When is the best time of year to convert?
Over half of the conversions that took place in 2015 occurred in the last three months of the year. While some of these conversions had tax credit deadlines that drove the timing of closing, many did not have any financing deadline influencing the timing of conversion. Conversations with PHAs, as well as comments made in a Listening Session in late March, suggest that a significant factor informing many of these late-in-the-year closings is a mis-perception about the funding process used for RAD. As a result of what we heard, HUD will publish funding instructions that provide a comprehensive description of the funding process used for RAD conversions. In the short-term, this article highlights that with good planning, underwriting, and communication across all members of a transaction team regarding the revenue available during the initial year, there is no significant reason to convert in the last three months of the calendar year.
Background: Funding in the Initial Year of Conversion
In the year of conversion, projects continue to be funded from the public housing accounts at the level of public housing subsidy they are due to receive in that calendar year. Then, in the next year, funding is based on the RAD contract rents. Some PHAs and their consultants have concluded that there is a financial benefit to convert later in the calendar year so as to minimize the number of months in which a project is subsidized through public housing. Some lenders and investors want to minimize the number of months they are involved in a transaction before the RAD rents come into effect.
A property never receives more subsidy because it converts later in the year. Regardless of the timing of conversion, a converting property will be supported through the public housing subsidy for the remainder of the year. Consider a property that receives $1.2 million a year in Operating and Capital Fund subsidies, or $100,000/month. No matter when that project converts, the total subsidy for that project will be just $1.2 million. If the project closes in, say, March, then the effective date of the Housing Assistance Payments (HAP) project will be April 1. It will have received $300,000 for the first three months as a public housing property and will receive $900,000 for the remaining nine months as a RAD project. If it closes in September (with an October 1 HAP effective date), it will have received $900,000 as a public housing property and will receive $300,000 for the remaining three months as a RAD project. In either event, the project still only generates $1.2 million in subsidy, whether as public housing or as a Section 8 RAD project. Moreover, there is no financial benefit to converting after the annual allocation of Capital Funds or after the Capital Fund reporting date. Neither date impacts the amount of funding HUD will obligate to a PHA nor the amount of funds a PHA may utilize on a converting property, either as rental subsidy or in the development budget. HUD will put out additional guidance shortly on the handling of A property that converts earlier in the year actually receives more revenue over the course of 20 years. All contracts receive an Operating Cost Adjustment Factor (OCAF) rent increase at each annual anniversary of the HAP contract. The earlier in the year that a conversion occurs, the earlier in each subsequent calendar year the OCAF will be effective. Properties that convert earlier in the year receive up to a full additional OCAF increase relative to year-end conversions. Compare two 100-unit properties converting this year: one with a February 1 effective date and one with a November 1 effective date. Both have an initial contract rent of $650, with an average expected OCAF of 2% for the next twenty years. In each calendar year following conversion, the revenue for the property that converted earlier in the year will be 1.5% higher due to the earlier OCAF increase in that year. Over twenty years, this will total to $300,000 in greater revenue for the property that converted effective February 1.
In nearly every conversion, the funding in the initial year does not create financial risk to the project. While the funding available to a Covered Project through Operating Funds, Capital Fund, and tenant rents may differ modestly from the rent schedule in the HAP contract, the difference is typically small and almost always surmountable:
- For transactions that will not be taking on any new debt, the property will continue to receive the subsidy that was supporting operations prior to conversion, plus a portion of the PHA’s Capital Fund. Given that HUD has underwritten the transaction with an expense cushion, the public housing amounts and tenant rents should cover project operations. These PHAs don’t have any third parties to satisfy after the conversion and should not delay their closing because of issues related to the flow of Capital and Operating Funds.
- For transactions that are financed with debt, often the debt service payments will not begin until the construction loan is converted to a permanent loan. All deals underwritten by FHA fall into this category. In non-FHA deals, if the debt service payments do begin immediately, there is typically sufficient debt service coverage built into the underwriting to withstand a temporary and what is almost always a small revenue gap. When needed, a PHA can create a reserve to cover any projected revenue differential in the first year. The key is communicating expectations with the lender so that the lender understands how the first year funding works.
- For transactions that involve tax credits, investors typically require a lease-up reserve and a six-month operating reserve. Owners can negotiate with investors to use a small portion of these funds to cover any revenue gap to the extent that it would impact the owner’s ability to pay operating costs, or create a separate reserve for this purpose.
- For transactions that require relocation, while the Section 8 programs would typically not fund the vacant units, under RAD they are eligible for Rehab Assistance Payments so there is more subsidy available compared with typical affordable housing development. The key for transactions that are working with third party financing sources is to make sure expectations around the revenue available during this period are well understood, can be planned for and can be accurately incorporated into underwriting.
It is risky to try to close near the end of the year. The steps leading to conversion depend on actions by the PHA and HUD in the simplest cases, and a developer, lender, investor, Housing Finance Agency, contractor and local and state government in more complex cases. Setting out to convert at a particular time of year can easily backfire. Any given variable may throw off a PHA’s timing, including the heavy workload for HUD staff at the end of the year. PHAs should be mindful that because of the holidays and the year-end volume, HUD is not able to hold closings on all deals if PHAs wait until the final quarter of the calendar year. Some PHAs that submitted Financing Plans late in 2015 with the hopes of converting before the end of November discovered that the RAD closing pipeline was too full to accommodate their request. While HUD prioritizes high-impact transactions, including those at risk of losing a 9% tax credit allocation, HUD cannot provide this treatment for every conversion. Please remember that those developments that do close in December receive a January 1 effective date and thus remain on the public housing accounts for another full year. If a PHA’s primary goal is to close in a particular calendar year, it is best to close as soon as the transaction is ready.
In sum, PHAs should focus on closing their RAD deals as soon as they have all necessary approvals and documentation. PHAs should not attempt to time their closings at the final quarter of the calendar year in search of an insignificant or non-existent financial benefit.