briefings included discussions about Ernst
    & Young's sampling and statistical methods, market surveys for
    estimating the market rents for the insured Section 8 properties,
    site inspections for estimating the properties' deferred maintenance
    and capital needs, and the financial model for determining the effect
    of portfolio reengineering on the properties and estimating the costs
    and savings associated with reengineering.

    We reviewed selected aspects of Ernst & Young's sampling and
    statistical methodology.  For example, we reviewed the computer
    programs that Ernst & Young used to select sample projects and
    reviewed the statistical methods that the firm planned to use to
    estimate population totals from the sample.  We also reviewed the
    presentation of information derived from the sample in Ernst &
    Young's May 2, 1996, report.

    When data are missing for sampled projects, a potential exists for
    the results of the sample to create a biased representation of the
    entire population of projects.  In addition, assigning values on the
    basis of the observed sample mean can cause the sampling errors to be
    somewhat understated.  We checked the completeness of the data
    collected for Ernst & Young's sampled projects.  Only one project
    subject to portfolio reengineering was excluded from the study.  For
    the 558 projects included in the study, the data collection was
    generally complete.  About 85 percent of the projects in the final
    sample had complete data.  For the remaining projects, one or more of
    the following were missing:  (1) data from financial statements, (2)
    data on tenants' payments, and (3) data on deferred maintenance.
    Tenant payment data were missing most frequently--about 12 percent of
    the time.  Financial statement data and deferred maintenance data
    were missing no more than 3 percent of the time.  When data were
    missing for a project, Ernst & Young assigned a value to it based on
    the average of the known sample properties or industry standards.
    (The overall reasonableness of Ernst & Young's study is discussed in
    ch.  2.)

    To evaluate Ernst & Young's estimates of market rents, we reviewed
    the firm's methodology for performing market surveys and, as
    discussed in greater detail below, contracted with three licensed
    real estate appraisal firms to estimate the market rents for 10
    properties in Ernst & Young's sample.

    To assess Ernst & Young's estimates of deferred maintenance needs and
    capital costs, we met with Ernst & Young officials to understand the
    firm's methodology and underlying assumptions.  We also obtained and
    analyzed related data collection documents used in the firm's study,
    including the instructions to those conducting on-site property
    inspections and the completed inspection forms and supporting
    documentation for the 10 properties independently assessed by the
    contract appraisers.  We also discussed Ernst & Young's methodology
    with industry representatives and provided Ernst & Young's estimates
    for the 10 properties to the respective owners and managers and to
    the contract appraisers.  We asked those who reviewed Ernst & Young's
    estimates to comment on the reasonableness and accuracy of the
    estimates; to state whether they generally agreed or disagreed with
    the estimates; and if they disagreed with an estimate, to provide
    specific information on the adjustments needed and the reasons for
    the adjustments.

    To review Ernst & Young's financial model for assessing the effects
    of portfolio reengineering on the sample properties, we obtained a
    copy of the model and discussed the assumptions used in it with Ernst
    & Young staff.  Because the model contains hundreds of data fields,
    formulas, and assumptions, we did not attempt to examine every data
    element or verify every formula or calculation.  Rather, we focused
    on assessing the structure of the model and reviewed its key data
    elements and the logic of what we considered to be its major
    assumptions.  We also discussed the financing and operating
    assumptions used in the model with officials of various organizations
    that have expertise in underwriting and/or servicing mortgages on
    multifamily housing properties (including Fannie Mae, Freddie Mac,
    the Reilly Mortgage Group, and GMAC Commercial Mortgage Corporation).
    Our assessment of the model is discussed in chapter 2.  As discussed
    in chapter 2, we used information obtained from these experts to
    perform sensitivity analyses that assess the effects of changes in
    the assumptions on the model's results.  We also used data from Ernst
    & Young's sample to estimate certain costs.  These estimates apply to
    the 8,363 projects from which the sample was drawn.  Had we made
    estimates for the number of properties that Ernst & Young assumed to
    be affected by portfolio reengineering (8,563 properties), our
    estimates of the totals would have been about 2 percent higher.  As
    discussed earlier, HUD now believes that 8,636 properties would be
    affected by its proposal.

    We did not verify the accuracy of the data that Ernst & Young derived
    from HUD's data systems for use in its study except for certain data
    pertaining to the 10 case study properties.  We found that the final
    data used in Ernst & Young's study for these properties were
    generally consistent with the data we obtained.  HUD's OIG conducted
    a more detailed assessment of the data that Ernst & Young derived
    from HUD's information systems.  The OIG tested 69 of the 189 data
    elements that Ernst & Young used for 56 projects.  The OIG found
    differences between the data it obtained and the data Ernst & Young
    used for 423 of the 3,864 data elements it reviewed, 114 of which the
    OIG determined to be significant.  The OIG shared the results of its
    analysis with Ernst & Young and HUD.  Ernst & Young officials
    informed us that they had used the OIG's results to improve the
    study's data.

    We provided comments to HUD and Ernst & Young about issues that arose
    throughout the study's design and implementation.  HUD and Ernst &
    Young officials were generally responsive to our concerns, replacing
    their original sample, for example, with one that they could analyze
    using appropriate statistical methods.

    We obtained data on the characteristics of 10 properties included in
    Ernst & Young's sample and assessed the effects of HUD's proposal on
    the properties.  We selected these properties judgmentally from a
    list of properties in Ernst & Young's sample.  The 10 properties are
    not statistically representative of the properties in either HUD's
    insured Section 8 housing portfolio or Ernst & Young's sample.  We
    selected the 10 properties to reflect differences in geographical
    location (they are located in six states and the District of
    Columbia), assisted rent levels, and physical condition (as indicated
    in physical inspection reports from HUD).  We did not have
    information on many characteristics of the properties--such as how
    their assisted rents compared with the market rents they could
    command, who resided in them, and what types of housing markets they
    were located in)--when we selected the properties.

    To obtain data on the properties' characteristics, we visited each
    property and interviewed its manager and/or owner.  We also obtained
    data on the properties' characteristics from HUD's field office and
    property records.  We provided the basic data we obtained on each
    property to the property owner or manager for review and
    verification.  To develop estimates of the market rents that the
    properties could command and assessments of the effects that
    portfolio reengineering would have on the properties, we contracted
    for the services of three licensed real estate appraisal firms with
    experience in assessing properties insured or assisted by HUD:
    Goyette Roark Appraisal Services; Maiden, Haase & Smith, Ltd.; and
    Miller Appraisal Review.  The firms provided us with a report on each
    of the properties they reviewed.  We also obtained comments on each
    appraisal report from the property's owner or manager.  The results
    of the reports are summarized in appendix V.

    We identified and formulated our observations on the key issues
    facing the Congress through our review of (1) HUD's proposals, (2)
    comments on HUD's proposals and alternative proposals prepared by
    various parties representing the views of those who would be
    affected, (3) testimony provided at several congressional hearings
    and our discussions with housing and lending industry officials and
    with the owners, managers, and selected tenant representatives at the
    10 case study properties.

    We provided a draft copy of this report to HUD for its review and
    comment.  HUD provided written comments on the draft, and these
    comments are presented and evaluated in chapter 2 and appendix VI.
    We conducted our review from August 1995 through September 1996 in
    accordance with generally accepted government auditing standards.

    --------------------
    \7 See the Related GAO Products at the end of this report for a list
    of our earlier work on problems associated with insured Section 8
    properties.

    EVALUATION OF THE RESULTS AND
    REASONABLENESS OF THE PORTFOLIO
    REENGINEERING STUDY CONDUCTED
    FOR HUD BY ERNST & YOUNG
    ============================================================ Chapter 2

    In May 1996 Ernst & Young reported on the results of its study
    analyzing the effects of HUD's original mark-to-market proposal on
    insured Section 8 properties.  Ernst & Young's study indicates that
    for most of the properties subject to portfolio reengineering, the
    assisted rents are greater than the estimated market rents.  In
    addition, according to the study, the properties have significant
    amounts of immediate deferred maintenance and short-term and
    long-term capital needs.  The study further indicates that about 80
    percent of the properties would need to have their debt reduced in
    order to continue operations after reengineering.  For approximately
    22 to 29 percent of the properties, writing down the existing debt to
    zero would not reduce their costs enough for them to cover their
    operating expenses and/or address their deferred maintenance and
    capital needs.  Ernst & Young's report does not present information
    gathered during the study on the costs of portfolio reengineering to
    the government--that is, on how the costs of providing Section 8
    assistance would change and what the likely claims against FHA's
    insurance fund would be.  Our analysis of these data indicates that
    although the costs of Section 8 assistance would eventually be lower
    under portfolio reengineering than under the current renewal
    policies, little or no Section 8 savings would be achieved over the
    next 10 years if all Section 8 properties were reengineered when
    their current Section 8 contracts expire.  Furthermore, Ernst &
    Young's data indicate that the cost of insurance claims associated
    with the reengineering proposal during the 10-year period would
    amount to between $6 billion and $7 billion.

    Ernst & Young's financial model provides a reasonable framework for
    projecting the overall results of portfolio reengineering, such as
    the number of properties that would need to have their debt reduced.
    Furthermore, we did not identify any substantive problems with the
    model's sampling and statistical methodology.  However, some
    assumptions used in the financial model may not reflect the way in
    which insured Section 8 properties would actually be affected by
    portfolio reengineering.  In addition, our comparison of Ernst &
    Young's data with the information we gathered on our 10 case-study
    properties raises questions about one key data element--the estimated
    costs of deferred maintenance and capital needs.  Specifically, the
    owners or managers of the 10 properties and the independent
    appraisers we retained questioned the model's cost estimates for
    deferred maintenance at the properties, generally indicating that the
    estimates were too high.

    To assess the extent to which the use of different assumptions would
    affect the results of Ernst & Young's study, we performed sensitivity
    analyses of Ernst & Young's model using two sets of revised
    assumptions that we developed through our discussions with
    multifamily housing industry officials.  One scenario reflects
    assumptions that are more optimistic in terms of the cost to the
    government of portfolio reengineering.  The other uses assumptions
    that are more conservative or pessimistic.  Under all
    scenarios--Ernst & Young's results and the optimistic and pessimistic
    variations--a substantial number of properties would likely do well
    and others would have difficulty sustaining operations.

       STUDY WAS DESIGNED TO PROVIDE
       UPDATED DATA
    ---------------------------------------------------------- Chapter 2:1

    In early 1995, when HUD proposed the mark-to-market initiative, the
    Department did not have current or complete information on the
    insured Section 8 portfolio to use as a basis for developing
    assumptions about, and estimates of, the costs and effects of the
    proposal.  For example, HUD lacked reliable, up-to-date information
    on both the market rents that the properties could be expected to
    command and the properties' physical condition--two variables that
    strongly influence the effects on properties of the mark-to-market
    proposal.  Information on market rents and physical condition is also
    needed to estimate (1) the change in Section 8 subsidy costs if
    assisted rents are replaced with market rents and (2) the claims
    against FHA's insurance fund if mortgage debt is reduced to allow the
    properties to operate at market rents.  Because HUD did not have
    current data on the market rents and physical condition of the
    properties in the insured Section 8 portfolio, the Department had to
    rely on data collected for HUD's 1990 multifamily stock study.\1 An
    update to this study assessing changes in the stock since 1990 was
    scheduled to begin in the fall of 1995, but the results were not
    expected to be available for some time.

    To obtain interim data to better assess the likely outcomes of the
    mark-to-market proposal, HUD contracted with Ernst & Young LLP\2 in
    1995 for a study of a random sample of HUD-insured properties with
    Section 8 assistance to (1) determine the market rents and physical
    condition of the properties and (2) develop a financial model to show
    the effects of the proposal on the properties and to estimate the
    costs of the subsidies and claims associated with the proposal.  The
    study was conducted on a sample of 558 properties out of 8,363
    properties and extrapolated to the total population of 8,563
    properties identified by HUD at that time as representing the
    population subject to portfolio reengineering.\3 The study was
    planned to take about 2 months and be completed in 1995.  However,
    the study took longer than estimated, in large part because of delays
    in completing the physical inspections and the fiscal year 1996
    federal budget impasse, which required many government agencies,
    including HUD, to shut down operations for various periods last fall
    and winter.  HUD and Ernst & Young released the report summarizing
    the study's findings on May 2, 1996.

    --------------------
    \1 Assessment of the HUD-Insured Multifamily Housing Stock Final
    Report (HUD-1412-PDR, Sept.  1993).

    \2 The study was conducted by the E&Y Kenneth Leventhal Real Estate
    Group.

    \3 Ernst & Young reported that because of technical and cost
    considerations, the sample was drawn from a population of 8,363
    properties rather than the HUD-identified population of 8,563
    properties.  As noted earlier, HUD now believes that 8,636 properties
    would be subject to portfolio reengineering.

       STUDY FINDS THAT MANY
       PROPERTIES WOULD REQUIRE
       RESTRUCTURING
    ---------------------------------------------------------- Chapter 2:2

    Ernst & Young's report provides current information comparing
    assisted rents at the properties with market rents, assessing the
    physical condition of the properties, and estimating the effects on
    the properties of HUD's reengineering proposal as it existed while
    the study was under way.  Hence, the study's results do not reflect
    the effects of changes that HUD made to its proposal in early 1996.
    Ernst & Young's report estimates that the majority of the properties
    have assisted rents that exceed market rents and significant amounts
    of immediate deferred maintenance and future capital needs.  The
    analysis also indicates that about 80 percent of the properties would
    not be able to continue operations without debt restructuring.

          MOST PROPERTIES WOULD HAVE
          TO ADJUST TO LESS INCOME
    -------------------------------------------------------- Chapter 2:2.1

    Ernst & Young conducted market surveys to estimate market rents at
    the properties.  The properties whose assisted rents currently exceed
    market rents would generate less rental income after reengineering;
    therefore, they would likely have difficulty meeting their existing
    debt service requirements when their rents were adjusted to market
    levels.  Ernst & Young's study estimates that a majority of the
    properties--between 60 and 66 percent--have above-market rents and
    between 34 and 40 percent have below-market rents.\4 Most of the
    properties with assisted rents that exceed market rents are newer
    assisted properties.  Conversely, most of the properties with
    assisted rents that are less than market rents are older assisted
    properties.  During fiscal years 1997 through 1999, most of the
    properties whose Section 8 contracts are scheduled to expire are
    older assisted properties, whereas from fiscal year 2000 and beyond,
    most of the properties with such contracts are newer assisted
    properties.

    The properties whose assisted rents are more than 120 percent above
    market levels are of special concern because they would likely
    experience substantial decreases in rental income.  The Ernst & Young
    study estimates that between 41 and 47 percent of the properties have
    such rents.

    --------------------
    \4 All estimates for projects whose assisted rents were determined,
    on the basis of Ernst & Young's sample, to be above or below market
    rents may be misstated because the sample did not contain properties
    with both types of rents in each group, or stratum, sampled.  Thus,
    the estimates assume that none of the assisted rents for 510 projects
    from three strata containing newer projects were below market rents.
    The estimates also assume that none of the assisted rents for 372
    older projects from two strata were above market rents.

          PHYSICAL CONDITION NEEDS ARE
          LARGE AND STRONGLY INFLUENCE
          RESULTS OF PORTFOLIO
          REENGINEERING
    -------------------------------------------------------- Chapter 2:2.2

    Ernst & Young hired an engineering firm, Louis Berger & Associates,
    to identify the properties' comprehensive capital needs.  In order to
    obtain new loans, the property owners will need sufficient resources
    to address immediate deferred maintenance as well as future capital
    needs.

    As table 2.1 shows, Ernst & Young's study indicates a widespread need
    for capital--between $9.2 billion and $10.2 billion--to address the
    properties' capital needs.  The study defines capital needs as the
    costs of the improvements needed to bring the properties into
    adequate physical condition to attract uninsured, market-rate
    financing.  Three categories of capital needs are defined:  (1)
    immediate deferred maintenance, or the estimated costs to bring all
    operating systems up to market conditions and lenders' underwriting
    standards, (2) the short-term capital backlog, or the estimated
    expired costs for subsystems and components with a remaining useful
    life of 5 years or less,\5 and (3) the long-term capital backlog, or
    the estimated expired costs for subsystems and components with a
    remaining useful life of more than 5 years.  The immediate and
    short-term capital costs are a significant factor in determining the
    impact of portfolio reengineering on the properties.

    The study estimates that the properties have only approximately $1.3
    billion to $1.6 billion in replacement reserves (i.e., funds set
    aside to cover future capital needs) and other cash reserves that
    could be used to address their capital needs, resulting in total net
    capital needs of between $7.7 billion and $8.7 billion.  The average
    cost per unit of the total capital needs, less the reserves, is
    estimated to be between $9,116 and $10,366.

                                   Table 2.1

                            Identified Capital Needs

                             (Dollars in billions)

    Category of need                    Range
    ----------------------------------  ----------------------------------
    Immediate deferred maintenance      Between $3.4 and $4.0

    Short-term capital backlog          Between $2.9 and $3.5

    Long-term capital backlog           Between $2.5 and $3.1

    ======================================================================
    Total                               Between $9.2 and $10.2
    ----------------------------------------------------------------------
    Note:  Each category of need, as well as the total of the three
    categories, has an individual sampling error.  Therefore, the total
    estimate is not equal to the sum of the individual estimates.

    Source:  GAO's presentation of data from Ernst & Young.

    The study indicates that while the older assisted properties have a
    high level of capital needs, the newer assisted properties also
    require a significant investment.  For example, the older properties
    have needs ranging between $3.8 billion and $4.4 billion for
    immediate deferred maintenance and short-term capital backlog, and
    the newer properties have needs ranging between $2.5 billion and $3.1
    billion.  On a per-unit basis, these amounts average between $8,665
    and $10,217 for the older properties and between $6,201 and $7,491
    for the newer ones.

    --------------------
    \5 Estimated expired costs are the partial replacement costs of
    items.  For example, a $15,000 roof with an original useful life of
    15 years would, when it was 11 years old, have estimated expired
    costs of $11,000, which would be included in the property's
    short-term capital backlog.

          STUDY INDICATES A
          SIGNIFICANT LEVEL OF DEBT
          RESTRUCTURING WOULD BE
          NEEDED
    -------------------------------------------------------- Chapter 2:2.3

    The study was designed to use information on market rents and the
    properties' physical condition gathered by Ernst & Young, as well as
    financial and Section 8 assistance data from HUD's data systems, in a
    financial model designed to predict the proposal's effects on the
    portfolio as a whole.  Specifically, the model estimates the
    properties' future cash flows over a 10-year period, assuming that
    the loans will be reengineered (marked to market) when their current
    Section 8 contracts expire.\6 The model classifies the loans into
    four categories--performing, restructure, full write-off, and
    nonperforming--that reflect the effects of reengineering on the
    properties.  A property's placement in one of the four categories is
    based on the extent to which the income from the reengineered
    property would be able to cover its operating costs, debt service
    payments, and immediate deferred maintenance and short-term capital
    expenses.

    If portfolio reengineering were implemented, Ernst & Young estimates
    that about 80 percent of the properties--with current estimated
    unpaid principal balances ranging from $12.6 billion to $14.5
    billion--would have to have their existing mortgage debt reduced.  In
    addition, approximately 22 to 29 percent of the properties would not
    meet all of their needs even if their debt were written down to zero.
    The study further estimates that between 11 to 15 percent of the
    properties would not even be able to cover all of their operating
    expenses.  Table 2.2 provides an overview of the results.

                                   Table 2.2

                       Effects of Reengineering on HUD's
                          Insured Section 8 Portfolio

                                                    Costs covered with
    Status of loan after    Percent of              reengineered cash
    reengineering           portfolio               flows
    ----------------------  ----------------------  ----------------------
    Performing              17 to 23                Existing debt,
                                                    operating expenses,
                                                    all capital needs

    Restructure             50 to 58                Restructured debt,
                                                    operating expenses,
                                                    all capital needs

    Full write-off          11 to 15                Operating expenses and
                                                    some capital needs but
                                                    no debt

    Nonperforming           11 to 15                Some operating
                                                    expenses but no debt
                                                    or capital needs
    ----------------------------------------------------------------------
    Note:  In this analysis, Ernst & Young defines capital needs as
    immediate deferred maintenance and short-term (5 years or less)
    capital needs, less available reserves.  In addition, the financial
    model assumes annual deposits to replacement reserves.

