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. ***