Multifamily Housing: HUD's Proposals for Reengineering Its Insured
Section 8 Portfolio (Stmnt. for the Rec., 06/27/96, GAO/T-RCED-96-210).

GAO discussed the Department of Housing and Urban Development's (HUD)
proposal to restructure its section 8 multifamily rental housing
portfolio. GAO noted that: (1) the section 8 portfolio suffers from high
subsidy costs, exposure to insurance losses, and deteriorating property
conditions; (2) HUD has proposed to implement a mark-to-market process
that would allow property owners to set rents at market levels and allow
HUD to reduce mortgage debt, terminate mortgage insurance, and
restructure section 8 subsidies; (3) HUD contracted for a study to
obtain information on market rents and the physical condition of the
properties in its portfolio; (4) the study showed that the majority of
insured section 8 properties would require debt reduction or forgiveness
to continue operating; (5) the study also showed that, for most
properties, assisted rents are higher than estimated market rents; (6)
the contractor's study methodology was reasonable; and (7) any benefits
that the HUD proposal realizes may come at a high cost.

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

 REPORTNUM:  T-RCED-96-210
     TITLE:  Multifamily Housing: HUD's Proposals for Reengineering Its 
             Insured Section 8 Portfolio
      DATE:  06/27/96
   SUBJECT:  Housing programs
             Low income housing
             Federal aid for housing
             Rental housing
             Rent subsidies
             Rental rates
             Mortgage loans
             Accountants
             Maintenance (upkeep)
IDENTIFIER:  HUD Section 8 Loan Management Set-Aside Program
             HUD Section 8 New Housing Construction Program
             HUD Section 8 Rental Assistance Program
             HUD Section 8 Substantial Rehabilitation Program
             Federal Housing Insurance Fund
             HUD Mark to Market Program
             
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Cover
================================================================ COVER


Before the Subcommittee on Housing Opportunity and Community
Development, Committee on Banking, Housing, and Urban Affairs, United
States Senate

Statement
Submitted on
June 27, 1996

MULTIFAMILY HOUSING - HUD'S
PROPOSALS FOR REENGINEERING ITS
INSURED SECTION 8 PORTFOLIO

Statement for the Record by
Judy A.  England-Joseph, Director,
Housing and Community Development Issues,
Resources, Community, and Economic
Development Division

GAO/T-RCED-96-210

GAO/RCED-96-210T


(385636)


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

  FHA - Federal Housing Administration
  GAO - General Accounting Office
  HUD - Department of Housing and Urban Development

============================================================ Chapter 0

Mr.  Chairman and Members of the Subcommittee: 

We are pleased to submit this statement for the record in conjunction
with the Subcommittee's June 27, 1996, hearing on proposals to
reengineer about 8,600 properties from the Department of Housing and
Urban Development's (HUD) multifamily rental housing portfolio. 
These 8,600 properties, which we refer to as the insured Section 8
portfolio, are properties that receive mortgage insurance from HUD
through its Federal Housing Administration (FHA) and that receive
Section 8 rental subsidies that are tied directly to the properties
(Section 8 project-based assistance).  During the past few years,
this Subcommittee, HUD, GAO, and others have given increased
attention to the problems affecting this segment of HUD's portfolio
and to identifying possible strategies for resolving the problems
while protecting the interests of all affected parties--property
owners, residents, mortgage lenders, HUD, state and local housing
agencies, and, of course, the federal taxpayer, who will ultimately
benefit from the savings or bear the extra costs that result from the
strategy that is adopted. 

In May 1995, HUD proposed a resolution process it called
"mark-to-market." In early 1996, HUD modified that process in
response to stakeholders' concerns and renamed it "portfolio
reengineering." This statement provides the preliminary results of
our work on an assignment relating to HUD's proposals.  In addition
to providing background information on the insured Section 8
portfolio, this statement discusses (1) the problems currently
affecting the portfolio, (2) HUD's plans for addressing these
problems, (3) a HUD-contracted study by Ernst & Young LLP that
estimates how the properties are likely to be affected by HUD's
reengineering proposal, and (4) our preliminary assessment of Ernst &
Young's study.  We are also providing observations on HUD's portfolio
reengineering initiative. 