    --------------------
    \6 For properties with more than one Section 8 contract, the model
    assumes that the property would be reengineered when the contract
    with the earliest expiration date expired.

       MODEL'S RESULTS RAISE QUESTIONS
       ABOUT SAVINGS THAT MIGHT BE
       ACHIEVED
    ---------------------------------------------------------- Chapter 2:3

    Ernst & Young's model estimated the subsidy costs for HUD's insured
    Section 8 portfolio before and after reengineering and the claims
    against FHA's insurance fund entailed in writing down the mortgages
    and addressing the deferred maintenance needs at the properties.
    However, Ernst & Young's May 2, 1996, report does not present this
    information.  According to HUD's Deputy Assistant Secretary for
    Operations, HUD plans to use Ernst & Young's cost data in developing
    future budget estimates relating to portfolio reengineering, but it
    never intended that the cost data be included in Ernst & Young's May
    1996 report or that the model generate budget estimates.  For various
    reasons, the cost estimates in HUD's fiscal year 1997 budget request
    and in Ernst & Young's study differ.  For example, the budget request
    assumes that many loans will be reengineered before the related
    Section 8 contracts expire, while Ernst & Young's study assumes that
    reengineering will occur after the contracts expire.  In addition,
    according to HUD, the budget assumes that Section 8 subsidy costs
    increase at a faster rate than Ernst & Young's study.\7

    In the model, the claims costs include (1) the amount of debt
    reduction needed for each property to sustain its operations at
    market rents and (2) funding for some or all of the property's
    immediate deferred maintenance and short-term capital needs.
    However, the claims costs cannot exceed the unpaid principal balance
    of the loan at the time of its restructuring.  For a property whose
    estimated capital needs exceed its loan's unpaid principal balance,
    any unresolved capital needs are tracked in the model.  In addition,
    the claims costs are based on an evaluation, for each property, of
    the loan amount that the property could support using standard
    financial underwriting standards without the continuation of FHA
    insurance.\8

    --------------------
    \7 HUD officials have also indicated that Ernst & Young's cost
    estimates do not conform with budget rules or scoring methodology.

    \8 According to an Ernst & Young official, the model was based on an
    underwriting approach that considered several factors for each
    property:  (1) the debt service coverage ratio, (2) the mortgage
    interest rate, (3) the immediate deferred maintenance needs, (4) the
    annual replacement reserve requirements, (5) the funding needed to
    cover underfunded replacement reserves (short-term capital needs);
    and (6) the ability to stabilize under "market" conditions.  The
    Ernst & Young official indicated that all these factors must be
    considered together before a conclusion can be made on the
    appropriateness of any one of the factors.

          SHORT-TERM REDUCTIONS IN
          SECTION 8 ASSISTANCE COSTS
          WOULD BE UNLIKELY
    -------------------------------------------------------- Chapter 2:3.1

    Our analysis of these data indicates that although the costs of
    providing Section 8 rental assistance would decrease over the long
    term, little or no aggregate savings in Section 8 rental assistance
    costs would accrue over the next 10 years if, as the model assumes,
    all insured Section 8 properties were reengineered when their current
    Section 8 contracts expire.  These data indicate that, for the period
    from fiscal year 1996 through fiscal year 2005, there may be little
    difference in the aggregate costs of Section 8 assistance under the
    current program and under portfolio reengineering:

      -- If project-based assistance is continued at current levels
         (including inflation), the costs in present value terms are
         estimated to be between $27.2 billion and $31.0 billion.\9

      -- The cost of Section 8 assistance after reengineering is
         estimated to be between $26.5 billion and $29.8 billion.\10

    A primary reason for the similarity in cost estimates is that the
    model assumes projects would be reengineered when their current
    Section 8 contracts expire.  This assumption reflects HUD's
    contractual obligations, which the Department has repeatedly
    indicated that it will not abrogate.  Because the contracts for many
    properties with below-market rents will expire during the first part
    of the 10-year period and the properties would therefore be
    reengineered early in the process, the costs of providing Section 8
    assistance would increase during the early years but then begin to
    decrease as more projects with above-market rents were reengineered
    in the later years.  In fiscal year 2005, after virtually all of the
    projects have been reengineered, the Section 8 assistance costs are
    estimated to be between $1.9 billion and $2.2 billion per year on a
    present value basis.  The model indicates that annual savings of
    between $298 million to $493 million (between 13 to 19 percent) could
    subsequently be achieved if reengineering were implemented in place
    of the current program.

    However, Ernst & Young's model does not reflect the changes that HUD
    made to its proposal in early 1996.  Some of the changes offer the
    potential for additional Section 8 cost savings.  For example, HUD is
    proposing to use a proactive approach to portfolio reengineering,
    under which it would encourage owners to terminate their Section 8
    contracts voluntarily before the contracts expire and go through the
    reengineering process.  However, it is not clear to what extent HUD
    will succeed in attracting owners to restructure before their Section
    8 contracts expire or what additional incentives HUD may have to
    offer to achieve this goal.

    In addition, HUD now plans to focus initially on reengineering
    properties with above-market rents.  To the extent that portfolio
    reengineering focuses on such properties, the savings would increase.
    For example, Ernst & Young's data indicate that the 10-year costs of
    providing Section 8 assistance for properties with above-market rents
    would be between $21.2 billion and $25 billion under the current
    program compared with between about $18.5 billion and $21.5 billion
    if the loans for such properties were restructured when their Section
    8 contracts expire.  In addition, some further savings would result
    if, as Ernst & Young's model assumes, mortgage interest subsidies
    were terminated when projects were reengineered.  Ernst & Young
    estimates that without reengineering, mortgage interest subsidies
    would range from about $841 million to $1.1 billion (in present value
    terms) over the next 10 years.  However, most properties that receive
    interest subsidies are believed to have below-market rents.

    --------------------
    \9 These and other total cost estimates contained in our report are
    based on a universe of 8,363 properties--the population from which
    Ernst & Young selected its sample.  The estimates contained in Ernst
    & Young's May 1996 report are based on a population of 8,563
    properties.  The difference between these two numbers represents the
    properties that did not have a chance to be included in the sample
    because of technical and cost considerations.  In general, the
    estimates in our report would increase by about 2 percent if they
    were applied to 8,563 properties rather than 8,363, assuming that the
    additional properties identified by HUD were similar to those in the
    original population.

    \10 For both estimates, the model assumes that Section 8 subsidy
    costs increase by 3 percent a year.  We discounted these costs by
    6.75 percent a year to arrive at a present value estimate.

          INSURANCE CLAIMS COSTS WOULD
          LIKELY BE HIGH
    -------------------------------------------------------- Chapter 2:3.2

    Our analysis of Ernst & Young's data indicates that, under portfolio
    reengineering, the claims against FHA's multifamily insurance
    funds--for mortgage write-downs and deferred maintenance and other
    capital needs for properties with mortgages that need
    restructuring--would be substantial.  The mortgage balances for such
    properties--including those in the full write-off and nonperforming
    categories whose mortgages would be fully written off--would need to
    be reduced by between 61 and 67 percent.  Over the next 10 years,
    according to Ernst & Young's data, this reduction would result in
    claims costs, calculated on a present value basis, of between $6
    billion and $7 billion.\11 If, however, HUD's proactive approach were
    successful, the costs of claims to cover mortgage write-downs could
    be higher than indicated in Ernst & Young's study because (1) the
    loans would be restructured earlier when the unpaid principal
    balances were higher and (2) the present value of the claims
    occurring in the earlier years would be higher.  However, HUD
    believes that without a proactive approach, owners would disinvest in
    the properties.  Such disinvestment would have an adverse impact on
    the properties' physical condition, resulting in higher claims costs
    at a later date.

    The claims payments estimated in Ernst & Young's study indicate
    substantial loan loss rates for the government.\12 For example, the
    portfolio reengineering claims for properties with assisted rents
    that exceed market rents are estimated to be between $4.8 billion and
    $5.8 billion and the related unpaid principal balances at the time of
    restructuring are estimated to be between $6.9 billion and $8.1
    billion.  The estimated loss rate would be between 67 and 75 percent.
    Table 2.3 provides the claims, unpaid principal balances, and loss
    rates for the properties subject to portfolio reengineering.

                                            Table 2.3

                               Impact of Portfolio Reengineering on
                             FHA's Insurance Fund, Fiscal Years 1996-
                                               2005

                              (Dollars in billions (present value))

                                                       Unpaid principal
    Relative value of assisted     FHA insurance       balances at date
    rents before restructuring     claims costs        of restructuring    Loss rate
    -----------------------------  ------------------  ------------------  ------------------
    Greater than or equal to       Between $4.8 and    Between $6.9 and    67% to 75%
    market rents                   $5.8                $8.1

    Less than market rents\a       Between $1.0 and    Between $2.2 and    40% to 51%
                                   $1.5                $3.1

    =========================================================================================
    Total                          Between $6.0 and    Between $9.5 and    61% to 67%
                                   $7.0                $10.8
    -----------------------------------------------------------------------------------------
    Note:  All estimates for projects whose assisted rents were
    determined, on the basis of Ernst & Young's sample, to be above or
    below market rents may be misstated because the sample did not
    contain properties with both types of rents in each group, or
    stratum, sampled.  Thus, the estimates assume that none of the
    assisted rents for 510 projects from three strata containing newer
    projects were below market rents.  The estimates also assume that
    none of the assisted rents for 372 older projects from two strata
    were above market rents.

    \a This estimate may be misstated because no projects with claims
    were found among the projects with assisted rents below market rents
    sampled from four strata.  Thus, the estimate assumes that none of
    the 985 projects from these strata were projects with assisted rents
    below market rents that resulted in claims.  The 985 projects
    included 807 newer and 178 older projects.

    --------------------
    \11 FHA uses its General Insurance Fund and Special Risk Fund to
    account for the claim payments and other cash flows, such as premium
    receipts, associated with multifamily insurance programs.  In fiscal
    year 1995, the premiums collected in these funds totaled $286
    million.

    \12 The loss rate represents the ratio of claims to unpaid principal
    balances at the date of restructuring.

       GAO'S EVALUATION OF THE MODEL
       AND ITS RESULTS
    ---------------------------------------------------------- Chapter 2:4

    Ernst & Young's financial model provides a reasonable framework for
    projecting the overall results of portfolio reengineering, such as
    the number of properties that would need to have their debt
    restructured and the related costs of insurance claims.\13 In
    addition, as discussed in appendix III, we did not identify any
    substantive problems with Ernst & Young's sampling and statistical
    methodology.  However, some assumptions used in Ernst & Young's
    financial model may not reflect the way in which insured Section 8
    properties would actually be affected by portfolio reengineering.
    Our comparison of Ernst & Young's data with the information we
    obtained on 10 case study properties raised questions about one key
    data element--the estimated costs of deferred maintenance and capital
    needs.

    --------------------
    \13 The model does not attempt to predict owners' or residents'
    behavior, and, as noted earlier, does not reflect the changes made to
    HUD's proposal in early 1996.

          CASH FLOW MODEL PROVIDES THE
          BASIS FOR EVALUATING THE
          OUTCOME OF PORTFOLIO
          REENGINEERING
    -------------------------------------------------------- Chapter 2:4.1

    Ernst & Young's financial model is a 10-year cash flow model that
    computes the net operating incomes for each property before, during,
    and after the rents are set at market levels.  That is, the model
    produces annual revenues, operating costs, and replacement reserve
    requirements (i.e., amounts that need to be set aside to cover future
    capital needs) and calculates net income on the basis of these
    amounts.  The initial cash flows are based on data, adjusted for
    inflation, from the properties' audited financial statements for
    1994.  The model assumes that income and tenant payments will grow by
    3 percent a year and expenses by 4 percent a year.  The higher growth
    rate for expenses was intended to provide more conservative
    estimates.  The model assumes that market rents will be phased in
    over 9 months, beginning 3 months after the first Section 8 contract
    for each property expires, and that the operating costs for some
    properties will be reduced.\14 HUD's rental assistance, included in
    the model as part of revenues, is based on the existing project-based
    subsidies, adjusted for inflation, until 3 months after the first
    contract expires.  After the restructuring, the model assumes,
    residents will receive tenant-based assistance (certificates or
    vouchers) covering the estimated market rents at the properties.
    However, the assistance is no longer linked to specific properties,
    and the residents could choose to relocate.

    For each of the 10 years covered, the model computes both a net
    operating income and an adjusted net operating income.  The net
    operating income represents the total revenues less the operating
    expenses, whereas the adjusted net operating income is further
    reduced by the amount required annually for a replacement reserve.
    Each property is then subjected to two tests of its loan's
    performance when the first Section 8 contract expires to determine
    whether the cash flows provide sufficient income for the property to
    cover (1) the current debt service (mortgage payment) excluding any
    interest subsidy currently available and (2) the immediate deferred
    maintenance and short-term capital backlog costs.  If a loan passes
    both tests, it is categorized as performing.  Loans that are not
    classified as performing are analyzed further to determine whether
    their appropriate portfolio reengineering category is debt
    restructure, full write-off, or nonperforming.\15

    --------------------
    \14 For properties whose current operating expenses exceed industry
    averages, as obtained from the Institute of Real Estate Management
    (IREM), and whose rental revenues would decrease under reengineering,
    Ernst & Young's model reduced the estimated operating expenses by up
    to 15 percent of the difference between the properties' historical
    operating costs and IREM's average costs to reflect operating
    efficiencies after reengineering.

    \15 Table 2.2 provides the criteria for placement in the four
    categories used in the study to describe the potential outcome of
    portfolio reengineering.

          FINANCIAL MODEL IS
          REASONABLE, BUT SOME
          ASSUMPTIONS ARE QUESTIONABLE
    -------------------------------------------------------- Chapter 2:4.2

    In general, Ernst & Young's financial model provides a reasonable
    framework for analyzing the impact of HUD's portfolio reengineering
    proposal on the insured Section 8 portfolio.  However, some of its
    assumptions may not reflect the way in which insured Section 8
    properties would actually be affected by portfolio reengineering.  In
    addition, some of the model's assumptions may not be apparent to
    readers of Ernst & Young's May 1996 report.  The market rents
    projected for 10 case study properties by Ernst & Young and by the
    contract appraisers were generally consistent.  However, our
    comparison of the immediate deferred maintenance needs identified at
    the 10 properties by Ernst & Young and by the contract appraisers and
    our discussions with the owners or managers of the properties
    indicated that the study's results may not always accurately reflect
    conditions at these properties.  More detailed discussions of the
    differences between Ernst & Young's and the contract appraisers'
    assessments of the 10 case study properties are presented in
    appendixes I and V.

          MARKET RENTS APPEAR
          REASONABLE, BUT DEFERRED
          MAINTENANCE COSTS RAISE
          QUESTIONS
    -------------------------------------------------------- Chapter 2:4.3

    As part of our review, we contracted with three licensed real estate
    appraisal firms for assessments of 10 HUD-insured Section 8
    properties included in Ernst & Young's sample.  The appraisers' tasks
    included studying the local markets in which the properties are
    located and determining what market rents the properties would be
    able to command.  As table 2.4 indicates, for 8 of the 10 properties,
    the estimated market rents that Ernst & Young developed in its market
    surveys are reasonably close to (i.e., within 10 percent of) the
    rents developed by the appraisers we retained.

                                   Table 2.4

                    Comparison of Estimated Market Rents for
                    10 Properties in HUD's Insured Section 8
                                   Portfolio

                                     Ernst &  Appraisa
                                     Young's  l firm's  Differen  Differen
                                    estimate  estimate     ce in     ce in
    Case study property/location          \a        \a   dollars   percent
    ------------------------------  --------  --------  --------  --------
    Capitol Towers,
     Washington, D.C.                   $491      $451       $40         9
    Fannie E. Taylor,
     Jacksonville, Florida               403       387        16         4
    Green Ridge Meadow,
     Evergreen, Colorado                 475       530        55        10
    Jackie Robinson,
     San Francisco, California         1,042     1,071        29         3
    Jacksonville Townhouse,
     Jacksonville, Florida               431       391        40        10
    Murdock Terrace,
     Dallas, Texas                       495       471        24         5
    Onterie Center,
     Chicago, Illinois                 1,245     1,134       111        10
    St. Andrew's Manor,
     Oakland, California                 489       616       127        21
    Terrace Gardens,
     Staten Island, New York             739       952       213        22
    Universal City,
     Chicago, Illinois                   578       594        16         3
    ----------------------------------------------------------------------
    \a Estimates reflect a weighted average of apartment sizes (studio,
    1-bedroom, etc.) and include the costs of utilities.

    For two properties, however, there are significant differences.
    Ernst & Young's estimates of the market rents for St.  Andrew's Manor
    and Terrace Gardens are more than 20 percent lower than the contract
    appraisers' estimates.  This difference reflects, in large measure,
    Ernst & Young's use of a different methodology to estimate market
    rents in neighborhoods consisting primarily of assisted
    properties--where few, if any, comparable properties with market
    rents were identified.  In these cases, Ernst & Young assumed that
    because the neighborhoods were essentially maintained by
    non-market-driven forces, there were no markets for unassisted rents
    other than those controlled by the local housing authorities.  Thus,
    Ernst & Young based its estimates of market rents on the rents
    subsidized by the local housing authorities.  In contrast, the
    appraisers believed that there were comparable properties that could
    be used to estimate market rents for the two properties.

    While Ernst & Young and the contract appraisers arrived at generally
    consistent estimates of market rents for the 10 case study
    properties, they developed widely differing estimates of the
    properties' capital needs.  In general, Ernst & Young projected
    significantly higher costs.  These differences occurred, in part,
    because Ernst & Young and the contract appraisers used different
    approaches for assessing capital needs.

    Ernst & Young retained a firm to conduct engineering studies at the
    properties.\16

    As discussed earlier, Ernst & Young's assessment of a property's
    capital needs included three components:  the immediate deferred
    maintenance, short-term capital backlog, and long-term capital
    backlog.  In the model, Ernst & Young assumed that funding would be
    provided to cover the immediate deferred maintenance and short-term
    capital needs at the time the property was reengineered (up to a full
    write-down of the property's mortgage).  The short-term capital needs
    cover the "estimated expired costs" rather than the full replacement
    costs of the items with remaining useful lives of 5 years or less.
    For example, a $15,000 roof with an original useful life of 15 years
    would, when it was 11 years old, have estimated expired costs of
    $11,000, which would be included in the property's short-term capital
    backlog.  The additional funding needed to replace the roof in 4
    years would be funded by annual replacement reserves factored into
    the property's annual cash flows.  Thus, the reserves cover part of
    the short-term capital backlog and the replacement of systems and
    components that have remaining useful lives of more than 5 years.
    Ernst & Young's approach for estimating capital needs involved
    reviewing a property's major subsystems and unit components and then
    estimating, for each, the original useful life, remaining useful
    life, replacement cost, and need for repairs or replacement.  This
    information was used to calculate the property's immediate deferred
    maintenance needs and short-term capital backlog.  According to Ernst
    & Young, the estimates included in the study represent the (1) costs
    for items that require immediate attention, (2) costs for items that
    may still be operable but have outlasted their planned useful
    life,\17 and (3) expired costs (depreciation) for items that are
    expected to need replacement in the next 5 years.

    In general, the contract appraisers based their estimate of a
    property's capital needs on their assessment of the repairs and
    renovations required for the property to operate as a market-rate
    property after reengineering.  This approach relies primarily on an
    evaluation of the property relative to others in the same market,
    whereas Ernst & Young's approach depends, in part, on useful-life
    standards.  The appraisers based their assessment on their review of
    the property's previous physical inspections and on their own
    physical inspection.  The appraisers were not, however, tasked with
    performing engineering studies.

    Because of these methodological differences, direct comparisons of
    Ernst & Young's and the appraisers' estimates are difficult.  In our
    view, the most comparable estimates are for immediate deferred
    maintenance needs; these estimates for 10 properties appear in table
    2.5.  Ernst & Young's estimates are taken from the firm's May 2,
    1996, report.

