Determining the Amount of HOME Subsidy
Once the PJ has evaluated the developer’s financial information and has determined that the cost estimates are sound, the PJ must analyze this information to determine whether or not to fund the project, and if so, the amount of the HOME subsidy.
The maximum HOME subsidy that can be invested in a project is the lesser of these three amounts:
- The financial needs of the project, based on a subsidy layering review
- The portion of the total project cost that is HOME-eligible and can be allocated to HOME- assisted units
- The 221(d)(3) maximum per unit subsidy limit.
The PJ can make changes to its assumptions about the HOME funding, in order to increase the amount of funding it invests in the project. For instance, by increasing the number of units that are designated HOME-assisted, the amount of HOME funds that can be allocated to the project increases.
In a HOME-LIHTC project, there are a number of specific issues that the PJ must analyze to make these final determinations, such as:
- What is the appropriate level of subsidy for the project, given the tax credit equity?
- Is the project’s financing gap closed?
- Are the PJ’s requirements met?
- Is the proposed subsidy at or below the HOME maximum per unit subsidy limit?
- How does the form of the HOME subsidy (grant vs. loan, and interest rate terms) impact the potential tax credit contribution?
- Will the tax credits be marketable to investors for the proposed project, and at what price?
With a thorough analysis, the PJ can make the best possible choices about how to invest HOME funds in the project to ensure that the HOME investment is protected, and potentially yields a return to the PJ.
The Financing Gap
Typically, the role of HOME funding in a HOME-LIHTC project is to fill the financing gap between the development budget, on the one hand, and the available sources of funds, on the other hand. Exhibit 2-11 illustrates a project with a financing gap.
Exhibit 2-11: Illustration of the Financing Gap
The financing gap is not static. It changes every time the owner or the PJ alters its key economic assumptions (e.g., rents and the unit mix that affects rents, rent loss, expenses, and development costs). Exhibits 2-12 and 2-13 illustrate how the financing gap changes for a proposed 50-unit HOME-LIHTC project with gross potential rents at $650 per unit per month (Exhibit 2-12) versus $600 per unit per month (Exhibit 2-13). In some jurisdictions, this might be the rent differential between the High HOME Rent and the LIHTC rent.
In each illustration, the arrow indicates the direct relationship between the amount of first mortgage debt service that the NOI can support, and the first mortgage amount.
Exhibit 2-12: Illustration When Gross Potential Rent is $650 Per Unit Per Month
Without having changed any other assumptions, the $50 (7.7%) reduction in rents results in a $294,000 (43%) increase in gap financing requirements for this sample project.
Most economic assumptions are interrelated, and every time one key assumption changes, the underwriter needs to re-evaluate how the change impacts the other assumptions. For example, in the illustrations above, if the rents are lowered, there may also be a reduction in rent loss, because the proposed rents are more of a bargain.
Or, the underwriter may need to consider how a reduction in unit size might impact rents and operating expenses. For instance, the cost to repaint or replace carpet might be lower for a smaller unit.
The financing gap can only be determined after generating a relatively realistic development budget and operating pro forma. The PJ must evaluate its funding estimates by asking:
- Is the development budget aggressive? Conservative? Adequate without being excessive?
- Is the operating budget aggressive? Conservative? Adequate without being excessive?
- Are the proposed reserves adequate without being excessive?
- Are the proposed rents achievable?
- Are the underwritten rent loss (vacancy and bad debt) assumptions realistic?
- Is the proposed income from other sources (laundry, parking, or commercial space) realistic?
- Could the owner get a real estate tax abatement or payment in lieu of taxes?
- Might the owner secure better loan terms from another lender?
- Could the owner secure a lower interest rate than that proposed?
- Could the owner get a loan with longer amortization, later maturity, lower origination or prepayment costs, or fewer restrictions?
- Is the proposed LIHTC equity price competitive? Does the equity pay in early (resulting in lower bridge financing costs), or later?
Subsidy Layering Requirements
HOME and LIHTC each contain requirements to ensure that the total amount of government assistance is no more than is necessary to produce the project. The term subsidy layering analysis refers to the process that PJs (for HOME) and state LIHTC allocating agencies use in order to make this determination. The subsidy layering review ensures that the PJ identifies the amount of the financing gap and invests no more funds than the amount that is sufficient to fill the gap, neither more nor less. Funding more than the gap means the project is over-subsidized. Funding less than the gap means that the owner may have inadequate funds to complete the project successfully.
HOME Subsidy Layering Requirements
The PJ is required to conduct a Subsidy Layering Review (SLR) whenever HOME funding is combined with other public funding, including LIHTC funding. HOME requires the PJ to develop and use standardized procedures to conduct this subsidy layering review. The PJ’s SLR must be in writing and must remain in the PJ’s project file.