In summary, we found the following: 

  -- The basic problems affecting the insured Section 8 portfolio are
     high subsidy costs, high exposure to insurance loss, and the
     poor condition of many properties.  These problems stem from one
     or more of several basic causes.  These include (1) program
     design flaws that have contributed to high subsidies and put
     virtually all the insurance risk on HUD; (2) HUD's dual role as
     mortgage insurer and rental subsidy provider, which has resulted
     in the federal government's averting claims against the FHA
     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. 

  -- In 1995, HUD proposed to address these problems through a
     process it called "mark-to-market." This process would allow
     property owners to set rents at market levels, while HUD would
     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.  Although HUD expected the proposal to reduce the
     costs of Section 8 subsidies, lowering mortgage debt would
     result in claims against FHA's insurance fund.  Many questions
     and concerns were raised about the proposal, including (1)
     whether data on the physical and financial condition of
     properties in the portfolio were reliable, (2) how the process
     would affect the properties and existing residents, and (3)
     whether the result would be a net saving or cost to the
     government.  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.  In response to the concerns, in early 1996 HUD made
     several changes to the proposal but left most of its basic
     thrust intact. 

  -- During 1995, HUD also contracted with Ernst & Young LLP to
     obtain up-to-date information on market rents and the physical
     condition of the properties in the insured Section 8 portfolio
     and to develop a financial model to show how HUD's proposal
     would affect the properties.  Ernst & Young's May 1996 report on
     the Department's proposal indicates that the vast majority of
     the insured Section 8 properties--between 77 and 83
     percent--would need to have their debt reduced in order to
     continue operations.  The study also estimates that between 22
     and 29 percent of the properties in the portfolio would have
     difficulty sustaining operations even if their mortgages were
     totally forgiven.  These projections are based on current data
     on market rents and the physical condition of the properties
     obtained by Ernst & Young.  Furthermore, it is important to note
     that the study's results reflect the provisions contained in
     HUD's mark-to-market proposal prior to the changes that HUD made
     to the proposal in early 1996.  The study also confirms earlier
     data that, for most of the properties subject to portfolio
     reengineering, the assisted rents are higher than the estimated
     market rents.  In addition, the properties in the portfolio were
     found to have significant amounts of immediate deferred
     maintenance and short-term and long-term capital needs. 

  -- Our preliminary analysis of Ernst & Young's financial model
     indicates that it provides a reasonable framework for studying
     the outcomes of portfolio reengineering, such as how many
     properties will need to have their debt reduced.  In addition,
     we did not identify any substantive problems with Ernst &
     Young's sampling and statistical methodology.  We are still
     assessing how assumptions used in the model affect its estimates
     of the effects of portfolio reengineering.  In addition, we are
     examining subsidy and claims cost data that were developed by
     Ernst & Young as part of its study but not included in its May
     1996 report.  Our preliminary analysis of these cost data
     indicates that the claims costs will be substantial--Ernst &
     Young's data indicate that the average debt writedown for
     properties whose mortgages need restructuring is approximately
     61 to 67 percent of the insured loans' unpaid principal balances
     at the time of restructuring. 

  -- In our view, 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 less than the mortgages on the properties suggest.  Until
     now, this reality has not been recognized and we have continued
     to subsidize the rents at many properties above the level the
     properties could command in the commercial real estate market. 
     While HUD deserves credit for offering an approach that would
     address the major problems that affect the portfolio and
     potentially lead to long-term savings in Section 8 subsidy
     costs, the benefits achieved by the proposal may come at a high
     cost.  Accordingly, it is important for the Congress to
     carefully examine HUD's proposal as well as any other proposals
     for reengineering HUD's insured Section 8 portfolio, taking into
     account the differences in the properties that make up the
     portfolio and the different ways that these properties will be
     affected by reengineering. 


   BACKGROUND ON THE PORTFOLIO AND
   GAO'S 10 CASE STUDY PROPERTIES
---------------------------------------------------------- Chapter 0:1

HUD, through FHA, provides insurance that protects private lenders
from financial losses stemming from borrowers' defaults on mortgage
loans for both single-family homes and multifamily rental housing
properties for low- and moderate-income households.  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. 