                                   Table 2.5

                       Comparison of Estimated Immediate
                       Deferred Maintenance Needs for 10
                     Properties in HUD's Insured Section 8
                                   Portfolio

                                       Ernst & Young's    Appraisal firms'
    Property/location                         estimate            estimate
    ------------------------------  ------------------  ------------------
    Capitol Towers,
     Washington, D.C.                       $1,356,434          $1,033,535
    Fannie E. Taylor,
     Jacksonville, Florida                     362,349                   0
    Green Ridge Meadow,
     Evergreen, Colorado                         5,000                   0
    Jackie Robinson,
     San Francisco, California                 325,350             707,200
    Jacksonville Townhouse,
     Jacksonville, Florida                     797,402                   0
    Murdock Terrace,
     Dallas, Texas                           5,663,798             370,000
    Onterie Center,
     Chicago, Illinois                          58,892                   0
    St. Andrew's Manor,
     Oakland, California                       415,220             176,000
    Terrace Gardens,
     Staten Island, New York\a               2,478,562             546,500
    Universal City,
     Chicago, Illinois                         214,184                   0
    ----------------------------------------------------------------------
    Note:  See app.  II for Ernst & Young's estimates of the total
    capital costs for the 10 properties.

    \a This property includes two buildings covered by separate insured
    mortgages, one of which was included in Ernst & Young's sample.
    Ernst & Young's estimate applies only to the building in the sample.
    Therefore, for purposes of comparison, we have included half of the
    appraiser's total estimate, which covers both buildings included in
    the appraisal.

    In commenting on this comparison, Ernst & Young officials indicated
    that their firm's estimates of deferred maintenance needs are likely
    to be higher than those of the contract appraisers because they
    include costs not only for the major subsystems and components that
    need major repair or are in poor condition but also for items such as
    appliances and heating and air-conditioning systems that are still
    functioning but have outlasted their useful life.  Ernst & Young's
    estimates assumed that investors or lenders would want to replace
    such items.  To demonstrate the effect of this assumption on their
    firm's estimates of deferred maintenance needs, Ernst & Young
    officials provided us with an analysis showing how the exclusion of
    such items would change the estimates.  This additional information
    showed that using useful-life standards generally resulted in higher
    cost estimates than using, as the contract appraisers did, the actual
    condition of systems and components and comparisons of the appraised
    property with other properties in the local real estate market.

    Table 2.6 adjusts Ernst & Young's estimates for the 10 properties'
    immediate deferred maintenance needs, eliminating the global
    assumption that items exceeding their estimated useful life would be
    replaced.  This adjustment reduced Ernst & Young's estimates, in some
    cases substantially.\18 For example, the estimate for Murdock Terrace
    in Dallas, Texas, was adjusted from $5.7 million to $2.1 million when
    the replacement costs for items that were still operable but had
    exceeded their useful life were excluded.

    Even after adjusting Ernst & Young's estimates, we found that, for
    some properties, Ernst & Young's estimates still differed
    substantially from those of the contract appraisers.  For example,
    Ernst & Young's estimate of the immediate deferred maintenance needs
    at Jacksonville Townhouse in Jacksonville, Florida, remained at
    $797,402, while the appraiser did not identify any deferred
    maintenance needs.  The property's owner and manager also strongly
    disagreed with Ernst & Young's cost estimates for immediate deferred
    maintenance, especially the estimate of $360,018 to replace heating
    and air-conditioning systems.  The manager said the main system is
    only 3 years old and is covered by a maintenance contract and that
    the cost of work in the individual units, which Ernst & Young had
    estimated at $295,492 (or $3,545 a unit), is more than four times
    higher than necessary.  He said that the heating and air-conditioning
    systems had recently been replaced in 35 units at a cost of $800 per
    unit.

                                   Table 2.6

                     Comparison of Ernst & Young's Revised
                        Estimates of Immediate Deferred
                     Maintenance Needs and Appraisal Firms'
                      Estimates for 10 Properties in HUD's
                          Insured Section 8 Portfolio

                                       Ernst & Young's           Appraisal
    Property/location                adjusted estimate     firms' estimate
    ------------------------------  ------------------  ------------------
    Capitol Towers,
     Washington, D.C.                       $1,107,384          $1,033,535
    Fannie E. Taylor,
     Jacksonville, Florida                     128,535                   0
    Green Ridge Meadow,
     Evergreen, Colorado                         5,000                   0
    Jackie Robinson,
     San Francisco, California                 308,150             707,200
    Jacksonville Townhouse,
     Jacksonville, Florida                     797,402                   0
    Murdock Terrace,
     Dallas, Texas                           2,144,209             370,000
    Onterie Center,\
     Chicago, Illinois                              \a                   0
    St. Andrew's Manor,
     Oakland, California                       376,820             176,000
    Terrace Gardens,
     Staten Island, New York\b               1,092,922             546,500
    Universal City,
     Chicago, Illinois                          89,383                   0
    ----------------------------------------------------------------------
    \a Ernst & Young did not provide a revised estimate for this
    property, which was inspected but subsequently dropped from the
    study.

    \b This property includes two buildings covered by separate insured
    mortgages, one of which was included in Ernst & Young's sample.
    Ernst & Young's estimate applies only to the building in the sample.
    Therefore, for purposes of comparison, we have included half of the
    appraiser's total estimate, which covers both buildings included in
    the appraisal.

    Because the estimates of capital needs that Ernst & Young presented
    in its study were difficult to compare directly with those of the
    contract appraisers, we provided both estimates to the owners and
    managers of the 10 case study properties for their review and
    comment.\19 The owners and managers generally disagreed with Ernst &
    Young's estimates.  For the most part, they said that the estimates
    were too high and did not accurately reflect the physical condition
    of the properties.  In some cases, the owners and managers questioned
    some of the underlying assumptions used in developing the estimates
    and identified cost estimates that they considered too high--in some
    cases, almost twice as high as they would estimate.  For example, one
    property manager agreed that all of the property's operating systems
    needed major rehabilitation.  However, his detailed estimate of about
    $3 million, including a $500,000 allowance for overruns, was about 50
    percent lower than Ernst & Young's estimate of nearly $5.7 million.
    The contract appraiser for that property also believed that Ernst &
    Young's estimate was excessive.  He stated that the neighborhood's
    standards and rental rates would not justify the renovation costs
    identified by Ernst & Young.  When Ernst & Young adjusted its
    estimate by removing the replacement costs of items that had exceeded
    their useful life but were still in working condition, the revised
    estimate of $2.1 million was more in line with the property manager's
    assessment of the property's physical condition.

    Another property manager said that Ernst & Young's estimate was
    "grossly overstated and in no way accurately represent[ed] the
    condition of the property" because it did not appear to reflect a $2
    million rehabilitation that was done in 1991 and 1992.  While Ernst &
    Young estimated immediate deferred maintenance needs of $362,349 for
    this property, the manager said there were no deferred maintenance
    needs and the contract appraiser identified no deferred maintenance
    or other repairs needed for the property to compete in the
    marketplace.  Ernst & Young's adjusted estimate of the immediate
    deferred maintenance needs for this property was $128,535.

    According to an official from the engineering firm retained by Ernst
    & Young, with whom we discussed the owners' and managers' assessments
    of Ernst & Young's cost estimates, the owners' cost estimates may be
    understated.  He said, for example, that current owners may be less
    concerned than new investors with comparing their property to others
    in the surrounding market and may therefore not plan for some changes
    that new owners would want to make.  He said the estimates used in
    Ernst & Young's study represent the costs of meeting the standards of
    the industry and of the surrounding market.\20

    Other comments provided by owners and property managers and our
    review of the estimates indicated that Ernst & Young's estimates may
    not take into account all of the ongoing maintenance at the
    properties, such as the cyclical replacement of carpets and other
    unit items, preventive maintenance performed under contracts, recent
    improvements, and improvements that were under way at the time of
    Ernst & Young's inspections.  For example, one manager said that
    Ernst & Young's study did not reflect the actual condition of the
    property's heating and air-conditioning systems because it included
    the full replacement cost of $253,000 for the heating system in its
    estimate of the property's immediate deferred maintenance needs.
    However, the manager noted that when the engineering firm retained by
    Ernst & Young inspected the property in January 1996, the system's
    renovation was well under way.  The manager said the renovated
    heating system has a life expectancy of 30 years.  According to Ernst
    & Young, this difference occurred because the study used a
    "point-in-time" methodology.  This approach included only
    improvements that had been substantially completed at the time of the
    inspection and specifically excluded those that were planned or
    ongoing.  Consequently, even though the inspector noted that work on
    the heating system was occurring in most units and would be completed
    within 2 months, the estimate does not reflect this work because it
    was not substantially completed.

    We identified some additional limitations in Ernst & Young's approach
    that may affect the accuracy of the firm's capital needs estimates.
    For example, officials from Ernst & Young and the engineering firm
    acknowledged that although they intended to base these estimates on
    inspections of 10 percent of each property's randomly selected units,
    they were not always able to do so because of management, tenant, or
    timing considerations.  At 7 of the 10 case study properties, Ernst &
    Young's inspectors examined fewer than 10 percent of the units.
    Also, Ernst & Young calculated cost estimates for unit items, such as
    cabinets, appliances, and heating and air-conditioning components, by
    multiplying the estimated immediate cost per unit by the total number
    of units at the property.  However, in some cases this approach may
    not have been reliable because of differences among units.  For
    example, at one of the case study properties, which has 112
    apartments with kitchens and 92 assisted living units without
    kitchens, Ernst & Young's estimate of the property's immediate
    deferred maintenance needs included the costs of replacing kitchen
    cabinets in all of the units.

    --------------------
    \16 Officials from Ernst & Young and the engineering firm indicated
    that the inspections provide preliminary data that can be used for
    budgeting purposes.  However, the inspections were not the full
    engineering studies that would be used in financial underwriting or
    negotiations with owners.

    \17 The useful life standards for Ernst & Young's study represent a
    composite based on standards from two sources, Fannie Mae and the Air
    Force.

    \18 We did not validate the immediate deferred maintenance estimates
    generated by Ernst & Young for the 10 case study properties.
    Specifically, we did not trace the capital needs estimates back to
    the source documentation and to the computer program that generated
    Ernst & Young's estimates to determine whether the inspectors'
    evaluations were accurately reflected or to identify the instances in
    which estimated useful-life standards provided the basis for the
    estimates.

    \19 We provided the owners and managers with (1) Ernst & Young's
    estimates of the properties' immediate deferred maintenance,
    short-term capital needs, and annual replacement reserve requirements
    used in the study and (2) the appraisers' reports identifying any
    repairs and renovations needed for the properties to operate at
    market rates.  The estimates we provided to the owners and managers
    did not include Ernst & Young's revised estimates of immediate
    deferred maintenance needs, presented in table 2.6, because we
    received this information subsequently, on July 24, 1996, in response
    to the statement of facts we provided to HUD for its review and
    comment.

    \20 The cost estimates in Ernst & Young's study represent a composite
    based on national cost standards from Means Repair and Remodeling and
    the Department of Defense, adjusted with a cost factor for geographic
    location.

          QUESTIONS EXIST ABOUT SOME
          ASSUMPTIONS THAT CAN AFFECT
          THE STUDY'S RESULTS
    -------------------------------------------------------- Chapter 2:4.4

    Through our discussions with representatives of multifamily housing
    lending organizations and other multifamily housing industry
    officials and through our own analysis, we identified some
    assumptions used in the financial model that may not (1) reflect the
    way in which insured Section 8 properties would actually be affected
    by portfolio reengineering or (2) be apparent to readers of Ernst &
    Young's May 1996 report but are important to understanding the
    study's results.

      -- Ernst & Young's assumptions about the transition period for
         reengineered properties may be overly optimistic.  During this
         period, a reengineered property changes from an assisted
         property with rental subsidies linked to its units to an
         unsubsidized property competing in the marketplace for
         residents.  The model estimates that the entire transition will
         be completed within a year after the first Section 8 contract
         expires.  In addition, the model assumes that during this year,
         the property's rental income will move incrementally towards
         stabilization over 9 months.  The lenders with whom we discussed
         the reasonableness of the model's major assumptions considered a
         transition period of 1 to 2 years more likely.  They also
         anticipated a less stable transition than the model assumed,
         with less income and more costs.  An Ernst & Young official told
         us that the 9-month period was designed to reflect an average
         transition period for reengineered properties.  While
         recognizing that the transition period for some properties would
         be longer, he believed that for others it could be shorter.

      -- In Ernst & Young's financial model, the first test of a loan's
         performance under portfolio reengineering assumes the
         elimination of the interest subsidy that many older assisted
         properties currently receive.  Specifically, the model compares
         the net operating income under market rents with the current
         debt service, excluding any interest subsidy provided with the
         current loan.  This assumption puts fewer loans in the
         performing category than would appear there if the subsidies
         were assumed to continue.  According to Ernst & Young, the model
         excludes the current interest subsidies under portfolio
         reengineering because it assumes that subsidies would not exist
         under true market conditions.  However, such an assumption
         implies a change in the terms of loans to which both borrowers
         and lenders have agreed.  Hence, while this assumption might be
         appropriate for restructuring loans on which defaults would
         occur if the terms of the loans were not changed, it is not, in
         our view, appropriate for identifying the loans that need
         restructuring.  As long as the borrowers continue to meet the
         terms of these loans, HUD cannot, as an official indicated,
         unilaterally discontinue the interest subsidy payments on them.
         Typically, the interest subsidies reduce interest payments on
         the loans to 1 percent.  If Ernst & Young's model assumed that
         interest subsidies would continue, some additional properties
         would be classified as performing.  This change would decrease
         the model's estimates of the claims costs associated with
         portfolio reengineering but would entail the Department's
         continuing to incur interest subsidy costs.

      -- The debt service coverage ratios, loan-to-value ratios,\21 and
         amortization periods used in the model provide for higher levels
         of mortgage debt than the lenders we contacted generally
         understood to be available.  If their understanding is correct,
         the model's assumptions would provide for lower claims than
         might actually result.  For example, the lenders we contacted
         generally believed that most lenders would want to see at least
         1 year's worth of operations at the stabilized level before
         approving a loan.  Without such a stabilized period of
         operations, they believed, many commercial lenders would
         consider the properties too risky to provide long-term
         commercial financing at standard terms.  Some officials believed
         that venture capital firms might be the only firms interested in
         properties whose operations had not stabilized after
         reengineering.  In any case, they believed that the financing
         terms available for reengineered properties without proven track
         records would be more conservative than standard financing
         terms.  The lenders believed that the 1.20 debt service coverage
         ratio\22 and the 1.0 loan-to-value ratio used in the model would
         not likely be available for loans on many reengineered
         properties, particularly given the uncertainties concerning (1)
         how these properties would operate in a market-rate environment
         and (2) whether, what type of, and what levels of Section 8
         assistance would be available in the future.  They believed that
         higher debt service coverage ratios and lower loan-to-value
         ratios would be more likely.  In addition, they believed that
         30-year loan amortizations might not be available.  The lenders
         indicated that 25-year loan amortizations were typical for
         commercial loans.\23 In commenting on the views of the lenders
         we contacted, an Ernst & Young official stated that the
         underwriting criteria would take into account not only the debt
         service coverage and loan-to-value ratios and the amortization
         periods but also the level of capital provided through the
         short-term capital needs estimates and annual replacement
         reserves, as well as the interest rates, operating expenses, and
         revenues estimates.  He believed that these factors would
         provide lenders with more comfort about the ability of
         properties to make the transition to a market environment.  When
         obtaining the views of the lenders, we provided them with
         information on the full range of underwriting assumptions used
         by Ernst & Young, including those relating to the funding for
         capital needs, interest rates, revenues, and operating expenses.
         The Ernst & Young official also noted that Ernst & Young's terms
         assumed the Congress would continue to subsidize residents with
         Section 8 tenant-based assistance under a multiyear program.
         Finally, the Ernst & Young official noted that the financial
         model used 1.0 as a loan-to-value ratio so that the model would
         calculate the mortgage amounts for reengineered properties on
         the basis of their debt service coverage ratios rather than
         their loan-to-value ratios.

      -- The model assumes that replacement reserves must cover the
         estimated annual replacement costs for all major property
         systems.  In contrast, the lenders we spoke with generally
         require replacement reserves for capital items for a set period
         of time--such as over the life of the loan or over the life of
         the loan plus 2 years.  Thus, Ernst & Young's approach requires
         higher replacement reserves than the private sector may require.
         The requirements for replacement reserves affect annual cash
         flows and the funding available to support mortgage debt.  For
         example, in Ernst & Young's study, if a property's hot water
         systems were evaluated to have a remaining useful life of 25
         years, the annual replacement reserve would include prorated
         amounts for the full cost of replacing the hot water systems.
         However, if the restructured loan were for 15 years, the lenders
         we spoke with believed that annual funding for replacing the hot
         water systems typically would not be required.  Some replacement
         reserve items funded in Ernst & Young's study, such as walls and
         foundations and parking lots, have useful lives of more than 50
         years.

      -- The Section 8 costs for reengineering are estimated only for the
         residents who currently receive Section 8 project-based
         assistance.  In contrast to HUD's original proposal, which was
         the basis of Ernst & Young's study, HUD's current proposal
         includes the residents who do not receive Section 8
         project-based assistance but would qualify for assistance when
         market rents were applied.

    --------------------
    \21 The debt service coverage ratio indicates the extent to which a
    property's net income covers the mortgage principal and interest
    payments.  The loan-to-value (LTV) ratio compares the amount of a
    loan with a property's value and assists a lender in determining the
    appropriate amount to lend.  For example, an LTV of 80 percent would
    indicate a loan of $800,000 for a property valued at $1 million.

    \22 Ernst & Young used a 1.2 debt service coverage ratio for two of
    the four categories of loans that will be restructured.

    \23 The model also does not reflect lenders' views that loans without
    FHA insurance for reengineered properties would typically be for 5,
    10, or 15 years, with 25-year amortizations and balloon payments.

       SENSITIVITY ANALYSIS CAN ASSIST
       IN EVALUATING THE RANGE OF
       POSSIBLE OUTCOMES
    ---------------------------------------------------------- Chapter 2:5

    Any estimates of the outcomes and costs of portfolio reengineering
    are likely to be subject to some error because they rely on
    predicting the reactions of numerous owners, lenders, and residents.
    In addition, as discussed above, some assumptions used in Ernst &
    Young's financial model may not accurately reflect the effects of
    portfolio reengineering on insured Section 8 properties or, at a
    minimum, are subject to debate.  To assess the extent to which the
    use of different assumptions affects the results of Ernst & Young's
    study, we performed sensitivity analyses of Ernst & Young's model
    using two sets of revised assumptions that we developed through our
    discussions with multifamily housing industry officials.  One
    scenario reflects assumptions that are more optimistic in terms of
    the cost to the government of portfolio reengineering.  The other
    uses assumptions that are more conservative or pessimistic.  Taken
    together, these sets of assumptions are intended to reflect the range
    of potential outcomes resulting from the basic policy assumptions
    used in Ernst & Young's study.  We recognize that using alternative
    policy assumptions could produce different outcomes.

    Appendix IV provides information on the assumptions used in Ernst &
    Young's study and in our optimistic and pessimistic analyses.
    Because the owners and managers and the contract appraisers generally
    believe that the capital costs for the 10 case study properties were
    significantly lower than those Ernst & Young estimated, we reduced
    all capital costs used by Ernst & Young by 25 percent in our
    optimistic scenario.  We did not adjust Ernst & Young's capital costs
    in the pessimistic scenario.

    As table 2.7 indicates, under both the optimistic and the pessimistic
    alternatives, as well as under Ernst & Young's original assumptions,
    a substantial number of properties are likely to do well and other
    properties will have difficulty sustaining operations.  For example,
    under the optimistic assumptions, between 24 and 30 percent of the
    properties fall into the performing category, but between 15 and 20
    percent fall into the two bottom categories--full write-off or
    nonperforming.  Under the pessimistic assumptions, between 10 and 14
    percent are in the performing category and between 39 percent and 46
    percent are in the full write-off or nonperforming category.