For HOME-LIHTC projects, PJs are permitted to accept the subsidy determination of the state allocating agency for subsidy layering purposes, as described in the following section. The PJ must still conduct its own review to determine compliance with all other HOME requirements.
Tax Credit Subsidy Layering Requirements
The LIHTC regulations contain a requirement similar to the HOME subsidy layering requirement. These regulations require that the state allocating agency have procedures for making the tax credit allocation determination, including standards for acceptable developer and builder fees.
For tax credit projects, if the PJ chooses to adopt the subsidy determination of the state allocating agency, it must request a copy of the state’s subsidy layering review. The PJ should thoroughly review and analyze it to ensure there is agreement with its determinations. If the PJ determines it is satisfactory, it can adopt the review for the HOME-LIHTC project and retain a copy of this review in the project file.
Rate of Return on Equity
When conducting a subsidy layering review, the PJ should carefully assess the rate of return on the owner’s equity. All else equal, the more cash flow and residual profit the owner can expect, the less HOME funding should be provided, because the owner should be expected to make more of an initial investment itself.
Post-Construction Subsidy Layering Reviews
Both the PJ and the state allocating agency are required to conduct a SLR at the time the HOME award is made. LIHTC projects are also required to include a post-construction cost certification audit by an independent accountant. This type of audit details the actual development costs that are incurred by a project. Because often there are material changes between the projected and actual sources and uses, it can be extremely helpful for the PJ to also conduct a final SLR based on the actual sources and uses. A post-construction (actual cost) subsidy layering analysis determines whether actual uses were lower than estimated in the underwriting. For tax credit projects, this is done to verify that there was enough actual basis for the tax credits.
If the PJ intends to carry out a post-construction SLR based on actual costs, the written agreement between the PJ and the owner should make the owner aware of this requirement and should provide that the amount of the HOME award may be decreased (but not increased) based on the result of eligible costs within the post construction SLR.
For more information on subsidy layering requirements and evaluating the owner’s rate of return, see Layering Guidance for HOME Participating Jurisdictions When Combining HOME Funds with Other Government Subsidies, HUD Notice CPD 98-01, issued January 22, 1998. This Notice is available online at https://www.hud.gov/program_offices/comm_planning/affordablehousing/programs/home/.
Allocation of Costs to HOME-Assisted Units
All HOME funds that the PJ invests in a project must be allocable to the HOME-assisted units plus a proportionate share of costs for the common areas. This is sometimes called HOME’s fair share. The PJ can never invest more HOME funds in a project than its fair share.
The approach to determining the cost allocation depends on whether or not the units in the project are comparable units, meaning similar in size, quality, and amenities. When the units that are HOME-assisted are not comparable to the non-HOME-assisted units, the PJ must determine cost allocation based on actual unit costs plus a fair share of common costs. When the units are comparable, a pro-rata method of cost allocation can be used, or the actual cost method can be used. Attachment 2-3, found at the end of this chapter, illustrates both methods of cost allocation.
HOME Maximum per Unit Subsidy Limit
HOME imposes a maximum per unit subsidy limit. This is a fixed dollar amount that is based on the current Section 221(d)(3) cost limits for the city or county where the proposed project is located, based on number of bedrooms. These 221(d)(3) limits are available from the HUD Field Office or online on the HOME Program website at https://www.hud.gov/program_offices/comm_planning/affordablehousing/programs/home/.
The total amount of HOME funds invested in a project can never exceed the per unit subsidy multiplied by the total number of HOME-assisted units in the project.
Impact of Lender Requirements on the Financing Gap
The first mortgage lender imposes a number of important requirements, typically including the following:
- First mortgage loan amount. This affects the size of the financing gap.
- First mortgage monthly payment (debt service). This is based on the term and interest rate. It affects the financial viability of the project on an ongoing basis.
- Prepayment / refinancing requirements. Some loans may not be refinanced for some period of time (referred to as a prepayment lockout period). Other loans may be refinanced if the owner pays a fee (referred to as a prepayment penalty). Other loans must be refinanced at a particular point in time (these loans are referred to as balloon loans or bullet loans). Depending on these requirements, the underwriter can make different assumptions about changes to debt service over time.
- Funding conditions. The first mortgage commitment specifies the requirements the developer must meet before the first mortgage loan funds will be made available to the project. Funding conditions for a HOME-LIHTC project typically include:
- Completion of the project
- Issuance of certificates of occupancy
- Evidence that all buildings are placed in service within the required deadline
- Satisfaction of the lease-up requirement, typically 90 percent physical occupancy for 90 consecutive days
- An NOI requirement, typically achievement of the pro forma stabilized NOI for three consecutive months.