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 project-based
assistance.  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, 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.  Data provided by HUD in April 1996 show that, together, these
properties have unpaid principal balances totaling $17.8 billion and
contain about 859,000 units, of which about 689,000 receive
project-based Section 8 subsidies.\2 According to HUD's data, about
45 percent of the insured Section 8 portfolio (3,859 properties,
303,219 assisted units, and $4.8 billion in unpaid loan balance)
consist of what are called the "older assisted" properties.  These
are properties that 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, 385,931 assisted
units, and $13.0 billion in unpaid loan balance) consists of what are
called the "newer assisted" properties.  These properties generally
were built after 1974 under HUD's Section 8 New Construction and
Substantial Rehabilitation programs and received project-based
Section 8 subsidies based on formulas with automatic annual
adjustments, which tended to be relatively generous to encourage the
production of affordable housing. 

There is great diversity among the properties in HUD's insured
Section 8 portfolio, as illustrated by the 10 properties that we
studied in greater depth as part of our current assignment.  These
properties differ in a number of important respects, such as the
amount of their remaining unpaid mortgage debt; the types and amounts
of assistance they receive from HUD; and their financial health,
physical condition, rents, types of residents served, and surrounding
neighborhoods and rental housing markets.  These factors can
influence the effect that HUD's or other reengineering proposals
would have on the properties. 

There is wide variation in the size of the insured mortgages at these
properties.  The unpaid mortgage balances at our 10 properties (as of
Dec.  31, 1995) ranged from about $731,000 to almost $75 million. 
There is also wide variation in the types and amounts of assistance
HUD provides to the properties.  For example, HUD provides
project-based Section 8 rental subsidies for all 60 apartment units
at the smallest of our 10 properties but for only 119 of the 594
units at the largest property.  In addition, the rents that HUD
subsidizes vary greatly.  The rents for a one-bedroom apartment, for
instance, ranged from $332 to $1,231.  HUD also subsidizes the
interest rate at six of the properties, reducing the rate actually
paid by the properties to between 1 and 2 percent.  The other four
properties pay mortgage interest rates ranging from 7.5 percent to
11.9 percent.  Furthermore, 3 of our 10 properties also have received
low-interest loans from HUD for repairs and maintenance, and 2 of
these 3 have received grants from HUD to combat drug-related crime. 
Finally, the financial and physical conditions of our 10 case study
properties also varied substantially. 

The majority of the residents in our 10 case study properties have
low incomes.  According to the properties' records, between 60
percent and 96 percent of the Section 8 units at each property are
occupied by households earning less than $10,000 per year.  However,
the properties tend to serve different types of households.  At six
of the properties, all or almost all of the Section 8 units are
occupied by elderly or disabled persons, while at the other four
properties, family and single adult households constitute a much
larger percentage (in three cases, a majority) of the assisted
households. 

Our 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, ranging from areas
with declining physical conditions, high crime rates, high
unemployment, abandoned buildings, and/or frequent drug activity, to
areas with economic growth, lower crime rates, and high income
levels.  Some properties are in neighborhoods dominated by
multifamily, government-subsidized housing, while others are in
neighborhoods dominated by unsubsidized housing, and in some cases
single-family residences.  The rental housing markets in the
neighborhoods also vary, with occupancy rates ranging from about 88
percent to 100 percent.\3


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

\2 For various reasons, HUD chose to exclude from its restructuring
proposals properties with project-based Section 8 assistance that was
provided under its "moderate rehabilitation" program.  HUD estimates
that there are about 167 insured moderate rehabilitation properties
containing about 16,800 units. 

\3 We are analyzing how the case study properties would be affected
by portfolio reengineering. 


   PROBLEMS AFFECTING THE
   PORTFOLIO
---------------------------------------------------------- Chapter 0:2

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 the properties in the insured Section 8
portfolio now receive subsidized rents above market levels, many
substantially above 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 paid for the initial
development or rehabilitation of these properties under these
programs by initially establishing rents above market levels and then
raising them regularly through the application of set formulas that
tended to be generous to encourage the production of new affordable
housing. 

The overall 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.\4 For example, HUD
is requesting $863 million in budget authority in fiscal year 1997 to
renew expiring contracts covering almost 293,000 units in the insured
Section 8 portfolio.  As long-term Section 8 contracts expire and
1-year contract renewals continue to roll over annually, HUD's
estimated annual renewal costs will increase steadily in each of the
following 9 fiscal years. 

A second key problem affecting the portfolio is the high risk of
insurance loss.  Under FHA's insurance program, HUD bears virtually
all the risk in the event of loan defaults.  A third, closely related
problem is the poor physical condition of many properties in the
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." Properties were considered to be
distressed if they failed to provide sound housing and lacked the
resources to correct deficiencies or if they were likely to fail
financially. 