                                   Table 2.7

                     Effects of Portfolio Reengineering on
                     Loan Performance Under Three Scenarios

                         (Loan performance in percent)

                                                       Ernst &  Pessimisti
                                        Optimistic     Young's           c
                                        assumption  assumption  assumption
    Loan performance                             s           s           s
    ----------------------------------  ----------  ----------  ----------
    Performing                            24 to 30    17 to 23    10 to 14
    Restructure                           53 to 60    50 to 58    42 to 49
    Full write-off and nonperforming      15 to 20    22 to 29    39 to 46
    ----------------------------------------------------------------------
    As table 2.8 indicates, the cost of FHA insurance claims associated
    with portfolio reengineering are estimated to be between $4.9 billion
    and $5.9 billion under optimistic assumptions and between $8.2
    billion and $9.4 billion under pessimistic ones.  Because we used the
    same market rents for our optimistic scenario as Ernst & Young
    assumed, the 10-year costs of Section 8 assistance are the same.
    However, the 5-percent reduction in rents assumed in the pessimistic
    scenario lowered these 10-year costs by between $0.9 billion and $1.0
    billion.

                                   Table 2.8

                     Effects of Portfolio Reengineering on
                     10-Year Subsidy and Claims Costs Under
                                Three Scenarios

                     (Dollars in billions (present value))

                                                       Ernst &  Pessimisti
                                        Optimistic     Young's           c
                                        assumption  assumption  assumption
    Costs for fiscal years 1996-2005             s           s           s
    ----------------------------------  ----------  ----------  ----------
    Section 8 subsidies                   $26.5 to    $26.5 to    $25.6 to
                                             $29.8       $29.8       $28.8
    Claims against FHA's
     Insurance Fund                        $4.9 to     $6.0 to     $8.2 to
                                              $5.9        $7.0        $9.4
    ----------------------------------------------------------------------
    As previously discussed, these subsidy estimates assume that loans
    are restructured when their first Section 8 contract expires.
    However, as noted, HUD is now proposing a proactive approach under
    which owners would agree to restructure their loans before the first
    Section 8 contract expires.  In addition, HUD is proposing to
    initially restructure only loans for properties whose assisted rents
    exceed market rents, thereby providing for decreases in subsidies.

       CONCLUSIONS
    ---------------------------------------------------------- Chapter 2:6

    Although questions have arisen about some of the data and assumptions
    used in Ernst & Young's study, we nevertheless believe that the study
    represents an important step in understanding the effects of
    reengineering on and the condition of the properties in HUD's insured
    Section 8 portfolio.  Quantitative, statistically reliable
    information based on case-by-case analyses of the properties, such as
    that produced by the study, can assist the Congress in evaluating
    HUD's proposal and comparing it to other reengineering alternatives.

    As the Congress and HUD continue to address issues associated with
    portfolio reengineering (see ch.  3), we believe that opportunities
    exist for HUD to make further use of Ernst & Young's data and to
    carry out additional analyses of the insured Section 8 portfolio.
    One important task will be to incorporate the results of Ernst &
    Young's study into HUD's budget estimates under portfolio
    reengineering.  Other areas that merit additional analysis are the
    effects of including or excluding various segments of the portfolio
    in reengineering; the cost implications of continuing versus
    discontinuing FHA's insurance after reengineering and of using
    project-based versus tenant-based assistance; and the options for
    dealing with those properties that fall into the nonperforming or
    full write-off categories after reengineering.  In addition, given
    the uncertainties about the capital costs used in the study, further
    analysis of the physical condition and related capital needs of the
    insured Section 8 portfolio is needed.  The update to HUD's 1990
    multifamily stock study, currently under way, should help to address
    this open issue.

       AGENCY COMMENTS AND OUR
       EVALUATION
    ---------------------------------------------------------- Chapter 2:7

    In commenting on a draft of this report, HUD said the report provided
    an excellent summary of the portfolio reengineering proposal and its
    likely impact on the insured multifamily portfolio.  HUD also noted,
    among other things, that differences in the estimates of deferred
    maintenance and capital needs developed by Ernst & Young and by the
    contract appraisers are due to differences in the methodologies used.
    (HUD's comments are reproduced in app.  VI).  While agreeing that
    differences in the estimates are due, in part, to differences in the
    methodologies, we continue to question certain aspects of Ernst &
    Young's approach, including (1) the assumption that working systems
    and components will be replaced if their estimated useful lives have
    expired and (2) the inclusion in the capital needs estimates of the
    cost of work that is under way but not yet completed.  The fact that
    Ernst & Young's estimates for 7 of the 10 case study properties that
    GAO reviewed were based on inspections of fewer than 10 percent of
    each property's units also adds to the uncertainty of the estimates.
    For these reasons, as noted in our conclusions, we believe that
    further analysis is needed of the physical condition and capital
    needs of the insured Section 8 portfolio.

    HUD's comments also indicate that HUD inferred from the comments
    provided by the lenders we contacted that they were not fully
    informed of the methodology and assumptions used in the Ernst & Young
    model.  In fact, we provided the lenders we spoke to with information
    on the full range of underwriting assumptions used by Ernst & Young.

    In addition, HUD commented that the estimated costs of restructuring
    HUD's multifamily portfolio that we derived from Ernst & Young's
    model do not conform with federal budget rules and scoring
    methodology and do not reflect all aspects of HUD's current portfolio
    reengineering proposal.  As stated in the report, the data we present
    on the cost of restructuring HUD's multifamily portfolio are intended
    to reflect the results of Ernst & Young's financial model, including
    the assumptions used by Ernst & Young.  We recognize that the cost
    estimates do not conform with federal budget rules and scoring
    methodology and do not reflect all aspects of HUD's current portfolio
    reengineering proposal.  Both of these points are discussed earlier
    in the chapter and were clearly stated in the copy of the draft
    provided to HUD for comment.

    KEY ISSUES FACING THE CONGRESS ON
    HUD'S PORTFOLIO REENGINEERING
    PROPOSAL
    ============================================================ Chapter 3

    The Congress faces a number of significant and complex issues in
    evaluating HUD's portfolio reengineering proposal.  How these issues
    are resolved will, to a large degree, determine the extent to which
    the problems that have long plagued the portfolio are corrected and
    prevented from recurring, as well as the extent to which
    restructuring results in savings or costs to the government.  Key
    issues include the following:  To what extent should FHA provide
    insurance for restructured loans?  Should rental assistance be
    project-based or tenant-based?  What protection should be given to
    households at reengineered properties?  To what extent should the
    federal government finance the costs of rehabilitation?  What actions
    should be taken to address problems in HUD's management of the
    insured Section 8 portfolio?  To what extent should properties with
    assisted rents below market rents be included in portfolio
    reengineering?  What processes should be used to restructure
    mortgages?  What should be done to help the large number of
    properties that would have difficulty sustaining operations?  To what
    extent should the government provide tax relief to owners affected by
    portfolio reengineering?  Will the recently enacted portfolio
    reengineering demonstration program cover the full range of options
    and outcomes?

       TO WHAT EXTENT SHOULD FHA
       PROVIDE INSURANCE FOR
       RESTRUCTURED LOANS?
    ---------------------------------------------------------- Chapter 3:1

    An issue with short- and long-term cost implications is whether HUD
    should continue to provide FHA insurance for the restructured loans
    and, if so, under what terms and conditions.  If HUD were to
    discontinue the insurance when restructuring the loans, as it
    originally planned, it would likely incur higher debt restructuring
    costs because lenders would set the terms of the new loans (e.g.,
    interest rates) to reflect the risk of default that they would now
    assume.  The primary benefits of discontinuing FHA insurance are that
    (1) the government's dual role as mortgage insurer and rental subsidy
    provider would end, eliminating the management conflicts associated
    with this dual role, and (2) the risk of default borne by the
    government would end as the loans were restructured.

    If FHA insurance were continued, another issue is whether it would
    need to be provided for the whole portfolio or could be used
    selectively.  The government could, for example, insure loans only
    when owners could not obtain reasonable financing without insurance.
    Also, if FHA insurance were continued, the terms and conditions under
    which it is provided would affect the government's future costs.
    Some lenders have indicated that short-term (or "bridge") financing
    insured by FHA might be needed while the properties make the
    transition to market conditions, after which time conventional
    financing at reasonable terms would be available.  Under such an
    arrangement, the government could insure loans for 3 to 5 years,
    instead of bearing the risk of default, as it now does, for the life
    of the loans--generally 40 years.  Finally, legislation could require
    a portion of the risk of default, now borne entirely by the
    government, to be assumed by state housing finance agencies or
    private-sector parties.

       SHOULD RENTAL ASSISTANCE BE
       PROJECT-BASED OR TENANT-BASED?
    ---------------------------------------------------------- Chapter 3:2

    One of the key issues to be decided in addressing the problems of the
    insured Section 8 portfolio is whether to continue project-based
    subsidies, convert the portfolio to tenant-based assistance, or
    combine the two types of assistance.  On the one hand, using
    tenant-based assistance can make projects more subject to the forces
    of the real estate market, potentially helping to control housing
    costs, foster housing quality, and promote residents' choice.  On the
    other hand, using project-based assistance, which links subsidies
    directly to rental units, can help sustain properties in housing
    markets that have difficulty supporting unsubsidized rental housing,
    such as inner-city and rural locations.  In addition, residents who
    would likely have difficulty finding suitable alternative housing,
    such as the elderly or disabled and those living in a tight housing
    market, might prefer project-based assistance to the extent that it
    would give them greater assurance of being able to remain in their
    current residence.

       WHAT PROTECTION SHOULD BE GIVEN
       TO CURRENTLY ASSISTED
       HOUSEHOLDS?
    ---------------------------------------------------------- Chapter 3:3

    If a decision is made to convert the Section 8 program from
    project-based to tenant-based assistance as part of portfolio
    reengineering, decisions must also be made about whether to protect
    the current residents from displacement.  HUD's April 1996
    reengineering strategy contains several plans to protect the
    residents affected by rent increases at insured properties.  For
    example, the residents of Section 8 units that were converted from
    project-based to tenant-based assistance would receive an enhanced
    voucher to pay the difference between 30 percent of their household's
    adjusted income and the market rent for their unit even if the market
    rent exceeded the area's fair market rent ceiling.  The residents of
    reengineered properties who live in units without project-based
    subsidies would receive similar assistance if reengineering increased
    their rent to more than 30 percent of their household's adjusted
    income.  Such provisions would limit residents' rent burden and
    reduce the likelihood of displacement, but they would also lower the
    anticipated savings in assistance costs, at least in the short run.
    The cost estimates in Ernst & Young's report assume that HUD would
    continue to assist the residents of currently subsidized units even
    if the market rent exceeded the fair market rent set by HUD.
    However, the report's cost estimates do not include any allowance for
    assisting the residents of currently unsubsidized units.

       TO WHAT EXTENT SHOULD THE
       GOVERNMENT FINANCE
       REHABILITATION COSTS?
    ---------------------------------------------------------- Chapter 3:4

    Who should pay for needed repairs, and how much, is another important
    issue in setting restructuring policy.  As discussed previously,
    Ernst & Young's study found substantial unfunded immediate deferred
    maintenance and short-term capital replacement needs across the
    insured Section 8 portfolio, particularly among the older assisted
    properties.  Ernst & Young's data indicate that between 22 and 29
    percent of the properties in the portfolio could not cover their
    immediate deferred maintenance and short-term capital needs even if
    their mortgage debt were fully written off.  HUD has proposed to use
    the affected properties' reserve funds and, as necessary, claims
    against FHA's insurance funds to pay for a substantial portion of the
    rehabilitation and deferred maintenance costs associated with
    restructuring.  Others have suggested that HUD use a variety of
    tools-- such as raising rents, restructuring debt, and providing
    direct grants--but that dollar limits be set on the federal
    government's payment per unit, with the expectation that some other
    source, such as the owner or investor, will pay any remaining costs.

       WHAT SHOULD BE DONE TO ADDRESS
       PROBLEMS IN HUD'S PORTFOLIO
       MANAGEMENT?
    ---------------------------------------------------------- Chapter 3:5

    A key cause of the current problems affecting the insured Section 8
    portfolio has been HUD's inadequate management of the portfolio.  As
    discussed in chapter 1, weaknesses in HUD's oversight and management
    have allowed physical and financial problems at a number of the
    multifamily properties insured by HUD to go undetected or
    uncorrected.\1 HUD's original proposal sought to address these
    problems by subjecting the properties to the disciplines of the
    commercial market by converting project-based subsidies to
    tenant-based assistance; adjusting rents to market levels; and
    refinancing existing insured mortgages with smaller, uninsured
    mortgages, if necessary, for the properties to operate at the new
    rents.  However, to the extent that the final provisions of
    reengineering perpetuate the use of FHA insurance and project-based
    subsidies, HUD's ability to manage the portfolio will remain a key
    concern.  Other means will have to be found to address the
    limitations impeding HUD's management of the portfolio, particularly
    in light of the planned staff reductions that will further strain
    HUD's management capacity.

    --------------------
    \1 We have frequently discussed HUD's problems in overseeing the
    multifamily portfolio.  See the Related GAO Products at the end of
    this report.

       TO WHAT EXTENT SHOULD LOANS FOR
       PROPERTIES WITH BELOW-MARKET
       RENTS BE REENGINEERED?
    ---------------------------------------------------------- Chapter 3:6

    Deciding which properties to include in portfolio reengineering will
    likely involve trade-offs between reducing the high costs of
    subsidies, on the one hand, and improving the poor physical condition
    of the properties and lowering the government's exposure to default,
    on the other hand.  Reengineering only those properties with rents
    above market levels would produce the greatest savings in subsidy
    costs.  Yet HUD has indicated that also including those properties
    with rents currently below market levels could help improve these
    properties' physical and financial condition and reduce the
    likelihood of default.  However, including such properties would
    decrease the estimated savings in Section 8 subsidy costs.  Although
    HUD's latest proposal would initially focus on properties with
    above-market rents, it notes that many of the buildings with
    below-market rents are in poor condition or have significant amounts
    of deferred maintenance that will need to be addressed at some point.

       WHAT PROCESSES SHOULD BE USED
       TO RESTRUCTURE MORTGAGES?
    ---------------------------------------------------------- Chapter 3:7

    Selecting a mortgage restructuring process that is feasible and
    balances the interests of the various stakeholders will be an
    important but difficult task.  Various approaches have been
    contemplated, including the payment of full or partial insurance
    claims by HUD, the sale of mortgages, and the use of third parties or
    joint ventures to design and implement specific restructuring actions
    at each property.  Because of concerns about HUD's ability to carry
    out the restructuring process in house, HUD and others envision
    relying heavily on third parties, such as state housing financing
    agencies or teams composed of representatives from these agencies,
    other state and local government entities, nonprofit organizations,
    asset managers, and capital partners.  These third parties would be
    empowered to act on HUD's behalf, and the terms of the restructuring
    arrangements that they work out could to a large extent determine the
    costs to, and future effects of restructuring on, stakeholders such
    as the federal government, property owners and investors, mortgage
    lenders, residents, and state and local government housing agencies.
    Some, however, have questioned whether third parties would give
    adequate attention to owners' interests or to housing's public policy
    objectives.  Despite these questions, HUD believes that third-party
    arrangements could be structured to align third parties' financial
    interests with those of the federal government to help minimize
    claims costs.

       WHAT SHOULD BE DONE TO ADDRESS
       PROPERTIES THAT HAVE DIFFICULTY
       SUSTAINING OPERATIONS?
    ---------------------------------------------------------- Chapter 3:8

    According to Ernst & Young's assessment, between 22 and 29 percent of
    HUD's insured portfolio would have difficulty sustaining operations
    if market rents replaced assisted rents.  Furthermore, between 11 and
    15 percent of the portfolio would not even be able to cover operating
    costs at market rents.  If these properties did not receive
    additional financial assistance, a large number of low-income
    residents would face displacement.  While HUD has not yet developed
    specific plans for addressing the problems at these properties,
    different approaches may be needed, depending on the circumstances at
    individual properties.  For example, properties in good condition in
    tight housing markets may warrant one approach, while properties in
    poor condition in weak or average housing markets may warrant
    another.  Further analysis of these properties should assist the
    Department in formulating strategies for addressing their problems.

       TO WHAT EXTENT SHOULD THE
       GOVERNMENT PROVIDE TAX RELIEF
       TO OWNERS?
    ---------------------------------------------------------- Chapter 3:9

    HUD's portfolio reengineering proposal would be likely to have tax
    consequences for the owners of some projects.  These tax consequences
    could result either from reductions in the properties' mortgage
    principal (debt forgiveness) or from actions that would cause owners
    to lose their property (for example, as a result of foreclosure).  We
    have not assessed the extent to which tax consequences would be
    likely to result from portfolio reengineering.  However, HUD has
    stated its belief that tax consequences could be a barrier to getting
    owners to agree to reengineer their properties proactively.  While
    HUD has not formulated a specific proposal for dealing with the tax
    consequences of portfolio reengineering, it has expressed its
    willingness to discuss with the Congress mechanisms to take into
    account the tax consequences of debt forgiveness for property owners
    who enter into restructuring agreements.

       HOW COMPREHENSIVE WILL THE
       DEMONSTRATION PROGRAM BE?
    --------------------------------------------------------- Chapter 3:10

    The multifamily demonstration program that HUD recently received
    congressional authority to implement provides for limited testing of
    some aspects of HUD's multifamily portfolio reengineering proposal.
    Such testing can provide needed data on the effects of reengineering
    on properties and residents, the approaches that may be used in
    implementing restructuring, and the costs to the government before a
    restructuring program is initiated on a broad scale.  However,
    because the program is voluntary, it may not test the full spectrum
    of effects that portfolio reengineering could have or the full range
    of restructuring tools that the Department could use.  For example,
    owners may be reluctant to participate in the program if HUD plans to
    enter into joint ventures with third parties because they may be
    concerned about losing their properties and/or suffering adverse tax
    consequences.  Another potential limitation of the program is that,
    according to HUD, the funding provided to modify the multifamily
    loans may not be sufficient to cover the limited number of units
    authorized under the demonstration program.  In September 1996, the
    Congress made changes to the demonstration program in legislation on
    HUD's fiscal year 1997 appropriation (P.L.  104-204).

       OBSERVATIONS
    --------------------------------------------------------- Chapter 3:11

    HUD's portfolio reengineering initiative recognizes a reality that
    has existed for some time--namely, that the value of many of the
    properties in the insured Section 8 portfolio is far lower than the
    mortgages on the properties suggest.  Until now, this reality has not
    been recognized and the federal government has continued to subsidize
    the rents at many properties above the level that the properties
    could command in the commercial real estate market.

    As the Congress evaluates the options for addressing this situation,
    the fundamental problems that have affected the portfolio and their
    underlying causes will be important to consider.  Any approach that
    is implemented should address not only the high costs of Section 8
    subsidies but also the government's high exposure to insurance loss,
    the poor physical condition of some of the properties, and the
    underlying causes of these long-standing problems with the portfolio.
    As the previous discussions of several key issues indicate, questions
    about the specific details of the reengineering process, such as
    which properties to include and whether or not to provide FHA
    insurance, will require weighing the likely effects of various
    options and the trade-offs involved when a proposed solution achieves
    progress in one area at the expense of another.  Changes to the
    insured Section 8 portfolio should also be considered in the context
    of a long-range vision of the federal government's role--and the size
    of that role, given the current budgetary climate--in providing
    housing assistance, and assistance generally, to low-income
    individuals.

    Addressing the problems of HUD's insured multifamily portfolio will
    inevitably be costly and difficult, regardless of the specific
    approaches implemented.  The overarching objective should be to
    implement the process as efficiently and cost-effectively as
    possible, recognizing not only the interests of the parties directly
    affected by restructuring but also the impact on the federal
    government and the American taxpayer.

    DIFFERENCES AMONG PROPERTIES WILL
    INFLUENCE THE RESULTS OF
    REENGINEERING
    =========================================================== Appendix I

    The HUD-insured Section 8 properties that would be affected by
    reengineering differ from one another in many respects.  These
    differences would influence the results of HUD's reengineering
    proposal, producing different outcomes at individual properties.
    Whereas some of the properties could maintain sufficient occupancy
    and generate a positive cash flow after reengineering, others could
    not.  Also, the extent to which low-income residents would be able to
    move to better housing or would be displaced, and the availability of
    suitable alternative housing for them, would vary from property to
    property.

