CDBG/HOME Underwriting Washington, D.C. February 15, 2017

1. CDBG/HOME Underwriting Washington, D.C.February15, 2017

2. Welcome • Trainer • Steve Gartrell, sgartrell@ncdaonline.org • Survey of Underwriting Requirements for the CDBG and HOME Programs

3. Agenda What is “Underwriting” Comparison of CDBG & HOME Underwriting Requirements Determining Project Costs are Reasonable Subsidy layering Multi-family underwriting for rental housing development projects Exercise Underwriting for homeownership development projects

4. What is “Underwriting?” • It’s doing Due Diligence to: • Ensure a need/market for what’s being provided • Ensure that costs (both development and long-term) can be covered, plus a little extra for: • Profit, or • Developer’s fee • Ensure that enough but no more subsidy than necessary is provided • Assessing the Risk of the project

5. Why Now? • For CDBG – No underwriting standards for housing & advisory for Economic Development (except Public Benefit) • Will likely change soon • For HOME – Only Subsidy Layering required until Washington Post article • Changed with 2013 Regs.

6. Goal of Class Intro to Underwriting Know what you should be looking at in a proposal Know when to get help

7. Current CDBG & HOME Underwriting requirements

8. Underwriting Procedures • The following slides are based on HUD’s guidance for HOME Program underwriting • Assume unless otherwise noted that these are requirements for the HOME Program • They are for the most part also applicable to CDBG project underwriting (both housing and economic development) • Will note CDBG/HOME differences • HUD has indicated it will make underwriting mandatory for CDBG projects as well

9. CDBG Underwriting Guidelines (§570.209 & App. A to §570) • Currently voluntary (except Public Benefit determination for Special Economic Development projects). • Objectives of underwriting guidelines are to ensure: • that project costs are reasonable; • that all sources of project financing are committed; • that to the extent practicable, CDBG funds are not substituted for non-Federal financial support; • that the project is financially feasible; • that to the extent practicable, the return on the owner’s equity investment will not be unreasonably high; and • that to the extent practicable, CDBG funds are disbursed on a pro-rata basis with other finances provided to the project.

10. HOME Underwriting & Subsidy Layering Guidelines • Required by 24 CFR 92.250 • “A PJ is required to develop and use such guidelines to evaluate and ensure that the level of HOME investment does not exceed the amount that is necessary to provide quality affordable housing that is financially viable.” • CPD 15-11 - Requirements for the Development and Implementation of HOME Underwriting and Subsidy Layering Guidelines • Any HOME units in project – must look at entire project

11. HOME Definition – §92.2(2)Commitment to a Specific Local Project PJs may not commit HOME funds to a project consisting of new construction or rehabilitation until: • All necessary financing is secured • A budget and production schedule is established • Underwriting and subsidy layering is completed • Construction is expected to start within 12 months

12. HOME Underwriting & Subsidy Layering - General Requirements • PJs must ensure long-term sustainable projects by establishing guidelines for: • Subsidy layering and underwriting • Market assessment (all units, not just HA) • Developer capacity and fiscal soundness • Applies to rental projects and homebuyer development projects • Must be done prior to funding commitment • Certify compliance in IDIS at project set-up

13. HOME Subsidy Layering & Underwriting§92.250 (b) • PJ must adopt Subsidy Layering & Underwriting guidelines, which must ensure that amount of HOME funds invested: • Alone or in combination with other governmental assistance, are no more than necessary to provide quality, financially viable affordable housing, that is: • Financially viable for a reasonable period • Will not provide profit or ROI that exceeds PJs standards for size, type, & complexity of project

14. HOME Subsidy Layering & Underwriting§92.250 (b) • In order to determine appropriate subsidy, PJ’s guidelines must require PJ to: • Examine Sources and Uses documentand determine that the development costs are reasonable • Do an assessment of: • Market demand • Experience & financial capacity of developer • Determine reasonable level of profit/return to owner/developer for size, type, complexity of project • Verify financial commitments are firm

15. Comparison of CDBG & HOME Underwriting Requirements HOME • Requirements are mandatory • PJs may not commit HOME funds to a project until: • All necessary financing is secured • A budget and production schedule is established • Underwriting and subsidy layering is completed • Construction is expected to start within 12 months CDBG • Guidelines are (currently)voluntary • Except evaluating Ec. Dev. Public Benefit • If not used, “ . . . expected to conduct basic financial underwriting” • Guidelines apply to Ec. Dev. Projects • But also useful for other kinds of projects, e.g. Housing