As we noted in testimony last year, the problems affecting HUD's
insured Section 8 portfolio stem from several causes.\5 These include
(1) program design flaws that have contributed to high subsidies and
put virtually all the insurance risk on HUD; (2) HUD's dual role as
mortgage insurer and rental subsidy provider, which has resulted in
the federal government averting claims against the FHA 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. 


--------------------
\4 The project-based Section 8 assistance for properties in the
insured Section 8 portfolio is covered by contracts, many of which
are long term.  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. 

\5 Multifamily Housing:  HUD's Mark-to-Market Proposal
(GAO/T-RCED-95-230, June 15, 1995). 


   HUD'S PLANS FOR ADDRESSING
   PROBLEMS WITH THE PORTFOLIO
---------------------------------------------------------- Chapter 0:3

The basic concept behind HUD's May 1995 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 proposed to do this by (1) eliminating the
project-based Section 8 subsidies as existing contracts expired (or
sooner if owners agreed), (2) allowing owners to rent apartments for
whatever amount the marketplace would bear, (3) facilitating the
refinancing of the existing FHA-insured mortgage with a smaller
mortgage if needed for the property to operate at the new rents, (4)
terminating the FHA insurance on the mortgage, 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 if they wanted to or if they no longer could afford to
stay in their current apartment. 

Recognizing that many properties could not cover their expenses and
might eventually default on their mortgages if forced to compete in
the commercial market without their project-based Section 8
subsidies, the mark-to-market proposal set forth several alternatives
for restructuring the FHA-insured mortgages in order to bring income
and expenses in line.  These alternatives included selling mortgages,
engaging third parties to work out restructuring arrangements, and
paying full or partial FHA insurance claims to reduce mortgage debt
and monthly payments. 

The proposed mark-to-market process would likely affect properties
differently, depending on whether their existing rents were higher or
lower than market rents.  If existing rents exceeded market rents,
the process would lower the mortgage debt, thereby allowing a
property to operate and compete effectively at lower market rents. 
If existing rents were below market, the process would allow a
property to increase rents, potentially providing more money to
improve and maintain the property.  HUD recognized, however, that
some properties would not be able generate sufficient income to cover
expenses even if their mortgage payments were reduced to zero.  In
those 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 House held hearings in 1995 on the
mark-to-market proposal, no consensus was reached on whether it or
some other approach should be adopted.  Part of the reason for this
was the lack of reliable data on the properties and their surrounding
rental markets.  Various potential stakeholders raised important
unanswered questions and concerns about the mark-to-market proposal. 
They sought information on the physical and financial conditions of
the properties in the insured Section 8 portfolio, the effects of the
proposed strategy on different types of properties, and the long-term
financial impact of the proposal on the government.  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. 

While leaving much of its original mark-to-market proposal intact,
HUD in early 1996 made several changes to the proposal in response to
stakeholders' concerns.  HUD also renamed the proposal "portfolio
reengineering." These changes included (1) giving priority attention
for at least the first 2 years to properties with subsidized rents
above market; (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.  In
addition, HUD stated a willingness to discuss with the Congress
mechanisms to take account of tax consequences related to debt
forgiveness for property owners who enter into restructuring
agreements.  More recently, HUD has also suggested that action on
properties that would not be able to generate sufficient income to
cover operating expenses after reengineering should be deferred until
strategies are developed that address community and resident needs
relating to the properties. 


   OBJECTIVES AND RESULTS OF ERNST
   & YOUNG'S STUDY
---------------------------------------------------------- Chapter 0:4

In May 1995, when HUD proposed the mark-to-market initiative, the
Department did not have current or complete information on the
insured Section 8 portfolio upon which to base assumptions and
estimates about the costs and impact of the proposal.  For example,
HUD lacked reliable, up-to-date information on the market rents the
properties could be expected to command and the properties' physical
conditions--two variables that strongly influence how properties will
be affected by the mark-to-market proposal.  To obtain data to better
assess the likely outcomes and costs of the mark-to-market proposal,
HUD contracted with Ernst & Young LLP\6 in 1995 for a study on
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 how the proposal would affect the
properties and to estimate the costs of subsidies and claims
associated with the mark-to-market proposal. 