       GAO'S 10 CASE STUDY PROPERTIES
       DIFFER
    --------------------------------------------------------- Appendix I:1

    To help assess the likely effects of HUD's reengineering strategy on
    different types of multifamily properties, we performed case studies
    at 10 of the 558 properties included in Ernst & Young's study.  These
    10 properties, which illustrate the diversity within HUD's insured
    Section 8 portfolio, differ from one another in their mortgage
    financing, unpaid mortgage balances, types of assistance received
    from HUD, financial and physical condition, types of residents
    served, and neighborhoods' and rental housing markets'
    characteristics.  Figure I.1 shows the names and locations of the
    case study properties.

       Figure I.1:  Names and
       Locations of GAO's Case Study
       Properties

       (See figure in printed
       edition.)

          MORTGAGE FINANCING
          ARRANGEMENTS AND UNPAID
          MORTGAGE BALANCES
    ------------------------------------------------------- Appendix I:1.1

    The 10 properties that we reviewed were developed under different HUD
    programs by different types of owners and currently have outstanding
    mortgage debt with varying terms and conditions.  As table I.1
    indicates, three of these properties are owned by nonprofit
    organizations, and seven are owned by for-profit concerns.  To
    develop the properties, the owners obtained FHA-insured mortgages
    under various HUD programs.

                                            Table I.1

                             Original Property Financing Arrangements
                                  at GAO's Case Study Properties

                                                       Newer assisted or
                                                       older assisted      Mortgage insurance
    Case study property            Type of ownership   property            program
    -----------------------------  ------------------  ------------------  ------------------
    Capitol Towers                 For profit          Older assisted      Section 236

    Fannie E. Taylor               Nonprofit           Older assisted      Section 236

    Green Ridge Meadow             Nonprofit           Newer assisted      Section 221(d)(3)

    Jackie Robinson                For profit          Older assisted      Section 236

    Jacksonville Townhouse         For profit          Newer assisted      Section 221(d)(4)

    Murdock Terrace                For profit          Older assisted      Section 236

    Onterie Center                 For profit          Newer assisted      Section 221(d)(4)

    St. Andrew's Manor             Nonprofit           Older assisted      Section 236

    Terrace Gardens                For profit          Older assisted      Section 236

    Universal City                 For profit          Newer assisted      Section 221(d)(4)
    -----------------------------------------------------------------------------------------
    The six older assisted properties are insured under HUD's Section 236
    program, which was available between 1968 and 1973, and these
    properties have HUD-subsidized interest rates that are as low as 1
    percent.  The four newer assisted properties were constructed between
    1978 and 1986 and are insured under HUD's Section 221(d)(3) market
    rate or Section 221 (d)(4) mortgage insurance programs.  These four
    properties have market interest rates that range from 7.50 to 11.86
    percent.

    As table I.2 indicates, the insured mortgages on the 10 properties
    were endorsed\1

    between 1971 and 1986, and all have 40-year terms, reaching maturity
    between the years 2011 and 2027.  The face amounts of the mortgages
    range from about $985,000 to $66.3 million, and as of December 31,
    1995, the unpaid balances ranged from about $731,000 to $49 million.
    At one property, Onterie Center, the mortgage debt was increased and
    a portion of the debt was assigned to HUD in 1992 because of
    continuing financial difficulties, raising the total unpaid balance
    to about $75 million.

                                            Table I.2

                                Mortgage Debt at GAO's Case Study
                                            Properties

                                      Year of   Amount of      Unpaid
                                        final    original  balance on        Note    Mortgage
                                   endorsemen     insured     insured    interest    maturity
    Case study property                     t    mortgage  mortgage\a        rate        date
    -----------------------------  ----------  ----------  ----------  ----------  ----------
    Capitol Towers                       1975  $1,177,100    $928,694     7.00%\b   Apr. 2015
    Fannie E. Taylor                     1971  $2,857,900  $2,216,233     8.50%\c   Apr. 2012
    Green Ridge Meadow                   1982  $2,757,200  $2,450,007       7.57%   Nov. 2020
    Jackie Robinson                      1973  $3,249,200  $2,486,859     7.00%\b   Mar. 2013
    Jacksonville Townhouse               1979  $5,685,000  $4,851,712       7.50%   Oct. 2019
    Murdock Terrace                      1971  $3,443,000  $2,359,540     7.50%\c   Nov. 2011
    Onterie Center                       1986  $66,313,50  $74,897,46     7.50%\d    May 2027
                                                        0         6\e
    St. Andrew's Manor                   1973    $985,200    $731,003     7.00%\b   Jan. 2013
    Terrace Gardens                      1973  $5,131,600  $3,907,219     7.00%\b   July 2013
    Universal City                       1984  $8,661,100  $8,400,000      11.86%    May 2024
    -----------------------------------------------------------------------------------------
    \a Unpaid balance as of Dec.  31, 1995.

    \b Property receives a 6-percent mortgage interest subsidy from HUD.

    \c Property receives a 6.5-percent mortgage interest subsidy from
    HUD.

    \d Interest rate changes to 7.18 percent after June 1, 2000.

    \e Total unpaid balance includes an increase in the property's
    mortgage debt, $26.3 million of which was assigned to HUD in 1992
    because of continuing financial difficulties at the property.

    --------------------
    \1 Final endorsement represents the time at which the final amount of
    the mortgage is set, following the completion of construction at the
    property.

          ASSISTANCE RECEIVED
          FROM HUD
    ------------------------------------------------------- Appendix I:1.2

    The total number of apartment units at the case study properties
    ranges from 60 to 594.  Most of these units receive Section 8
    project-based rental subsidies.  Six of the properties have
    project-based Section 8 subsidies for 100 percent of their units,
    while four properties are only partially subsidized, receiving
    project-based Section 8 subsidies for as few as 20 percent of their
    units.  (See fig.  I.2.)

       Figure I.2:  Number of Units at
       GAO's Case Study Properties

       (See figure in printed
       edition.)

    The Section 8 units are subsidized under contracts that expire
    between 1996 and 2006; the contracts at seven of the properties will
    expire by the end of 1999.  Residents of the subsidized units pay 30
    percent of their household's income (after certain adjustments)
    toward the rent and HUD pays the rest.  The rents that HUD subsidizes
    at the 10 properties vary considerably.  For example, the rents for a
    one-bedroom apartment with a Section 8 subsidy range from $332 to
    $1,231 per month.  (See fig.  I.3.)

       Figure I.3:  HUD-Subsidized
       Rents for One-Bedroom
       Apartments at GAO's Case Study
       Properties

       (See figure in printed
       edition.)

    Note:  For properties with a range of HUD-subsidized rent levels for
    one-bedroom apartments, the high end of the range is shown.

    In addition, at the six properties insured under the Section 236
    program, residents of the units without project-based Section 8
    subsidies may benefit from the reductions in rents attributable to
    HUD's mortgage interest subsidies.  HUD establishes two rent levels
    for these properties:  (1) a "basic" rent that reflects the revenue
    needed by the property after considering the effects of HUD's
    mortgage interest subsidy and (2) a "market" rent that is based on
    the revenue that would be needed if the property paid the full
    mortgage interest.  Residents of the units without project-based
    Section 8 subsidies at these properties pay the greater of the basic
    rent or 30 percent of their household's adjusted income, up to the
    market rent.

    Three of the case study properties (Fannie E.  Taylor Home for the
    Aged, Jackie Robinson Garden Apartments, and St.  Andrew's Manor)
    have also received low-interest loans for repairs and improvements
    under HUD's Flexible Subsidy Loan Program.  In addition, Jackie
    Robinson and St.  Andrew's have received grants from HUD to combat
    drug-related crime.

          FINANCIAL AND PHYSICAL
          CONDITION
    ------------------------------------------------------- Appendix I:1.3

    The financial and physical condition of the 10 case study properties
    also varied substantially.  HUD's fiscal year 1995 loan loss reserve
    analysis,\2 which included 8 of the 10 properties (and did not
    include Green Ridge Meadow Apartments and Murdock Terrace
    Apartments), provides a measure of the variation in the properties'
    financial health.  This analysis evaluated the properties' financial
    condition on the basis of several financial indicators that were
    weighted according to their correlation with the probability of a
    mortgage's being troubled or assigned to HUD.\3 Six of the eight
    evaluated properties were considered to be in either "good" or
    "standard" financial condition, but one (St.  Andrew's) was rated as
    "substandard" and another (Onterie Center) as "poor." Furthermore, as
    table 2.5 indicates, the physical condition and deferred maintenance
    needs of the 10 properties varied widely.

    --------------------
    \2 This is a multistep process used to estimate FHA's future losses
    on insured multifamily mortgage loans.  The risk of default for
    insured loans is estimated on the basis of several factors, such as
    the properties' surplus cash per unit and vacancy rates.  FHA uses
    these estimates to divide the insured portfolio into five risk
    categories and then calculates the loss reserves on the basis of the
    assumptions about the risk of default that it develops for each
    category.

    \3 This analysis used the following financial indicators to rank the
    case study properties:  the vacancy rate, the percent of gross rent
    subsidized, the number of units, the weighted average surplus cash
    per unit, the weighted average ratio of operating costs to total
    revenues, and the ratio of replacement reserves to total revenues.
    The analysis used two additional measures to rank the three newer
    assisted properties (Jacksonville Townhouse, Onterie Center, and
    Universal City):  the weighted average ratio of net income to total
    revenues and the weighted average ratio of current assets to
    liabilities.

          TYPES OF HOUSEHOLDS
    ------------------------------------------------------- Appendix I:1.4

    The majority of the residents in the 10 case study properties have
    low incomes.  According to the properties' records, between 60 and 96
    percent of the Section 8 units at each property are occupied by
    households earning less than $10,000 per year.  (See fig.  I.4.)

       Figure I.4:  Percentage of
       Section 8 Units at GAO's Case
       Study Properties Occupied by
       Households With Adjusted Annual
       Incomes of Less Than $10,000

       (See figure in printed
       edition.)

    Notes:  For program purposes, HUD adjusts annual income for certain
    expenses.

    Data for Capitol Towers include residents in units without Section 8
    project-based assistance.

    The residents represent various types of households:  families,
    single adults, elderly and disabled.  Four of the properties (Fannie
    E.  Taylor, Green Ridge Meadow, Jacksonville Townhouse, and St.
    Andrew's) are targeted exclusively to elderly and disabled residents.
    (See fig.  I.5.)

       Figure I.5:  Types of
       Households Residing in Section
       8 Units at GAO's Case Study
       Properties

       (See figure in printed
       edition.)

    Note:  Data for Capitol Towers include residents in units without
    Section 8 project-based assistance.

          TYPES OF NEIGHBORHOODS AND
          RENTAL HOUSING MARKETS
    ------------------------------------------------------- Appendix I:1.5

    The 10 case study properties are located in various types of
    communities:  6 in urban communities, 3 in suburban communities, and
    1 in a rural community.  The properties' neighborhoods also vary in
    terms of their economic and social conditions, prevalent housing
    types, and rental occupancy rates.  In addition, the larger rental
    housing markets in which the properties are located have different
    occupancy rates and trends.

    The properties' neighborhoods range from areas whose physical
    condition is declining, with high crime rates, high unemployment,
    abandoned buildings, and/or frequent drug activity, to areas whose
    economies are growing, with lower crime rates and high income levels.
    For example, St.  Andrew's Manor in Oakland, California, is in a
    neighborhood with vacant buildings and lots, run-down commercial
    space, and crime problems.  In contrast, Green Ridge Meadow
    Apartments in Evergreen, Colorado, is in an affluent area with strong
    economic growth, high household incomes, and high property values.

    The types of housing surrounding the 10 properties also vary.  Some
    properties, such as Jackie Robinson, are surrounded by
    government-subsidized housing, while others, such as Green Ridge
    Meadow, are in neighborhoods with predominately unsubsidized housing.
    In addition, the predominant types of buildings in the surrounding
    neighborhoods vary, ranging from single-family to multifamily
    residences.  For example, Green Ridge Meadow and Universal City are
    located in neighborhoods where 88 and 82 percent of the properties,
    respectively, are single-family homes.  In contrast, Onterie Center
    is located in an area where 97 percent of the properties are
    multifamily residences.

    The 10 properties are located in rental housing markets whose overall
    occupancy rates range from 90 to 100 percent.  In some areas, the
    occupancy levels have improved dramatically over the last several
    years.  For example, the occupancy rate in Jacksonville increased
    from 89 percent in the early 1990s to about 95 percent in 1995.
    Similarly, the occupancy levels in Dallas rose from 82 percent in the
    late 1980s to 94 percent in 1995.  Washington D.C., in contrast, is
    the only market area where the rental occupancy rate has been
    relatively stagnant, at about 90 percent.

    Overall occupancy trends, however, are not always indicative of the
    occupancy rates in the properties' immediate neighborhoods.  Of the
    10 projects, 3 are located in markets whose occupancy rates are
    somewhat lower than those of their respective neighborhoods, 4 are
    located in markets whose occupancy rates are higher than those of
    their neighborhoods, and 3 are located in markets whose occupancy
    rates are the same as those of their neighborhoods.  The Chicago
    rental market, for example, is weaker than that of Onterie Center's
    neighborhood, while the overall occupancy rate for Staten Island is
    about the same as for Terrace Gardens' neighborhood.  In contrast,
    the Dallas market, with 94 percent occupancy, is much stronger than
    Murdock Terrace's neighborhood, which is 88 percent occupied.

       EFFECTS OF REENGINEERING ON
       GAO'S 10 CASE STUDY PROPERTIES
    --------------------------------------------------------- Appendix I:2

    Information about the basic characteristics of properties, such as
    those described above, can be used to help assess the effects of
    HUD's reengineering proposal on individual properties.  These basic
    characteristics help to form the assumptions made about a property's
    potential cash flow after reengineering, which will be a product of
    several factors, particularly the rents that the property can be
    expected to command in the open market; the cost of the physical
    improvements required to address deferred maintenance needs and make
    the property competitive; and routine operating expenses.
    Assumptions about these factors can be combined to estimate the
    impact of reengineering on a property's future viability.

    To estimate the impact of HUD's proposal on the 10 case study
    properties, we obtained and analyzed the assessments that Ernst &
    Young performed of them as part of its contract with HUD.  We also
    contracted for assessments of the properties by three licensed
    appraisal firms and solicited comments on the appraisers' reports
    from the properties' owners and/or managers.  These assessments show
    that estimates of the effects of portfolio reengineering can vary
    significantly, depending on the assumptions used.

          RESULTS OF THE ANALYSES
    ------------------------------------------------------- Appendix I:2.1

    For each of the 10 case study properties, table I.3 presents Ernst &
    Young's and the contract appraiser's assessment of how the property
    would be affected by HUD's reengineering proposal.  Both assessments
    assume that project-based assistance at each property would be
    converted to tenant-based assistance and that if the project's
    mortgage required restructuring, FHA would not insure the new
    mortgage.\4

    To facilitate comparison, we grouped the appraisers' assessments into
    the four categories that Ernst & Young used to estimate the effects
    of adjusting properties' rents to market levels.  For the properties
    in the "performing" category, the cash flows would cover the
    operating expenses, current debt service, and deferred maintenance
    and short-term capital needs.\5 For the properties in the
    "restructure" category, the cash flows would cover the operating
    expenses and the deferred maintenance and short-term capital needs
    but only part of the current debt service.  In the "full write-off"
    category, the properties would be able to cover the operating
    expenses and part of the deferred maintenance and short-term capital
    needs but none of the debt service.  Finally, in the "nonperforming"
    category, the properties would be able to cover only part of their
    operating expenses and none of their debt service or deferred
    maintenance or short-term capital needs.

    In general, the properties in the performing category were estimated
    to have increasing rents, decreasing or stable operating expenses,
    and less than $750,000 in deferred maintenance costs, while the
    properties in the restructure and full write-off categories tended to
    have high deferred maintenance estimates, decreasing rents, and/or
    mortgage interest subsidies that were assumed to be discontinued.
    For the properties classified as nonperforming, the rents and/or
    occupancy levels were expected to decrease to the extent that the
    revenues would be insufficient to cover the operating costs.

                                   Table I.3

                     Outcomes of Reengineering at GAO's 10
                             Case Study Properties

                                                        Contract
                                    Ernst & Young's     appraisers'
    Property                        assessment          assessment
    ------------------------------  ------------------  ------------------
    Fannie E. Taylor                Performing          Restructure

    Jackie Robinson                 Performing          Performing

    Capitol Towers                  Restructure         Restructure

    Green Ridge Meadow              Restructure         Restructure

    Terrace Gardens                 Full write-off      Performing

    Jacksonville Townhouse          Full write-off      Restructure

    Murdock Terrace                 Full write-off      Performing

    St. Andrew's Manor              Nonperforming       Performing

    Universal City                  Nonperforming       Restructure

    Onterie Center                  \a                  Restructure
    ----------------------------------------------------------------------
    \a Ernst & Young dropped Onterie Center from its sample prior to the
    final analysis.

    As table I.3 shows, Ernst & Young found that, under reengineering two
    properties would be performing, two would require restructuring,
    three would need to have their debt fully written off, and two would
    be nonperforming.  For three of the properties, the contract
    appraisers' results were consistent with Ernst & Young's conclusions;
    however, for six of the properties, the appraisers' results differed.
    For example, Ernst & Young concluded that under reengineering St.
    Andrew's would be nonperforming--unable to cover its expenses even if
    its mortgage were fully written off.  In contrast, the contract
    appraiser classified St.  Andrew's as performing--able to cover its
    expenses fully even without restructuring.

    --------------------
    \4 These assumptions were part of HUD's proposal at the time the
    assessments were done.  As noted in ch.1, HUD's portfolio
    reengineering proposal would now give states and localities the
    option of continuing project-based assistance at reengineered
    properties and would allow owners to apply for FHA insurance on
    restructured loans.

    \5 As discussed in ch.  2, the tests that Ernst & Young used to
    determine whether properties' loans would be performing after
    reengineering assumed that the interest subsidies received by older
    assisted properties would no longer continue.  To ensure
    comparability, the appraisers made the same assumption.

          INFLUENCE OF ASSUMPTIONS ON
          RESULTS
    ------------------------------------------------------- Appendix I:2.2

    Differences in the assessments' results were due primarily to
    differences in the assumptions made by the contract appraisers and by
    Ernst & Young.  Key differences concerned estimated market rent
    levels, deferred maintenance needs, and operating expenses.
    Differences also appeared in assumptions about other factors, such as
    financing terms and vacancy rates, but these seemed generally to have
    less effect on the predicted outcomes.  (App.  V contains information
    on the differences in the assumptions used for each of the case study
    properties.)

             ASSUMPTIONS ABOUT MARKET
             RENTS
    ----------------------------------------------------- Appendix I:2.2.1

    The rental income that a property will be able to command is one of
    the most important predictors of reengineering's effects because it
    will, in large part, determine the property's cash flows after
    reengineering.  Differing assumptions about the rents that a property
    will be able to charge as a market-rate building can lead to
    different conclusions about the property's prospects for success
    under reengineering.  Estimating market rents is easier for some
    properties than for others.  As noted earlier in this chapter, some
    properties, such as Onterie Center, are located in areas where
    comparable market-rate rental housing can be used to estimate the
    market rents that the Section 8 properties could command.  However,
    other properties, such as Green Ridge Meadow, are located in areas
    with little comparable rental housing, or, like Jackie Robinson, with
    predominately assisted housing.  In such cases, estimating market
    rents is subject to greater uncertainty.

    If the rents for units under Section 8 contracts were adjusted to
    market levels at the 10 case study properties, the contract
    appraisers estimated that the new weighted average rents for units of
    all sizes would range from $387 to $1,134 per month, compared with
    the current weighted average rents of $325 to $1,204 per month.  At
    six of the properties, the units' monthly rents would increase
    between 10 and 39 percent.  At the other four properties, the market
    rents would be about 6 to 51 percent lower than the current contract
    rents.  (See fig.I.6.)