16. Comparison of CDBG/HOME Underwriting Requirements

17. Determining Project Costs are Reasonable • Develop review guidelines for: • Budgets • Sources and Uses • Pro forma for Operating Expenses, and • How decisions will be made by Grantee • Review guidelines include • Underwriting criteria such as key ratios and dollar limits • Guidance on reasonable costs • Acceptable forms of documentation

18. Stages of Underwriting (HOME) • Preliminary Underwriting (UW) – Use UW & SL Guidelines to: • Review project development budget for reasonable & necessary development costs • Review operating budget & pro-forma for long-term viability • Analyze the initial funding gap (need for HOME funds) • Projected return to developer

19. Stages of Underwriting (HOME) • Cost Allocation (HOME) – If <100% of units will be HA – PJ must either: • Do cost allocation to determine minimum # of HA units required based on HOME $ requested; or • Use proposed # of HA units to determine cost of HA units and max. permissible HOME investment • See CPD Notice 16-15 on HOME Cost Allocation requirements

20. Stages of Underwriting (HOME) • Final Underwriting – After cost allocation, • If PJ determines: • Too few HA units; or • Exceeds max. HOME subsidy limit • Underwriting must be adjusted to meet HOME limits, by: • Increasing # of HOME units; or • Decreasing HOME investment

21. Stage of Underwriting (CDBG) • CDBG different from HOME: • Project-based rather than unit-based: • Project as a whole must meet CDBG National Objective [ NO] (for housing: majority of units – low/mod) • No cost allocation required: If project meets NO up to 100% of costs can be funded by CDBG (but pro-rata subsidy highly recommended) • No affordability period required (but highly recommended)

22. Stage of Underwriting (CDBG) • Preliminary Underwriting (UW) – Use UW Guidelines to: • Review project development budget for reasonable & necessary development costs • Review operating budget & pro-forma for long-term viability • Analyze the funding gap (need for CDBG funds) • Projected return to developer • For Special Economic Development projects – must do Public Benefit Analysis

23. Reviewing Development Costs

24. Reviewing Development Costs • PJ must determine all costs are eligible, customary and reasonable • How CDBG/HOME funds will be used must be described • Compare costs to similar projects, use cost estimation tools, or use a procurement process • To document, obtain copies of: • Detailed development budget – Sources & Uses Statement • All sources of funds • Total funds needed to complete project • Supporting documentation

25. Sources & Uses

26. Determination of Subsidy • Development Costs (all) vs. Operating Costs (for rental projects) • Based primarily on capacity of project to earn revenue in excess of expenses and thus carry debt • To analyze rental project PJ must evaluate long term operating budget and assumptions such as escalation of rents, expenses along with vacancy rate as well as the development budget • To analyze homebuyer subsidy PJ must use affordability standards for each household • For projects – Development Budget • For buyers – each household

27. Rental ProjectsOperating Budgets & Pro-forma • Developer must provide operating budget and affordability period pro-forma (rental projects & CDBG projects w/ long-term payback) • PJ should establish standard electronic format for underwriting projects • See HUD website for examples (NSP Underwriting Template also City of Houston HOME Template) • At minimum should cover: • Projected income and vacancies • Operating expenses • Contributions to reserves • Debt service • Cash flow and payments of deferred fees

28. Operating Budget & Pro-Forma Step 1 – Review Year 1 Operating Budget to determine Cash Flow Step 2 – Review Year 1 Debt Service Coverage Ratio (DSCR) Step 3 – Review Operating Budget Pro-Forma over life of affordability period Step 4 – If Pro-Forma is unsustainable (negative cash flow at some point) – review & revise costs, especially debt service to provide sustainability

29. Operating Budget & Pro-Forma Step 1 – Review Year 1 Operating Budget to determine Cash Flow

31. Operating BudgetExpenses – Summary • All cash expenses should be shown • Reflect: • Type and location of project • Number of units • Physical characteristics of property • Cost environment for this project • Trend expenses realistically given history • Always higher than income growth • Look at comparable properties • Some PJs keep database

32. Operating Budget Reserves for Replacements • Deposits for future capital expenditures • PJs have often used standard rule of thumb (e.g., $250 per unit – A BAD IDEA!) • Better to do property-specific capital needs assessment • §92.251(b)(1): Capital Needs Assessment required when rehabbing projects with 26 or more total units • Research shows wide range of capital needs with average of $650 per unit per year