Determining the Form of HOME Assistance
HOME allows virtually any form of financial assistance, or subsidy, to be provided for eligible projects and to eligible beneficiaries. The PJ decides what forms of assistance it will provide. However, some forms of HOME assistance will affect the amount of tax credits the project may receive. In addition, some forms of assistance will require specific legal instruments to implement. The HOME regulations list the following forms of subsidy as eligible:
- Interest bearing loans or advances. These loans are amortizing loans. Repayment is expected on a regular basis, usually monthly, so that over a fixed period of time, all of the principal and interest is repaid.
- Such loans may have interest rates at or below the prevailing market rate. Often, very low interest rates (i.e., one to three percent) can make monthly payments more affordable to the borrower. Prior to 2008, the interest rate on the HOME loan determined whether the costs paid by that loan could be included in the LIHTC basis. However, with the Housing and Economic Recovery Act (HERA) programmatic changes in 2008, 3 any eligible amounts paid by a HOME loan may be included in basis, regardless of whether the interest rate on that loan was less or more than the applicable Federal rate (AFR).
- The property or some other assets are used as collateral.
- The term of the loan may vary.
Non-interest bearing loans or advances. The principal amount of such loans are paid back on a regular basis over time, but no interest is charged.
- As with interest-bearing loans, these loans use the property or other assets as collateral and the term of the loan varies depending on the nature of the activity funded.
- Such loans are made when the borrower is able to make regular payments but even a small amount of interest is not affordable.
- Eligible costs covered by these types of loans are generally permitted in the LIHTC basis provided there is a reasonable expectation that the loan will be repaid (i.e., that it is actually a loan and not a grant).
Deferred loans (forgivable or repayable). These loans are not fully amortized. Instead, some, or even all, principal and interest payments are deferred to some point in the future. Deferred loans can be structured in many different ways.
- Deferred payment loans can be forgivable or repayable.
- If forgivable, the forgiveness might be structured to occur at one point in time (such as at the end of the affordability period), or forgiven incrementally (such as forgiving one-fifth of the loan each year over five years).
- If repayable, repayment might be required at the sale or transfer of the property or at the end of a fixed period of time.
- Like the amortizing loans discussed above, these loans can either accrue interest or be non-interest bearing.
- Deferred payment loans require the property or some other form of collateral to be used as security for repayments.
3 Public Law 110-289, also known as the Housing and Economic Recovery Act of 2008 (HERA), became law on July 30, 2008. HERA made significant programmatic changes to the Low-income Housing Tax Credits (LIHTC).
- Deferred payment loans may be used to help rental projects by allowing deferral of loan payments for the first few years until the project becomes stable.
- Deferred payment loans may be problematic if the owner wishes to count the costs paid by these loans in the LIHTC basis. The state allocating agency needs to assess whether or not there is a reasonable expectation that this loan will be re-paid. If the state determines that the deferred loan functions like a grant, it will likely determine that the costs paid by this deferred loan are not eligible in the basis.
Grants. Grants are provided with no requirement or expectation of repayment.
- Grants require no liens on the property or other assets.
HOME is sometimes used for acquisition of land and other costs that are ineligible to be included in the LIHTC basis and therefore can be granted without impact on that basis.
- Interest subsidies. This is usually an up-front discounted payment to a private lender in exchange for a lower interest rate on a loan. An interest subsidy may also be a deposit into an interest-bearing account from which monthly subsidies are drawn and paid to a lender along with the homeowner’s monthly payment.
- Equity investments. An equity investment is an investment made in return for a share of ownership. Under this form of subsidy, the PJ acquires a financial stake in the assisted property and is paid a monetary return on the investment if money is left after expenses and loans are paid.
- Loan guarantees and loan guarantee accounts. HOME funds may be pledged to guarantee loans or to capitalize a loan guarantee account. A loan guarantee or a loan guarantee account ensures payment of a loan in case of default.
- A loan guarantee is a written promise to pay the lender some percentage of the outstanding principal balance of a loan in the event the borrower defaults. It may be held for a specified period of time or reduced by a specific amount over time as the loan principal is repaid.
- A loan guarantee account is a loan loss reserve held by the lender in an amount equal to some percentage of the outstanding principal.
- The lender holding the loan guarantee account may require a minimum balance, as well as a percentage of the principal amount of the loan. The percentage of the loan amount held as guarantee may vary from loan to loan, or from program to program.
- HOME rules require that the amount of money in a loan guarantee account must be based on a reasonable estimate of the default rate on the guaranteed loans, and may not exceed 20 percent of the total outstanding principal guaranteed, except that the account may include a reasonable minimum balance.
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