       Figure I.6:  Estimated Market
       Rents and Current Contract
       Rents at the 10 Properties

       (See figure in printed
       edition.)

    Note:  Both the estimated market and current contract rents are the
    weighted average rents for units of all sizes.

    Ernst & Young's market rent estimates were consistent with the
    contract appraisers' in most cases.  However, for two properties, St.
    Andrew's and Terrace Gardens, Ernst & Young's estimates were more
    than 20 percent below the contract appraisers' estimates.  The higher
    rent estimates contributed to the appraisers' more optimistic
    assessments of how the two properties would fare after reengineering.
    As discussed in chapter 2, the differences in the estimates for the
    two properties reflect, in large measure, the use of different
    methodologies to estimate market rents in neighborhoods consisting
    primarily of assisted properties.

    For some properties, including St.  Andrew's and Jackie Robinson, the
    owners or managers believed that the market rents estimated by the
    contract appraisers could be higher than the properties would be able
    to command.  In such cases, the properties' cash flows could be lower
    than estimated.

             ASSUMPTIONS ABOUT
             DEFERRED MAINTENANCE
             COSTS
    ----------------------------------------------------- Appendix I:2.2.2

    A second major factor in estimating the effects of HUD's proposal on
    assisted properties is determining how much deferred maintenance will
    need to be addressed before the properties can compete in the
    marketplace.  Differences in appraisers' assumptions about the costs
    of needed physical improvements can lead to differences in the
    outcomes predicted for properties under reengineering.

    For 9 of the 10 case study properties (including the five for which
    Ernst & Young projected more pessimistic results than the contract
    appraisers), Ernst & Young's estimates of the costs for deferred
    maintenance were higher than the contract appraisers' estimates.  In
    most cases, Ernst & Young's estimates were substantially higher.
    (See ch.  2 for a more detailed discussion of the estimates of
    deferred maintenance needs for the 10 properties, including the
    owners' and managers' comments on the estimates.)

             ASSUMPTIONS ABOUT
             OPERATING EXPENSES
    ----------------------------------------------------- Appendix I:2.2.3

    Another factor in determining the effects of HUD's proposal on the
    properties is the level of operating expenses (excluding mortgage
    payments) assumed for them after reengineering.  These assumptions
    can influence the outcomes projected for the reengineered properties.
    For example, some experts on low-income rental housing have predicted
    increases in certain operating expenses--such as the costs of
    advertising vacant units, the losses due to bad debts, and the
    redecorating expenses and lost rents associated with turnover--as the
    reengineered properties become more market-oriented and less reliant
    on a guaranteed, subsidized tenancy.  Conversely, the experts have
    predicted decreases in other expenses, such as property management
    fees and the administrative costs of complying with HUD's paperwork
    and management requirements.  Also, as some housing industry experts
    noted in reference to HUD's reengineering proposal, the competitive
    forces of the commercial market should create an incentive for
    properties that lose the security of their guaranteed Section 8
    project-based rental subsidies to seek new ways to minimize their
    operating expenses.

    Again, differences in the projected outcomes for the 10 case study
    properties were influenced by differences in the assumptions made by
    Ernst & Young and by the contract appraisers.  Ernst & Young based
    its estimates of the properties' operating expenses on the
    properties' 1994 audited financial statements.  However, for the
    properties whose current operating expenses exceeded the industry's
    averages\6 and whose revenues would decrease under reengineering,
    Ernst & Young adjusted the estimated operating expenses downward
    towards the industry's standards.  This adjustment, which assumes
    that properties can gain certain efficiencies after reengineering,
    reduced the estimated operating expenses by up to 15 percent of the
    difference between the properties' historical operating expenses and
    the industry's averages for market-based units.  Although the
    contract appraisers also based their estimates of the properties'
    operating expenses on the properties' historical financial data and
    the industry's standards, they did not restrict their adjustments to
    a predetermined maximum percentage.

    For example, the contract appraiser for St.  Andrew's adjusted the
    property's operating expenses downward by more than the maximum
    percentage used in Ernst & Young's analysis.  The appraiser
    estimated--on the basis of the property's 1995 expense data, a
    comparison with the operating expenses at similar properties, and the
    industry's data--that the total operating expenses would be reduced
    by 37 percent after reengineering.  The appraiser considered that,
    because the property is owned by a nonprofit organization and is
    targeted to elderly tenants, its annual expenses would remain above
    average for the industry but could still be lower than in the past.
    Such methodological differences in estimating operating expenses
    after reengineering contributed to the differences between Ernst &
    Young's and the contract appraisers' predicted outcomes for Murdock
    Terrace, St.  Andrew's, and Jacksonville Townhouse.

    At some properties, the owners and managers questioned the contract
    appraisers' assumptions about operating expenses.  For example, the
    owners of Jacksonville Townhouse believed that the property would not
    be able to achieve the reduction in operating expenses estimated by
    the appraiser.  The appraiser estimated that the property would be
    able to reduce its operating expenses to a level similar to that of
    comparable market-rate properties--a reduction of 48 percent.

    --------------------
    \6 Ernst & Young used data from the Institute of Real Estate
    Management, which annually compiles income and expense information
    for a voluntary sample of multifamily rental properties.

       EFFECTS OF REENGINEERING ON
       RESIDENTS
    --------------------------------------------------------- Appendix I:3

    The effects of reengineering would likely extend not only to the
    properties in HUD's insured portfolio but also to these properties'
    low-income residents.  While some current residents might choose to
    move to different housing if they received portable tenant-based
    Section 8 rental subsidies, others might be displaced and have to
    relocate involuntarily.  The extent to which such relocating
    residents could find suitable and affordable alternative housing
    would depend on the characteristics of their local rental housing
    market and on the amount of continued rental assistance that the
    Congress authorized HUD to provide.

    For residents, one of the greatest potential benefits of
    reengineering is greater flexibility to "shop around" for the best
    available apartment.  With a portable rental subsidy, rather than one
    tied to a specific unit at a specific property, a resident who could
    not now afford to move from an undesirable apartment would have more
    opportunity to do so.  Also, HUD's reengineering strategy could
    benefit residents to the extent that it would provide funding to
    address deferred maintenance problems at reengineered properties and
    create additional incentives for owners to better maintain their
    properties in the future.

    However, as discussed in chapter 2, some properties would not survive
    reengineering because, at market rents, they could not generate
    sufficient revenues to cover their operating expenses and/or deferred
    maintenance costs.  The residents of such properties might be
    displaced and need to find new housing.  HUD proposes to give such
    displaced residents tenant-based Section 8 subsidies.  As noted
    earlier, Ernst & Young's analysis indicated that five of the case
    study properties (Jacksonville Townhouse, Murdock Terrace, St.
    Andrew's, Terrace Gardens, and Universal City) would have difficulty
    surviving the reengineering process.  In contrast, the contract
    appraisers believed that these five properties would likely be able
    to sustain operations after reengineering.

    Other properties would survive reengineering because they would be
    able to command higher rents than they do now.  For example, both
    Ernst & Young and the contract appraisers believed that Capitol
    Towers, Jackie Robinson, and Fannie E.  Taylor would be able to
    command higher rents after reengineering.  For each of these
    properties, the average market rents would still be below the average
    fair market rents that HUD uses to limit tenant-based assistance
    payments under its Section 8 certificate program.  For Green Ridge
    Meadow, however, both the appraiser and Ernst & Young estimated that
    market rents, though lower than the property's current assisted
    rents, would exceed HUD's normal limits for Section 8 assistance in
    the area.

    HUD has proposed to protect current residents against the negative
    effects of rent increases in two ways.  First, a household that
    currently resides in a unit with project-based Section 8 assistance
    that is converted to tenant-based Section 8 would be eligible, after
    reengineering, for an "enhanced voucher." This voucher would pay the
    difference between 30 percent of the household's adjusted income and
    the new market rent for the unit, even if that rent were higher than
    HUD's normal limit for the locality.  Second, a currently
    "unassisted" household (one that resides in a unit without
    project-based Section 8 assistance) would be eligible for a rental
    subsidy if, after reengineering, it ended up paying more than 30
    percent of its adjusted income for rent and if the local government
    authority opted not to continue project-based subsidies at the
    property.  These provisions would, however, increase the costs of
    reengineering.

    The previously discussed conditions of the surrounding rental housing
    markets that would affect the properties' ability to operate
    successfully after reengineering would also affect the ability of
    relocating residents to find suitable new housing.  Local housing
    officials in some tight housing markets--those with low vacancy
    rates--report that people who now have tenant-based Section 8
    assistance have difficulty finding suitable rental housing.
    Relocating or displaced residents in such areas would likely
    experience similar difficulty, as would those living in areas with
    predominately single-family housing.  Those residing in markets with
    higher vacancy rates would be in a much better position to locate
    suitable alternative housing if they chose to or had to.

    ERNST & YOUNG'S ESTIMATES OF
    CAPITAL NEEDS FOR 10 PROPERTIES IN
    HUD'S INSURED SECTION 8 PORTFOLIO
    ========================================================== Appendix II

                                          Immediate    Short-term     Long-term         Total
                            Number of      deferred       capital       capital       capital
    Property/location           units   maintenance       backlog       backlog         needs
    -------------------  ------------  ------------  ------------  ------------  ------------
    Capitol Towers,
     Washington, D.C.              95    $1,356,434       $59,285      $125,625    $1,541,344
    Fannie E. Taylor,
     Jacksonville,                204       362,349       379,587       411,358     1,153,294
     Florida
    Green Ridge
     Meadow,                       79         5,000        89,947       371,656       466,603
     Evergreen,
     Colorado
    Jackie Robinson,
     San Francisco,               130       325,350       374,083       808,464     1,507,897
     California
    Jacksonville
     Townhouse,                   250       797,402       738,910       614,626     2,150,938
     Jacksonville,
     Florida
    Murdock Terrace,
     Dallas, Texas                256     5,663,798       206,298       375,928     6,246,024
    Onterie Center,
     Chicago, Illinois            594        58,892     1,585,771     3,839,698     5,484,361
    St. Andrew's
     Manor,                        60       415,220        67,360       228,337       710,917
     Oakland,
     California
    Terrace Gardens,
     Staten Island, New            99     2,478,562        74,106       791,942     3,344,610
     York
    Universal City,
     Chicago, Illinois            160       214,184       220,301     1,926,752     2,361,237
    -----------------------------------------------------------------------------------------

    STATISTICAL ISSUES
    ========================================================= Appendix III

    This appendix provides more detailed information on statistical
    issues related to estimates in Ernst & Young's May 2, 1996, report.
    Users of estimates developed from a sample need to know how much
    reliance to place on such estimates.  The sampling error provides a
    measure of an estimate's reliability or precision.  It indicates the
    extent to which an estimate based on a sample can be expected to
    differ from the value that would be obtained if all of the items in
    the population were included in the study.  Because the sampling
    error for one estimate derived from a sample can differ substantially
    from the sampling error for another estimate derived from the same
    sample, it is important to provide the sampling error for each
    estimate.  For estimates of the newer, older, and total project
    populations, HUD wanted the sampling error to be no more than plus or
    minus 10 percent of the estimated value, at the 90-percent confidence
    level.

    According to our analysis, about one-fourth of the estimates in the
    report had no limitations.  These were population estimates with a
    sampling error that was as precise as HUD had desired.  Approximately
    three-fourths of the estimates showed some limitations.  Some were
    population estimates with a sampling error that was less precise than
    HUD had desired.  Others were population estimates without a sampling
    error.  Still others were not population estimates; instead, they
    were the results of the sample that had not been adjusted to ensure
    appropriate estimates for the population as a whole.  The results of
    our analysis appear in table III.1.  According to HUD, all of the
    estimates with limitations were requested after the study was
    designed and HUD was aware that these items would be unlikely to have
    the desired level of precision.

                                  Table III.1

                     Completeness and Appropriateness of 63
                       Statistics in the Body of Ernst &
                          Young's May 2, 1996, Report

                                                    Percen          Percen
    Statistic                               Number       t  Number       t
    --------------------------------------  ------  ------  ------  ------
    Population estimate with a sampling                         36      57
     error
    Desired precision achieved                  15      24
    Desired precision not achieved              21      33
    Population estimate without a                               12      19
     sampling error
    No estimate for population--                                15      24
     sample data only
    ======================================================================
    Total                                       36      57      63     100
    ----------------------------------------------------------------------
    Note:  Ernst & Young developed these statistics from a sample of 558
    projects selected from HUD's FHA-insured Section 8 portfolio.

       POPULATION ESTIMATES LESS
       PRECISE THAN DESIRED
    ------------------------------------------------------- Appendix III:1

    For 15 of the 36 population estimates with a sampling error (42
    percent) in the May 1996 report, the error was within 10 percent of
    the estimate.  However, for 21 estimates, the error exceeded 10
    percent of the estimate.  For two of these estimates, the sampling
    error exceeded 25 percent of the estimate.  (See table III.2.)

                                  Table III.2

                    Population Estimates in Ernst & Young's
                       May 2, 1996, Report for Which the
                      Reported Sampling Error Exceeded 10
                            Percent of the Estimate

                                                                  Relative
                                                                  sampling
    Group                 Description                              error\a
    --------------------  --------------------------------------  --------
    Newer                 Percent of properties with assisted          28%
                           rents less than market rents
    Older                 Percent of properties with assisted          27%
                           rents greater than 120 percent of
                           market rents
    Older                 Percent of properties with assisted          24%
                           rents between 120 and 100 percent of
                           market rents
    Newer                 Percent of properties with assisted          19%
                           rents between 120 and 100 percent of
                           market rents
    All                   Percent of properties that cover             19%
                           operating expenses after full debt
                           write-off but still have unsolved
                           capital needs (Full write-off)
    All                   Percent of properties that do not            18%
                           cover operating expenses,
                           irrespective of debt and capital
                           needs (Nonperforming)
    Older                 Percent of properties with assisted          16%
                           rents greater than market rent
    Newer                 Long-term capital backlog ($ billions)       16%
    Older                 Long-term capital backlog ($ billions)       15%
    All                   Percent of properties with assisted          15%
                           rents between 120 and 100 percent of
                           market rents
    All                   Percent of properties that cover             14%
                           current debt, operating expenses, and
                           all capital needs (Performing)
    Newer                 Per-unit immediate deferred                  14%
                           maintenance costs
    Newer                 Immediate deferred maintenance ($            14%
                           billions)
    Older                 Short-term capital backlog ($                13%
                           billions)
    Older                 Per-unit short-term capital backlog          13%
    Newer                 Replacement and cash reserves ($             13%
                           billions)
    Newer                 Per-unit replacement and cash reserves       13%
    All                   Long-term capital backlog ($                 12%
                           billions)\b
    All                   Long-term capital backlog ($                 12%
                           billions)\b
    Older                 Per-unit replacement and cash reserves       11%
    Older                 Replacement and cash reserves ($             11%
                           billions)
    ----------------------------------------------------------------------
    \a Relative sampling error of the estimate.  This is the sampling
    error for the estimate at the 90-percent confidence level divided by
    the estimate, then stated as a percent.

    \b This estimate appeared in the report twice, once on page 18 and
    again on page 19.

       POPULATION ESTIMATES WITHOUT A
       SAMPLING ERROR
    ------------------------------------------------------- Appendix III:2

    Ernst & Young provided the sampling error for 57 percent (36 of 63)
    of the estimates that it developed from its sample of 558 insured
    Section 8 properties and presented in the body of its May 2, 1996,
    report.  However, this report did not provide the sampling error for
    12 estimates, including the following:

      -- $9.7 billion in comprehensive capital requirements,

      -- $8.3 billion in total comprehensive needs,

      -- $4.6 billion in total comprehensive capital needs for older
         properties, and

      -- $3.7 billion in total comprehensive capital needs for newer
         properties.

    Because Ernst & Young did not provide the sampling error for these 12
    estimates, readers of the briefing document cannot readily assess the
    estimates' reliability.

    To determine the reliability of these estimates, we calculated their
    sampling error on the basis of information provided in the briefing
    document's appendixes.  We found that the estimates generally had the
    desired level of precision.  For two estimates, the relative sampling
    error was slightly higher than desired--about 12 percent.  These
    estimates were for the total and the per-unit capital needs
    (including the immediate deferred maintenance needs, short-term
    capital backlog, and replacement and cash reserves) for newer
    properties.

       RESULTS OF SAMPLE PROVIDED
       INSTEAD OF POPULATION ESTIMATES
    ------------------------------------------------------- Appendix III:3

    On three pages of its May 1996 report, Ernst & Young presented
    statistics based on sample cases rather than statistics for the
    population.  These three pages contained about 24 percent of the
    statistics cited in the report.  On one page, Ernst & Young noted
    that the results applied to the sample cases and cautioned the reader
    that they could not be extrapolated to the portfolio with the
    designed statistical confidence.  However, on another page there was
    no indication that the results were based on the sample.  On the
    third page (p.  26), one of the statistics was based on the sample,
    while the other statistics were population estimates.

    Ernst & Young's sample of projects was not designed so that the
    unadjusted means and percentages would provide unbiased estimates for
    all of the projects.  Therefore, there is no assurance that the
    unadjusted means or percentages for the sample provide reasonable
    estimates of the corresponding means or percentages for the entire
    population of projects.

    By design, some types of projects are overrepresented in the sample
    and some are underrepresented.  For example, all of the projects with
    an unpaid loan balance of more than $25 million were included in the
    sample and are therefore overrepresented.  The projects with a
    smaller unpaid loan balance were sampled at lower rates and are
    therefore underrepresented to different extents.  The sampling rates
    for the projects with a smaller unpaid loan balance ranged from 1 out
    of every 9 to 1 out of every 32, depending on (1) whether the project
    was newer or older, (2) where the project was located geographically,
    and (3) whether the project was originally or subsequently identified
    by HUD as subject to mark to market.  Because of these over- and
    under-representations, the unadjusted mean for the sampled projects
    is a biased estimate of the mean for all of the projects.

    When projects have different chances of being included in a sample,
    formulas that account for these different chances must be used to
    develop appropriate statistical estimates for all of the projects.
    When such formulas are not used, estimates calculated directly from
    the sample can provide an inaccurate view of the population.  For
    example, for the population of projects with assisted rents below
    market rents, the appropriate estimate of the average unpaid
    principal at the time of restructuring was $902,000.  The
    corresponding average for the sampled projects was $1,265,000--a
    40-percent increase.\1

    At our request, Ernst & Young provided the population estimates and
    sampling errors for the samples of projects analyzed on two of the
    pages of the report.  As tables III.3 and III.4 show, for these
    estimates there is generally not much difference between the results
    of the sample and the estimate for the population.

                                  Table III.3

                        Comparison of Sample Results and
                     Population Estimates for Statistics on
                                    Page 23

    Type of property/per-unit cost
    of immediate deferred                                         Relative
    maintenance and short-term                Populati  Sampling  sampling
    capital needs                     Sample        on     error     error
    ------------------------------  --------  --------  --------  --------
    Older
    Less than $5,000                     14%       13%        3%       24%
    $5,000 to $15,000                    68%       73%        4%        6%
    More than or equal to
     $15,000                             18%       15%        3%       21%
    Newer
    Less than $5,000                     43%       44%        5%       10%
    $5,000 to $15,000                    53%       53%        5%        9%
    More than or equal to
     $15,000                              4%        4%        2%       47%
    ----------------------------------------------------------------------

                                  Table III.4

                        Comparison of Sample Results and
                     Population Estimates for Statistics on
                                    Page 27

                                                                  Relative
    Status of property under                  Populati  Sampling  sampling
    portfolio reengineering           Sample        on     error     error
    ------------------------------  --------  --------  --------  --------
    Performing,\a when current
     assisted rents are
    Above market                          7%        7%        2%       24%
    Below market                         13%       14%        3%       19%
    Restructure,\b when current
     assisted rents are
    Above market                         35%       35%        3%        9%
    Below market                         19%       19%        3%       15%
    Full write-off,\c when current
     assisted rents are
    Above market                          9%        8%        2%       23%
    Below market                          4%        4%        1%       35%
    Nonperforming,\d when current
     assisted rents are
    Above market                         13%       13%        2%       18%
    Below market                          0%        0%        0%        \e
    ----------------------------------------------------------------------
    \a Could cover current debt, operating expenses, and all capital
    needs.