33. Operating Budget & Pro-Forma • Step 2 – Determine Year 1 Debt Service Coverage Ratio (DSCR) • DSCR = Net Operating Income / Total Debt Service • DSCR = $57,798/$50,259 = 1.15 • DSCR should be: • 1.11 for Affordable housing • 1.4-20 for Market housing

34. Operating Budget & Pro-Forma Step 3 – Review Operating Budget Pro-Forma over life of affordability period

35. Review Pro-Forma over Aff. Period To End of Aff. Period

36. Review Pro-Forma over Aff. Period To End of Aff. Period

37. Evaluating the Operating Budget & Pro-forma • PJ can evaluate developer’s budget and pro-forma or do own calculations • If using developer’s, spot check the numbers • Ensure: • Income is sufficient to cover expenses and debt service for all years of affordability period • Expense cushion does not drop below threshold during affordability period • Adequate cash flow each year

38. Evaluating the Operating Budget & Pro-forma (cont) • Are rent assumptions realistic? • Most HOME rents only grow by 1-3% annually • Market rents should be based on comparable history • Vacancy estimated at no lower than 5% • Are expense assumptions realistic? • Base on comparable properties • Controllable vs. Non-Controllable Expenses • Expenses should always trend higher than income • Recent HOME rent study found that PJs underestimate expense increases

39. Developers Can and Should Make Money • Many sources of potential $$ • Developer Fees • Property Management • Appreciation and other equity increases • Net cash flow • Compare returns to other similar investment • Appropriate level of return depends on: • Project risk • Returns available elsewhere • OK for non-profit developers to earn revenue

40. Cash Flow • Remaining cash (if distributable) after payment of debt service • “Cash-on-cash” return to measure • Annual Cash Flow  Equity = X% • Example: ($10,000 Cash Flow  $100,000 Equity) = 10% cash-on-cash return • Since cash flow changes over time, average over the affordability period • This calculation is required by HUD Notice

41. Basics of Subsidy • Subsidy is determined by measuring the gap in funds needed to undertake the project and for the project to meet the long term requirements. • Market project must support itself – revenue must cover all expenses, reserves and debt coverage • Affordable project has lower revenue, so it can’t cover same debt and will need a subsidy to get it built • Projects unable to cover operating expenses will also need operating assistance not eligible under HOME (but can reduce debt upfront reducing debt burden) • PJ is liable for HOME investment based on the project successfully completing the entire affordability period.

42. Determining Debt and Debt. Service Positive Cash Flow (and appropriate Debt. Service Coverage Ratio) critical to sustainability of project Reducing the need for debt (and therefore debt coverage) is appropriate way to subsidize project

43. Determining Debt

44. How Much Debt? • Determine - Debt Service Coverage Ratio (DSCR) • The measure of the cash flow available to pay current debt obligations. • DSCR = Net Operating Income / Total Debt Service.  • DSCRs should range from a minimum of: • All Affordable – 1.11 • Market – 1.4 + • Less than these amounts means they don’t have sufficient income to pay debts • Much more than these means they should take on more debt (and get less subsidy)

45. To Determine Debt DSCR = Net Operating Income / Total Debt Service DSCR= $45,000/$40,000 = 1.125 To determine amount avail. for debt service NOI / desired DSCR = Amt. for DS $45,000/1.125=$40,000

46. Subsidy Process • Evaluate proposal and adjust all components for realism and accuracy • Don’t forget eligibility! • Apply appropriate cushions and controls • Apply HOME limits & do cost allocation • Negotiate • Apply the correct subsidy or reject • Later changes in scope or budget may require Subsidy Layering update & approval

47. Analyze Risk • Market risk • What is the environment in which this project will compete? • Developer risk • Is our partner credible, capable, and solvent? • Project risk • What are the specific assumptions about cost, value, buyer funds, etc? • Broader perspective also includes: • Portfolio risk—concentration by type, developer, etc. • Public considerations—subsidy layering & program performance

48. Decide & Certify • Document review & record decision • Balance risks & mitigating factors • Identify and explain waivers/exceptions to local policies and procedures • IDIS Certification: • “{PJ} has conducted an underwriting review, assessed developer capacity and fiscal soundness, and examined neighborhood market conditions to ensure adequate need for the project.” • Who certifies?

49. Key Elements of Underwriting

50. Key Elements of Underwriting • Program level considerations. Understand your… • Community’s housing needs, including • Rental vs. owner • Seniors vs. Families • Supportive housing • Housing costs (depth of affordability) • Developer community • Market • Tolerance for risk