The study was conducted on a sample of 558 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 its
mark-to-market proposal.\7 The sample was designed to be projectible
to the population with a relative sampling error of no more than plus
or minus 10 percent at the 90-percent confidence level.  A briefing
report summarizing the study's findings was released by HUD and Ernst
& Young on May 2, 1996.  It provides current information on how
assisted rents at the properties compare with market rents, the
physical condition of the properties, and how the properties are
expected to be affected by HUD's proposal as the proposal existed
while the study was under way.  As such, it is important to note that
the study's results do not reflect the changes that HUD made to its
proposal in early 1996. 


--------------------
\6 The study was conducted by the E&Y Kenneth Leventhal Real Estate
Group. 

\7 Ernst & Young reported that the sample was drawn from a population
of 8,363 properties rather than the HUD-identified population of
8,563 properties because of technical and cost considerations.  As
noted earlier, HUD now believes that 8,636 properties would be
subject to portfolio reengineering. 


      STUDY CONFIRMS EXCESS
      SUBSIDY COSTS AND
      SIGNIFICANT PHYSICAL NEEDS
      AT PROPERTIES
-------------------------------------------------------- Chapter 0:4.1

Ernst & Young estimates that the majority of the properties have
assisted rents exceeding market rents and that the properties have
significant amounts of immediate deferred maintenance and short-term
and long-term capital needs.\8 Specifically, Ernst & Young's study
estimates that a majority of the properties--between 60 and 66
percent--have rents above market and between 34 and 40 percent are
estimated to have below-market rents.  Ernst & Young's data also
indicate a widespread need for capital--between $9.2 billion and
$10.2 billion--to address current deferred maintenance needs and the
short- and long-term requirements to maintain the properties.  The
study estimates that the properties have between $1.3 billion and
$1.6 billion in replacement and cash reserves that could be used to
address these capital needs, resulting in total net capital needs of
between $7.7 billion and $8.7 billion.  The average per-unit cost of
the total capital requirements, less the reserves, is estimated to be
between $9,116 and $10,366. 


--------------------
\8 The study defines three categories of capital items:  (1)
immediate deferred maintenance, the estimated costs to bring all
property operating systems up to market conditions and lender
underwriting standards; (2) short-term capital backlog, the estimated
costs for the expired life of property systems requiring replacement
in 5 years or less; and (3) long-term capital backlog, the estimated
costs for the expired life of property systems requiring replacement
in more than 5 years. 


      STUDY INDICATES A
      SIGNIFICANT LEVEL OF DEBT
      RESTRUCTURING WOULD BE
      NEEDED
-------------------------------------------------------- Chapter 0:4.2

Ernst & Young's analysis also indicates that about 80 percent of the
properties would not be able to continue operations unless their debt
was restructured.  Furthermore, for approximately 22 to 29 percent of
the portfolio, writing the existing debt to zero would not
sufficiently reduce costs for the properties to address their
immediate deferred maintenance and short-term capital needs.  The
study estimates that between 11 and 15 percent of the portfolio would
not even be able to cover operating expenses. 

The study was designed to use the information on market rents and
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 on the basis of
the assumption that they would be reengineered (marked to market)
when their current Section 8 contracts expire.\9

The model classifies the loans into four categories--performing,
restructure, full write-off, and nonperforming--that reflect how the
properties would be affected by HUD's proposal.  Placement in one of
the four categories is based on the extent to which income from the
reengineered properties would be able to cover operating costs, debt
service payments, deferred maintenance costs, and short-term capital
expenses.  Table 1 shows the results of Ernst & Young's analysis of
how properties would be affected by HUD's proposal. 



                                Table 1
                
                   Effects of Reengineering on HUD's
                      Insured Section 8 Portfolio

                                 Percent
                                      of
Status of loan after            portfoli  Costs covered with
reengineering                          o  reengineered cash 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:  Capital needs represent immediate deferred maintenance and
short-term (5 years or less) capital needs.  In addition, the
financial model categorizing the loans assumes annual deposits to
replacement reserves. 


--------------------
\9 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 expires. 


   GAO'S ASSESSMENT OF THE MODEL
   AND THE RESULTS
---------------------------------------------------------- Chapter 0:5

We are currently evaluating Ernst & Young's financial model and
expect to issue our report late this summer.  Our preliminary
assessment is that the model provides a reasonable framework for
studying the overall results of portfolio reengineering, such as the
number of properties that will need to have their debt restructured,
and to estimate the related costs of insurance claims and Section 8
subsidies.  In addition, we did not identify any substantive problems
with Ernst & Young's sampling and statistical methodology.  However,
our preliminary assessment of the study indicates that some aspects
of Ernst & Young's financial model and its assumptions may not
reflect the way in which insured Section 8 properties will actually
be affected by portfolio reengineering.  Also, some of the
assumptions used in the model may not be apparent to readers of Ernst
& Young's May 1996 briefing report. 