    \b After restructuring, could cover new debt, operating expenses, and
    all capital needs.

    \c After full debt write-off, could cover operating expenses but not
    all capital needs.

    \d After full debt write-off, could not cover all operating expenses.

    \e Not available.  Division by zero is undefined.

    For the results of the sample reported on page 26, we obtained data
    from Ernst & Young and developed an estimate for the population of
    projects that could cover their operating expenses after their debt
    was fully written off but could not cover all of their capital
    needs.\2 For these projects, the report used the sample's unadjusted
    results to identify $4,900 in unsolved capital needs.  Using the
    appropriate adjustment, we estimated needs of $4,600, plus or minus
    $1,100.

    --------------------
    \1 This example is for illustrative purposes only.  The $1,265,000
    sample result did not appear in Ernst & Young's May 2, 1996, report.

    \2 Ernst & Young said it was not prepared to make estimates of this
    type, which would have required it to estimate both a dollar amount
    and a number of units from its sample.

    ASSUMPTIONS USED IN ERNST &
    YOUNG'S MODEL AND IN GAO'S
    SENSITIVITY ANALYSES
    ========================================================== Appendix IV

    The tables in this appendix present the assumptions used in (1) the
    financial model that Ernst & Young developed to project the
    performance of HUD's insured multifamily properties under portfolio
    reengineering and (2) the sensitivity analyses that GAO performed to
    determine the effects of changes in the assumptions on the model's
    results.  (See ch.  2).

    In developing its financial assumptions, Ernst & Young placed loans
    in performing, subperforming, or nonperforming categories on the
    basis of the extent to which projected net income after reengineering
    (i.e., adjusting the rents to market levels) covered the principal
    and interest payments.  The measure used in this process was the debt
    service coverage ratio (DSCR), which represents net income divided by
    principal and interest requirements.  Ernst & Young also established
    four subcategories within the subperforming category, depending on
    the DSCR after reengineering, and then developed a range of financing
    terms applicable to restructured loans in the various categories and
    subcategories.

                                            Table IV.1

                               Assumptions Used in Ernst & Young's
                              Financial Model for HUD's Multifamily
                                 Portfolio Reengineering Proposal

    Financing            1.00 and      0.85 -      0.50 -      0.10 -      0.01 -
    assumption              above        0.99        0.84        0.49        0.09         0.0
    -----------------  ----------  ----------  ----------  ----------  ----------  ----------
    Restructure DSCR         1.20        1.20        1.25        1.30          \a          \a
    Restructure LTV\b        1.00        1.00        1.00        1.00          \a          \a
    Restructure             9.75%       9.75%       9.85%      10.00%          \a          \a
     interest rate
    Restructure               360         360         360         360          \a          \a
     amortization
     period
    Allowance for bad          1%          1%          1%          1%          1%          1%
     debt
    Transaction costs          3%          3%          3%          5%          5%          5%
    -----------------------------------------------------------------------------------------
    \a Not applicable.

    \b The loan-to-value ratio (LTV) compares the amount of a loan with a
    property's value.  According to an Ernst & Young official, the model
    used a loan-to-value ratio of 1 so that the mortgages for
    reengineered properties would be calculated on the basis of the debt
    service coverage ratios used in the model rather than the
    loan-to-value ratio.

    Besides the financial loan terms presented in table IV.1, Ernst &
    Young's financial model also included the following assumptions:  (1)
    market rents replace assisted rents, (2) residents with project-based
    assistance receive tenant-based assistance, (3) FHA insurance is not
    provided for restructured loans, and (4) income and tenant payments
    grow at 3 percent and expenses at 4 percent.  In addition, Ernst &
    Young adjusted operating expenses downward if revenues decreased when
    rents were adjusted to market levels and actual operating expenses
    exceeded the Institute of Real Estate Management's (IREM) averages.
    Operating expenses were reduced by up to 15 percent of the difference
    between historical operating levels and IREM's averages to reflect
    assumed operating efficiencies after reengineering.  These general
    assumptions were not revised in GAO's sensitivity analyses.

    Tables IV.2 and IV.3 present the financial loan terms used in our
    sensitivity analyses, most of which reflect revisions to Ernst &
    Young's assumptions.  Table IV.2 also includes the revised
    assumptions covering replacement reserves, deferred maintenance, and
    short-term capital needs that we used for our optimistic scenario,
    discussed in chapter 2.  We did not revise these assumptions for our
    pessimistic scenario.

                                            Table IV.2

                               Optimistic Assumptions Used in GAO's
                             Sensitivity Analysis of Ernst & Young's
                              Financial Model for HUD's Multifamily
                                 Portfolio Reengineering Proposal

    Financing          1.00 and    0.85 -      0.50 -      0.10 -      0.01 -
    assumption         above       0.99        0.84        0.49        0.09        0.0
    -----------------  ----------  ----------  ----------  ----------  ----------  ----------
    Restructure DSCR   1.25        1.25        1.25        1.30        \a          \a

    Restructure LTV    0.85        0.85        0.80        0.75        \a          \a

    Restructure        8.75%       8.75%       8.85%       9.00%       \a          \a
    interest rate

    Restructure        300         300         300         300         \a          \a
    amortization
    period

    Allowance for bad  1%          1%          1%          1%          1%          1%
    debt

    Transaction costs  3%          3%          3%          5%          5%          5%

    Replacement        Reduce by   Reduce by   Reduce by   Reduce by   Reduce by   Reduce by
    reserves           25% but     25% but     25% but     25% but     25% but     25% but
                       set floor   set floor   set floor   set floor   set floor   set floor
                       at $200     at $200     at $200     at $200     at $200     at $200

    Deferred           Reduce by   Reduce by   Reduce by   Reduce by   Reduce by   Reduce by
    maintenance and    25%         25%         25%         25%         25%         25%
    short-term
    capital needs
    -----------------------------------------------------------------------------------------
    \a Not applicable.

                                            Table IV.3

                              Pessimistic Assumptions Used in GAO's
                             Sensitivity Analysis of Ernst & Young's
                              Financial Model for HUD's Multifamily
                                 Portfolio Reengineering Proposal

    Financing          1.00 and    0.85 -      0.50 -      0.10 -      0.01 -
    assumption         above       0.99        0.84        0.49        0.09        0.0
    -----------------  ----------  ----------  ----------  ----------  ----------  ----------
    Restructure DSCR   1.30        1.35        1.40        1.40        \a          \a

    Restructure LTV    0.70        0.70        0.65        0.65        \a          \a

    Restructure        10.75%      10.75%      10.85%      11.00%      \a          \a
    interest rate

    Restructure        300         300         300         300         \a          \a
    amortization
    period

    Allowance for bad  2%          2%          2%          2%          2%          2%
    debt

    Transaction costs  4%          4%          5%          5%          5%          5%

    Replacement        Use         Use         Use         Use         Use         Use
    reserves           model's     model's     model's     model's     model's     model's
                       estimate    estimate    estimate    estimate    estimate    estimate
                       but set     but set     but set     but set     but set     but set
                       floor at    floor at    floor at    floor at    floor at    floor at
                       $300        $300        $300        $300        $300        $300

    Market rents       Reduce by   Reduce by   Reduce by   Reduce by   Reduce by   Reduce by
                       5%          5%          5%          5%          5%          5%
    -----------------------------------------------------------------------------------------
    \a Not applicable.

    EFFECTS OF REENGINEERING ON 10
    CASE STUDY PROPERTIES
    =========================================================== Appendix V

    This appendix discusses the portfolio reengineering assessments
    performed by the appraisers we retained and by Ernst & Young for the
    10 properties that we judgmentally selected as case studies from the
    558 properties included in Ernst & Young's sample.

    As we explained in chapter 2, Ernst & Young designed and used a
    financial model to predict and analyze the outcomes of reengineering
    for a sample of 558 FHA-insured multifamily properties.  We noted
    that Ernst & Young used a variety of information, ranging from
    projected rents to estimated deferred maintenance needs, to classify
    the properties into four categories--performing, restructure, full
    write-off, and nonperforming.  These classifications depended on the
    extent to which the properties could cover their operating costs,
    debt service payments, and deferred maintenance and short-term
    capital needs.

    In appendix I, we used the 10 case studies to illustrate the diverse
    characteristics of HUD's properties and the effects of reengineering
    on the properties and their potential viability in an open market.
    For each property, we compared the contract appraiser's assessment
    with Ernst & Young's and found differences in the expected results of
    reengineering.  These differences stemmed primarily from differences
    in the assumptions made about each property's future rent levels,
    operating expenses, and deferred maintenance costs.

    The remainder of this appendix briefly discusses, for each of the 10
    case study properties, (1) the property's characteristics, (2) the
    contract appraiser's and Ernst & Young's classification of the
    property's performance under reengineering, and (3) the factors
    contributing to any differences in the projected performance.

       Figure V.1:  Capitol Towers
       Apartments, Washington, D.C.

       (See figure in printed
       edition.)

    Capitol Towers Apartments, constructed in 1927 and renovated with a
    HUD-insured loan in 1972, is an eight-story building containing 79
    zero-bedroom (efficiency) and 14 one-bedroom units occupied primarily
    by elderly and disabled households.  It includes a laundry room, as
    well as commercial space being rented to a dry cleaning firm and a
    delicatessen/liquor store.  HUD provides Section 8 assistance to 65
    of the 93 units.  On December 31, 1995, a balance of $928,694
    remained on the property's FHA-insured mortgage.

    Both the contract appraiser and Ernst & Young anticipated that
    Capitol Towers would fall into the restructure category if
    reengineered.  Both arrived at similar conclusions about the
    property's likely market rents, operating expenses, and
    rehabilitation requirements.

    The contract appraiser projected that, after reengineering, the
    average monthly rent would increase to $451 per unit, including
    utilities--a 39-percent increase in the current average rent of $325
    per month.  The appraiser also determined that the property's
    operating expenses would remain about the same and that about $1
    million would be required to repair the apartments' interiors and the
    property's mechanical systems.  On the basis of the property's market
    value and income potential, the appraiser determined that, after
    allowing for repairs, a mortgage of about $750,000 could be financed.

    Ernst & Young's assessment assumed that rents would increase to $491
    at the time of reengineering, a 51-percent increase.  Ernst & Young
    also projected that operating expenses would remain about the same
    and that about $1.4 million would be required to address deferred
    maintenance and short-term capital needs at the property.  Ernst &
    Young concluded that a mortgage of about $1.5 million could be
    financed at the new rent levels but that an insurance claim of about
    $670,000 would be incurred to restructure the mortgage and address
    the property's capital needs.

       Figure V.2:  Fannie E.  Taylor
       Home for the Aged,
       Jacksonville, Florida

       (See figure in printed
       edition.)

    The Fannie E.  Taylor Home for the Aged, a 25-year-old garden-style
    property with 30 separate buildings, is located in an older suburban
    neighborhood with a mixture of commercial space, single-family units,
    and apartments.  The property includes a 24-bed licensed nursing care
    section, assisted living section, cafeteria, community room, library,
    hair salon, hobby room, and exercise areas, and it provides laundry
    service, courtesy transportation, parking, and emergency call buttons
    in all units.  The property contains 204 units--92 zero-bedroom
    (efficiency) and 112 one-bedroom units--96 of which receive Section 8
    subsidies.  The FHA-insured mortgage, endorsed in 1971, had an unpaid
    balance of about $2.2 million on December 31, 1995.

    The contract appraiser concluded that, under reengineering, the
    property would fall into the restructure category, with a partial
    debt write-down of about $0.8 million.  Ernst & Young, however,
    classified the property as performing, or able to cover its operating
    expenses, existing FHA-insured debt, and deferred maintenance costs.
    The different classifications were primarily due to differences in
    the estimated market rents the property could command after
    reengineering.

    The contract appraiser estimated that the property's monthly rents
    would increase to an average of $360 per unit, including utilities,
    or slightly more than the current average assisted rent of $346 per
    unit.  The appraiser also believed that the property's physical
    condition was competitive with that of similar properties in the open
    market and determined, from the property's previous operating history
    and that of other properties in the market area, that operating
    expenses should remain about the same.  According to the appraiser,
    however, the projected cash flow would support a mortgage of only
    $1.4 million and reengineering would require HUD to satisfy a partial
    insurance claim of $0.8 million.

    Ernst & Young arrived at a more optimistic projection of rents under
    reengineering, estimating that the property could command average
    monthly rents of $403 per unit on the open market, or nearly 16
    percent more than the average assisted rent.  Ernst & Young also
    identified about $0.7 million in immediate deferred maintenance and
    short-term capital improvements needed primarily to the apartment
    buildings' interiors.  After factoring in the higher rents and
    assuming no significant changes in operating expenses, Ernst & Young
    projected that the cash flow would be sufficient to cover both the
    existing debt and the repairs needed at the property even if the
    current mortgage interest subsidy were discontinued.

       Figure V.3:  Green Ridge Meadow
       Apartments, Evergreen, Colorado

       (See figure in printed
       edition.)

    Green Ridge Meadow Apartments is a 15-year-old, four-story property
    for the elderly/disabled, located in an affluent rural community
    where few multifamily apartment units are available on the open
    market.  It includes a community room, laundry facility, library, and
    small sundries/ice cream shop, and it provides bus service, parking,
    and emergency call buttons in every unit.  The building contains 79
    one-bedroom units, all of which are subsidized with Section 8
    assistance.  The FHA-insured mortgage, endorsed in 1982, had an
    unpaid balance of about $2.45 million on December 31, 1995.

    Both the contract appraiser and Ernst & Young placed the property in
    the restructure category but developed somewhat different estimates
    of the mortgage write-down that would occur under reengineering.
    Both concluded that the property could be expected to cover all
    operating and deferred maintenance costs but only a portion of the
    existing FHA-insured debt.

    The contract appraiser estimated that the monthly rent, after
    reengineering, would be adjusted downward from HUD's subsidized level
    of $593 to $530 per month, including utilities, a reduction of about
    11 percent.  On the basis of the property's financial history,
    operating statements for similar buildings, and consultations with
    local building managers and agents, the appraiser believed that the
    property's operating expenses would increase slightly.  The appraiser
    also believed that the property's physical condition was adequate to
    attract market-rate renters.  From the property's expected cash flow
    and appraised value, the appraiser estimated that about $1.7 million
    in debt could be financed with the projected income stream, leaving
    about $0.73 million as an insurance claim and debt write-down.

    Ernst & Young, in contrast, projected that the property's monthly
    rent would be reduced from $593 to $475 under reengineering, a
    decrease of about 20 percent.  Ernst & Young assumed that the
    property's operating expenses would continue at about the same level
    and identified deferred maintenance and short-term capital needs of
    about $95,000.  Ernst & Young calculated that under the new rent
    levels, the property could support a mortgage of about $1.85 million,
    or about $0.6 million less than the existing debt of $2.45 million,
    resulting in an insurance claim of about $0.76 million, which would
    include funding for the property's maintenance and capital needs.

       Figure V.4:  Jackie Robinson
       Garden Apartments, San
       Francisco, California

       (See figure in printed
       edition.)

    Jackie Robinson Garden Apartments is a 24-year-old, 130-unit,
    garden-style property consisting of 11 three- and four-story
    buildings.  Located in an older urban area, the surrounding
    neighborhood is dominated by subsidized housing developments.  The
    property serves both families and elderly residents in units ranging
    from zero-bedroom studios to five-bedroom apartments.  All 130 units
    are subsidized with Section 8 assistance.  The FHA-insured mortgage,
    endorsed in 1973, had an unpaid balance of about $2.5 million on
    December 31, 1995.

    Both the contract appraiser and Ernst & Young classified Jackie
    Robinson Garden Apartments as a performing property under
    reengineering.  Both developed similar projections of market rents
    and of the repairs needed to improve the property's market appeal,
    although they differed somewhat in their estimates of the operating
    expenses under reengineering.

    The contract appraiser estimated that after reengineering the average
    monthly rent would increase by 24 percent, from $867 to $1,071,
    including utilities.  The appraiser also determined, from the past
    operating expenses of both the property itself and of properties in
    the surrounding market area, that operating expenses would decrease
    by about 14 percent.  Additionally, the appraiser determined that to
    achieve the anticipated rental revenues, repairs of $700,000 would be
    needed to the buildings' mechanical systems, common areas, apartment
    units, and exteriors.  According to the appraiser, Jackie Robinson
    Garden Apartments' income potential and market value indicated that a
    mortgage of about $6.7 million could be financed.

    Ernst & Young reached similar conclusions about the property's
    performance under reengineering, projecting that rents would increase
    to an average of $1,042 per month, provided deferred maintenance and
    short-term capital needs of about $700,000 were met.  This analysis
    assumed that the property's operating expenses would remain about the
    same.  The property's anticipated income was expected to be
    sufficient to cover the existing FHA-insured mortgage and repairs
    even without the mortgage interest subsidy that the property
    currently receives.

    According to the owner of Jackie Robinson Garden Apartments, both the
    contract appraiser and Ernst & Young overstated the average monthly
    market rents by $150 to $200.  The owner emphasized that the
    projected rents were unrealistic because of the neighborhood's
    higher-than-average crime rate and drug-related activity, which
    reduced the property's marketability and occupancy potential.  He
    also believed that the deferred maintenance estimates were overstated
    by 30 to 40 percent because they did not consider $200,000 in capital
    improvements already planned and approved for immediate
    implementation.

       Figure V.5:  Jacksonville
       Townhouse, Jacksonville,
       Florida

       (See figure in printed
       edition.)

    Jacksonville Townhouse is an 18-year-old, 10-story high-rise for the
    elderly in a suburban neighborhood of commercial, residential, and
    single-family development.  It includes a community room, laundry,
    and library and provides courtesy bus service, parking, and emergency
    call buttons in every unit.  The property contains 250 one-bedroom
    units, all of which are subsidized with Section 8 assistance.  The
    FHA-insured mortgage, endorsed in 1979, had an unpaid balance of
    about $4.85 million on December 31, 1995.

    The contract appraiser concluded that the property would fall into
    the restructure category because its cash flow would cover all of its
    operating expenses but only a portion of its outstanding FHA-insured
    debt.  As a result, a partial debt write-down of about $1.85 million
    would be required.  Ernst & Young, however, classified the property
    as a full write-off, projecting that it would cover its operating
    expenses but only a portion of its deferred maintenance and none of
    its remaining debt.  The primary factors contributing to these
    differences were differences in the projected market rents, operating
    expenses, and deferred maintenance requirements.

    The contract appraiser assumed that market rents would be reduced to
    $350 per month--substantially below the average monthly subsidized
    rents of $566.  The appraiser also evaluated other properties in the
    market area and concluded that the operating expenses would decrease
    by 48 percent and no immediate repairs would be needed for the
    property to compete in the open market.  The appraiser projected that
    the property's annual net operating income could support a mortgage
    of about $3 million, or about $1.8 million less than the HUD-insured
    loan balance.

    Ernst & Young, in comparison, believed that market rents would be
    reduced to $431 per month but that operating expenses would be about
    6 percent lower under reengineering and that the property would need
    about $1.5 million to cover its immediate deferred maintenance and
    short-term capital needs, including the repair and maintenance of
    carpeting, appliances, and cabinets, as well as air-conditioning,
    heating, and electrical systems.  Under these assumptions, Ernst &
    Young predicted that the property's cash flow would support a
    mortgage of about $0.7 million.  If there were a full claim against
    FHA's insurance fund (i.e., a claim equal to the property's mortgage
    balance at the time of the loan's restructuring), FHA would also be
    able to fund about $0.7 million in deferred maintenance needs.

    Jacksonville Townhouse's owner questioned the contract appraiser's
    estimate that operating expenses would be reduced by 48 percent after
    portfolio reengineering.  According to the owner, a 10-percent
    reduction would be more probable.

       Figure V.6:  Murdock Terrace
       Apartments, Dallas, Texas

       (See figure in printed
       edition.)