For example, Ernst & Young's assumptions about the transition period
that properties go through in the reengineering process may be overly
optimistic.  During the transition, a reengineered property changes
from a 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.  Lenders with whom we consulted on the reasonableness of the
model's major assumptions generally believed that a longer transition
period of 1 to 2 years is more likely.  They also anticipated an
unstable period with less income and more costs during the transition
rather than the smooth transition assumed in the model.  An Ernst &
Young official told us that the 9-month period was designed to
reflect an average transition period for reengineered properties. 
While he recognized that some properties would have longer transition
periods than assumed in the model, he believed that the transition
periods for other properties could be shorter than 9 months. 

In addition, Ernst & Young's May 1996 report does not detail all of
the assumptions used in the firm's financial model that are useful to
understanding the study's results.  In particular, the model assumes
that the interest subsidies some properties currently receive will be
discontinued after the first Section 8 contract expires, including
those in the performing category whose debts do not require
restructuring. 

We are currently examining how the assumptions contained in Ernst &
Young's study affect its estimates of the effects of portfolio
reengineering.  In addition, we are assessing how the use of
alternative assumptions would affect the study's results. 

We also observed that although Ernst & Young's study provided
information on the cost to the government of the portfolio
reengineering proposal, the May report did not provide these
results.\10 We are currently examining Ernst & Young's data and will
provide cost estimates derived from Ernst & Young's model covering
changes in the Section 8 subsidy costs and FHA insurance claims.  Our
preliminary review of this information indicates that the costs of
claims will be significant.  On average, the data indicate that
mortgage balances for properties needing mortgage
restructuring--including those in the full write-off and
nonperforming categories that would have their mortgages totally
written off--would need to be reduced by between 61 and 67 percent. 
This reduction would result in claims against FHA's multifamily
insurance funds. 


--------------------
\10 According to HUD's Deputy Assistant Secretary for Operations,
Office of Housing, while cost data were developed by Ernst & Young,
HUD never intended that the data be included as a part of the report
on the results of Ernst & Young's study. 


   OBSERVATIONS
---------------------------------------------------------- Chapter 0:6

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 less than the
mortgages on the properties suggest.  Until now, this reality has not
been recognized and we have continued to subsidize the rents at many
properties above the level the properties could command in the
commercial real estate market. 

In our view, HUD deserves credit for offering an approach that would
address the major problems that have affected the portfolio.  For
example, the proposal, if implemented, should lead to long-term
savings in the costs of Section 8 subsidies, although how soon and to
what extent these savings are realized will depend on how, when, and
which properties are reengineered.  Furthermore, by subjecting
properties to the discipline of the marketplace, the proposal should
reduce the need for governmental oversight and regulation.  To the
extent that FHA-insured mortgages on the properties are terminated,
the proposal would also relieve the government of the risk of future
defaults on loans.  Moreover, by making housing assistance subsidies
tenant-based rather than project-based, the proposal potentially
offers residents the opportunity to leave properties that fail to
provide adequate housing. 

Unfortunately, however, these benefits may come at a high cost.  As
Ernst & Young's data indicate, the vast majority of the properties
will need mortgage writedowns to survive in a market-rate environment
and the insurance claims associated with those writedowns will be
substantial--on average, around 61 to 67 percent of the properties'
mortgages.  In addition, the proposal may cause the loss of
affordable housing and may displace residents if, as the study
suggests, up to almost 30 percent of the properties in the portfolio
will have difficulty sustaining operations without financial support
in addition to a full writedown of their current mortgages. 
Accordingly, it will be important for the Congress to carefully
examine HUD's proposal as well as any other proposals to reengineer
HUD's insured Section 8 portfolio, taking into account the
differences in the properties that make up the portfolio and the
different ways that these properties will be affected by
reengineering. 


-------------------------------------------------------- Chapter 0:6.1

As indicated earlier in our statement, we are continuing to review
the results of Ernst & Young's study and other issues associated with
portfolio reengineering, and we will look forward to sharing the
results of our work with the Subcommittee as it is completed. 


*** End of document. ***