    Murdock Terrace Apartments, a 25-year-old, garden-style property
    consisting of 17 two-story buildings, is located in an older suburban
    setting characterized by commercial properties, single-family houses,
    and multifamily development.  The property includes a laundry
    facility and playgrounds and provides parking and security guards.  A
    mixture of elderly residents, families, and single persons live in 40
    one-bedroom, 176 two-bedroom, and 40 three-bedroom units.  HUD
    provides Section 8 assistance for 153 of the units under two
    contracts.  The FHA-insured mortgage, endorsed in 1971, had an unpaid
    balance of about $2.4 million on December 31, 1995.

    The contract appraiser determined that under portfolio reengineering
    the property would be in the performing category.  Ernst & Young, in
    contrast, considered the property to be a full write-off, able to
    cover its operating expenses but only part of its deferred
    maintenance costs and none of its existing FHA-insured debt.
    Differences in the two classifications stemmed from differences in
    the estimates for market rents, operating expenses, and deferred
    maintenance requirements.

    The contract appraiser projected that reengineering would raise the
    average monthly rent to $471, including utilities--an increase of
    about 33 percent over the average monthly subsidized rent of $354.
    According to the appraiser, deferred maintenance, consisting
    primarily of exterior work to the property's roofing and siding,
    would cost about $370,000.  Using expense information reported for
    properties sold in the neighborhood as well as for the overall
    market, the appraiser projected that the property's operating
    expenses would decrease by about 12 percent after reengineering.
    Under these assumptions, the property's income would be able to cover
    about $2.8 million in debt--a level roughly equivalent to the
    outstanding FHA-insured debt and the estimated costs of needed
    physical improvements.

    Ernst & Young's analysis assumed that under reengineering, the
    property's rents would rise to an average of $495 per unit, about 40
    percent above the average subsidized rents.  Ernst & Young also
    estimated significantly higher costs for deferred maintenance and
    short-term capital needs, concluding that about $5.9 million would be
    required for comprehensive repairs to units' interiors, buildings'
    exteriors, mechanical systems, and parking areas.  The analysis
    further assumed that operating expenses would continue at about the
    same level.  Using these assumptions, Ernst & Young projected that
    after reengineering the property could support a loan of about $4.3
    million, which would cover part of the deferred maintenance and
    short-term capital needs but none of the existing FHA-insured debt of
    $2.4 million.

    An official from the company responsible for managing Murdock Terrace
    Apartments disagreed with the deferred maintenance estimates
    developed by both the contract appraiser and Ernst & Young.  He said
    that recent physical assessments of the property's physical condition
    and several preliminary bids indicated expenditures of approximately
    $3 million for the property's deferred maintenance and capital needs.

       Figure V.7:  Onterie Center,
       Chicago, Illinois

       (See figure in printed
       edition.)

    Onterie Center is an 11-year-old, 60-story downtown multipurpose
    high-rise that operates as a retail, office, and residential complex.
    The property has 594 zero-bedroom (studio), one-bedroom, and
    two-bedroom units.  HUD provides Section 8 assistance for 119 of the
    units.  Onterie Center includes a fitness center, pool, laundry, and
    parking garage and provides security services.  On December 31, 1995,
    Onterie Center had a balance of $49 million on an FHA-insured
    mortgage and a balance of $26 million on a HUD-held mortgage for a
    total mortgage debt of about $75 million.

    The contract appraiser concluded that Onterie Center would fall into
    the restructure category because the projected market rents were not
    sufficient to fully refinance the existing mortgage.  Ernst & Young
    removed Onterie Center from its sample before the final analysis and
    therefore did not determine how the property would be affected by
    portfolio reengineering.

    The contract appraiser estimated that under reengineering the monthly
    rents at Onterie Center would range from $950 to $1,235, excluding
    electricity.  The appraiser's estimates approximated the subsidized
    rents of $826 to $1,232 per month.  The appraiser also determined
    that no significant improvements would be needed and that the
    operating expenses would remain about the same.  According to the
    appraiser, the property's market value and income potential indicated
    that the property could support a loan of about $32 million after
    reengineering.

       Figure V.8:  St.  Andrew's
       Manor, Oakland, California

       (See figure in printed
       edition.)

    St.  Andrew's Manor, a five-story, 24-year-old apartment building for
    the elderly, is located in an older, declining urban area of Oakland
    with a mix of commercial, single-family residential, and multifamily
    development.  The property comprises 60 apartments, including 51
    zero-bedroom (studio), 8 one-bedroom, and 1 two-bedroom units.  It
    includes a laundry facility and two activity rooms and provides
    parking, security services, and van service.  All 60 units are
    subsidized with Section 8 assistance.  The FHA-insured mortgage,
    endorsed in 1973, had an unpaid balance of about $0.7 million on
    December 31, 1995.

    The contract appraiser determined that the property would fall into
    the performing category, able to service its existing debt at the
    time of reengineering.  Ernst & Young, however, classified the
    property as nonperforming, determining that the existing debt would
    have to be written off and the property would operate at a loss.
    Differences in assumptions about market rents, operating expenses,
    and deferred maintenance requirements contributed to differences in
    the two determinations.

    The contract appraiser projected that after reengineering St.
    Andrew's Manor's rents would be adjusted to $616 per month, including
    utilities--a decrease of about 6 percent from the average subsidized
    rent of $654.  From his analysis of expense levels at St.  Andrew's
    and other properties in the surrounding market, the appraiser
    estimated that the reengineered property's operating expenses would
    decrease by 37 percent.  The appraiser also estimated that about
    $176,000 in repairs would be required to improve the property's
    marketability and retain occupancy.  After factoring in the
    property's overall value, the appraiser determined that the projected
    cash flow could support a mortgage of $2 million.

    Ernst & Young, in contrast, concluded that the property's average
    rent would decrease to $489 after reengineering, approximately 21
    percent lower than the contract appraiser's estimate.  Ernst & Young
    also forecasted that operating expenses would be about 6 percent
    lower under reengineering and that higher vacancies would result in
    decreased revenues.  Additionally, Ernst & Young estimated that about
    $482,000 would be needed for deferred maintenance and short-term
    capital improvements to mechanical systems, roofs, and units'
    interiors.  Under these assumptions, Ernst & Young determined that
    the property would operate at a loss and be unable to cover any of
    its existing FHA-insured debt.

    The owner of St.  Andrew's Manor believed that Ernst Young's market
    rent estimate more accurately reflected local market conditions than
    the contract appraiser's estimate.  The owner also questioned the
    37-percent reduction in operating expenses projected by the contract
    appraiser.  Such a reduction, the owner said, would seriously
    compromise the corporation's capacity to continue providing the
    current services, accessibility, and safety features at the property.
    In addition, the owner said that the true cost of performing deferred
    maintenance would fall somewhere between the contract appraiser's
    lower estimate of $176,000 and Ernst & Young's higher estimate of
    $482,000.

       Figure V.9:  Terrace Gardens
       Apartments, Staten Island, New
       York

       (See figure in printed
       edition.)

    Terrace Gardens I and III at Richmond is a 23-year-old property
    consisting of two seven-story buildings, each with 99 apartments.
    The property serves a mixture of families, elderly residents, and
    disabled persons in 66 one-bedroom, 96 two-bedroom, and 36
    three-bedroom units.  While Terrace Gardens is immediately adjacent
    to some single-family residential properties, the neighborhood also
    includes several other HUD-assisted multifamily rental properties, as
    well as public housing properties.  HUD provides Section 8 assistance
    for 197 units at Terrace Gardens.  The property's two FHA-insured
    mortgages, endorsed in 1973, had a combined unpaid balance of about
    $3.9 million on December 31, 1995.

    The contract appraiser determined that, under the reengineering
    process, the property would be classified as performing.  Ernst &
    Young, in comparison, placed the property in the full write-off
    category, assuming that it would be unable to cover any of its debt
    and only a portion of its deferred maintenance requirements.
    Differences in the estimated market rents and repair needs
    contributed to the difference in classification.  In addition, Ernst
    & Young's analysis focused on only one of the buildings--Terrace
    Gardens III--while the contract appraiser's assessment covered both
    buildings.

    The contract appraiser projected that reengineering would raise the
    average monthly rent from $734 to $952, including utilities.  In the
    appraiser's opinion, repairs of about $1.1 million would be needed
    for the property to compete at the higher market rates.  The
    appraiser concluded that Terrace Gardens' income potential and market
    value, less an allowance for repairs, would support a mortgage of
    $4.3 million.  If the property's physical condition remained as is,
    the appraiser believed, the mortgage would need to be restructured
    for the property to continue operating.

    Ernst & Young's evaluation of Terrace Gardens III projected an
    average monthly market rent of $739 per unit and identified $2.6
    million in deferred maintenance and short-term capital needs,
    including repairs to individual units, mechanical systems, and the
    building's exterior.

       Figure V.10:  Universal City
       Apartments, Chicago, Illinois

       (See figure in printed
       edition.)

    Universal City Apartments, a 13-year-old development, consists of 160
    units in one seven-story and four garden-style buildings.  The
    property is located in an older suburban neighborhood with both
    single-family and multifamily housing, and it serves a mixture of
    elderly residents and families in 83 one-bedroom, 51 two-bedroom, and
    26 three-bedroom apartments.  The property includes a laundry
    facility, a recreation and party room, and a small amount of
    commercial space, which is leased to small businesses.  In addition,
    the property retains a social services coordinator and provides
    parking, security fencing, and emergency alert buttons in the units
    for the elderly.  HUD subsidizes all 160 units with Section 8
    assistance.  The FHA-insured mortgage, endorsed in 1983, had an
    unpaid balance of $8.4 million on December 31, 1995.

    The contract appraiser determined that the property would fall into
    the restructure category, able to cover all of its operating expenses
    but to support a mortgage of only $1.7 million.  Ernst & Young, in
    comparison, categorized the property as nonperforming, unable to
    service any of its existing debt after reengineering.  Differences in
    the projected operating expenses and repair needs were primarily
    responsible for the difference in classification.

    The contract appraiser estimated that under reengineering the average
    monthly rent would fall significantly, from $1,204 to $594, including
    utilities.  The appraiser also projected that operating expenses
    would decrease somewhat in an open market (in part because of an
    expected reduction in real estate taxes) and that the property would
    not require any physical repairs to compete with other market-rate
    properties.  From these operating assumptions and the property's
    market value, the appraiser determined that the property's projected
    income could support a debt of about $1.7 million.

    Ernst & Young projected an average monthly rent of $578.  This
    estimate was 52 percent lower than HUD's average subsidized rent and
    3 percent lower than the contract appraiser's estimate.  Ernst &
    Young also estimated that the property's operating expenses would
    remain about the same after reengineering.  Differing primarily from
    the contract appraiser in its assessment of the property's deferred
    maintenance and short-term capital needs, Ernst & Young estimated
    repair costs of $434,485.  Ernst & Young concluded that the property
    would operate at a loss after reengineering even if its mortgage were
    entirely written off.  A full write-off would result in a claim equal
    to the entire balance of the property's FHA-insured debt, or about $8
    million.

    (See figure in printed edition.)Appendix VI
    COMMENTS FROM THE DEPARTMENT OF
    HOUSING AND URBAN DEVELOPMENT AND
    GAO'S EVALUATION
    =========================================================== Appendix V

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    The following are GAO's comments on the Department of Housing and
    Urban Development's (HUD) letter, received on September 16, 1996.

       GAO COMMENTS
    --------------------------------------------------------- Appendix V:1

    1.  Our report states that questions exist about Ernst & Young's
    estimates of the cost of deferred maintenance and that these
    estimates generally were significantly higher than those of the
    contract appraisers for the 10 case study properties we reviewed.  We
    also report that the owners and property managers who reviewed Ernst
    & Young's estimates generally believed that the estimates were too
    high.  However, the report also clearly states that the results of
    our 10 case studies cannot be generalized to the portfolio.  For that
    reason, the report does not conclude that Ernst & Young's estimates
    of the cost of deferred maintenance are too high but rather that
    further analysis of the physical condition and related capital needs
    of the insured Section 8 portfolio is needed, given the uncertainties
    about the capital costs used in the study.

    In addition, the report provides Ernst & Young's adjusted cost
    estimates of the properties' deferred maintenance needs.  For these
    estimates, Ernst & Young revised its global assumption that investors
    or lenders would replace all major subsystems and components that
    have outlasted their estimated useful life, including those that are
    still functioning.  While the adjusted estimates (which exclude the
    cost of replacing items that are still functioning) were generally
    closer to the contract appraisers' estimates than Ernst & Young's
    original estimates, 8 of the 10 adjusted estimates provided by Ernst
    & Young\1 are still higher than the contract appraisers' estimates.
    Furthermore, we continue to question the study's assumption that
    items functioning beyond their estimated useful life will be replaced
    even if they are still in good condition.  For example, some
    properties are likely to be competitive in their local markets even
    if systems that are old, but still in good condition, are not
    replaced.

    2.  Our report recognizes and discusses the differences in the
    methodologies used by Ernst & Young and the contract appraisers that
    contribute to the differences in their respective estimates of
    capital needs.  For example, the report states that Ernst & Young
    retained a firm to conduct engineering studies at the properties,
    whereas GAO's appraisers based their assessments on their reviews of
    previous physical inspections performed at the properties and their
    own physical inspections and were not tasked with performing
    engineering studies.  The report also notes that because of these
    differences in approach, we provided the properties' owners and
    managers with Ernst & Young's estimates of capital needs and the
    assumptions underlying them to obtain their views on the estimates.

    3.  HUD does not provide any data and analysis supporting its
    statement that the impact of estimates based on a sample of apartment
    units selected by property managers is immaterial to the overall
    conclusions of the report.  We continue to be concerned that for 7 of
    our 10 case study properties, Ernst & Young's inspectors examined
    fewer than 10 percent of the properties' units and that, for one
    property, Ernst & Young's estimate of the immediate deferred
    maintenance needs assumed that kitchen cabinets in all of the units
    would be replaced even though 92 of the 204 apartments are assisted
    living units without kitchens.

    4.  HUD states that any distortions in the estimates stemming from
    Ernst & Young's standard that improvements or planned repairs had to
    be "substantially complete" were "evened out in the total portfolio
    analysis." See comments 1 and 2.  In addition, HUD's response
    suggests that in some cases the estimates were too high and in other
    cases too low, with a neutral impact overall.  However, in our view,
    this assumption would tend to overstate the capital needs cost
    estimates by including the cost of work that is under way but not
    completed.

    5.  HUD's response indicates that the long-term capital needs
    identified in the study were estimated to provide information and
    that Ernst & Young used only short-term capital needs estimates to
    project properties' performance under portfolio reengineering.
    However, as discussed in the report, Ernst & Young's model assumes
    that the replacement reserve deposits included in the annual cash
    flows must cover the estimated annual replacement costs for all major
    property systems.  As a result, these amounts are a factor in
    determining both the need for restructuring a property's debt and the
    amount of the write-down that would be required if the rents were set
    at market levels.  As noted in the report, some replacement reserve
    items included in the study, such as walls and foundations, have
    useful lives of more than 50 years.

    6.  We gave the lenders with whom we spoke information on the full
    range of underwriting assumptions used by Ernst & Young, including
    the assumption that the current recipients of Section 8 project-based
    assistance would receive Section 8 tenant-based assistance.  As
    stated in the report, these lenders indicated that (1) a transition
    period of 1 to 2 years is more reasonable than the 9-month period
    used in the model and (2) an unstable period with lower income and
    higher costs is more likely during the transition than the
    incremental move towards stabilization over 9 months used in the
    model.  We disagree with HUD that the length of the transition period
    as modeled by Ernst & Young is not of concern because Ernst & Young
    assumed that every Section 8 resident currently in the property would
    receive Section 8 assistance at whatever level was needed to meet the
    new market rent requirements.  Given the study's assumption that
    project-based Section 8 assistance would be replaced with portable
    tenant-based assistance and that Section 8 assistance would not be
    provided to current residents who do not receive it, it is reasonable
    to assume that during a transition period, the vacancy rates at some
    properties might fall below the market vacancy rates used in the
    study.  In addition, Ernst & Young's deferred maintenance estimates
    indicate that a substantial amount of work is needed at many
    properties.  It is, therefore, reasonable to assume that at such
    properties more than 9 months may be needed to complete this work and
    that higher vacancy rates may occur while apartment units are
    off-line during construction.  Accordingly, we continue to believe
    that the concerns raised by lenders about the transition period are
    reasonable.

    7.  Lenders also questioned other financing terms used by Ernst &
    Young, including the debt service coverage ratios and loan-to-value
    ratios used in the study.  The effects of alternative financing terms
    on Ernst & Young's results were factored into the sensitivity
    analyses we performed.

    8.  As stated in the report, the data we present on the cost of
    restructuring HUD's multifamily portfolio are intended to reflect the
    results of Ernst & Young's financial model, including the assumptions
    used by Ernst & Young.  We recognize that the cost estimates do not
    conform with federal budget rules and scoring methodology and do not
    reflect all aspects of HUD's current portfolio reengineering
    proposal.  Both of these points were clearly stated in the copy of
    the draft report provided to HUD for comment.

    9.  Our discussion of the Section 8 cost estimates generated by Ernst
    & Young's financial model does include properties with below-market
    rents as well as those with above-market rents, since both types of
    properties were included in Ernst & Young's study.  However, our
    report also discusses the effect of including properties with
    below-market rents on the model's Section 8 cost savings estimates,
    notes that the changes HUD has made in its portfolio reengineering
    proposal offer the potential for additional Section 8 savings, and
    estimates the cost savings that would occur if only the properties
    with above-market rents were reengineered.

    10.  The report indicates that for properties that could not cover
    operating expenses at market rents, HUD proposed alternative
    strategies, including demolition.  The report does not state that
    this alternative represented a "preferred option" for dealing with
    such properties.

    11.  HUD says that Ernst & Young's study was not intended to evaluate
    the portfolio reengineering proposal and that our use of the study in
    this manner goes beyond the study's original design.  We note that
    Ernst & Young's "HUD Mark to Market - Overview of Field Work (Revised
    as of 8/31/95)" states that the objective of Ernst & Young's
    "engagement" was to assist HUD in understanding the effects of the
    mark-to-market initiative on HUD's portfolio of loans, programs, and
    housing stock.  Furthermore, as HUD's letter notes, a major section
    of Ernst & Young's May 2, 1996, report focuses on how properties are
    likely to be affected by HUD's proposal.  We recognize, nonetheless,
    that some aspects of HUD's current portfolio reengineering proposal
    are not reflected in the study's results, and we identified this
    limitation in both our draft and our final report.

    --------------------
    \1 Ernst & Young did not provide a revised estimate for one property
    which was inspected but subsequently dropped from the study.

    MAJOR CONTRIBUTORS TO THIS REPORT
    ========================================================= Appendix VII

    HOUSING AND COMMUNITY DEVELOPMENT
    ISSUE AREA

    Richard A.  Hale
    Christine M.B.  Fishkin
    Woodliff L.  Jenkins, Jr.
    Rose M.  Schuville
    Mark H.  Egger
    Leigh K.  Ward
    Joseph M.  Raple
    Andy C.  Clinton

    DESIGN, METHODOLOGY, AND TECHNICAL
    ASSISTANCE GROUP

    Karen E.  Bracey

       ECONOMIC ANALYSIS GROUP
    ------------------------------------------------------- Appendix VII:1

    Austin J.  Kelly

    RELATED GAO PRODUCTS
    ============================================================ Chapter 1

    Multifamily Housing:  HUD's Portfolio Reengineering Proposal:  Cost
    and Management Issues (GAO/T-RCED-96-232, July 30, 1996).

    Housing and Urban Development:  Comments on HUD's FY 1997 Budget
    Request (GAO/T-RCED-96-194 and GAO/T-RCED-96-205, June 17, 1996).

    Housing and Urban Development:  Limited Progress Made on HUD Reforms
    (GAO/T-RCED-96-112, Mar.  27, 1996).

    Multifamily Housing:  HUD's Mark-to-Market Proposal
    (GAO/T-RCED-95-230, June 15, 1995).

    HUD Management:  FHA's Multifamily Loan Loss Reserves and Default
    Prevention Efforts (GAO/RCED/AIMD-95-100, June 5, 1995).

    *** End of document. ***