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Elig. of 223(f) Ins. Proj. for 223(d) Oper. Loss Loan

Legal Opinion: GHM-0041

Index: 3.125, 3.135

Subject: Elig. of 223(f) Ins. Proj. for 223(d) Oper. Loss Loan

July 17, 1992

MEMORANDUM FOR: Linda D. Cheatham, Director, Office of Insured

Multifamily Housing Development, HMI

/s/ Mel Belin

FROM: David R. Cooper, Assistant General Counsel,

Multifamily Mortgage Division, GHM

SUBJECT: Eligibility of a Section 223(f) Insured Project

for a Section 223(d) Operating Loss Loan

This memorandum has been prepared in response to your

request for a legal opinion on whether a project with a mortgage

insured under Section 207 pursuant to Section 223(f) of the

National Housing Act (Act) would be eligible to apply for and

receive an operating loss loan insured pursuant to Section

223(d). Members of your staff have informed this Division that

they are not aware of a single Section 223(f) project whose

application has been approved to receive an operating loss loan.

Section 223(d) and 223(f) Program Background

Section 612(h)(3) of the Housing Act of 1961, Pub. L. No.

87-70 amended Section 223 of the National Housing Act by adding

subsection (d) permitting the insurance of \"operating loss loans\"

for losses that occurred \"during the first two years following

the date of completion of the project, as determined by the

commissioner. . . .\" The original intent of Congress in creating

the operating loss loan program is illustrated by the Committee

Summary of the Act contained in S. Rep. No. 281, 87th Cong., 1st

Sess., reprinted in 1961 U.S. Code Cong. & Admin. News 1923,

1969:

Section 507 would give FHA authority to assist

mortgagors of multifamily housing projects (including

those insured under FHA secs. 213, 220, 221, 222, 231,

232, or 233) in cases where occupancy of the projects

is delayed with the result that the income from the

projects is not sufficient to pay project expenses and

payments on the mortgages.

Testifying before Congress, Robert C. Weaver, Administrator of

the Housing and Home Finance Agency stated that the purpose of an

operating loss loan is to assist insured projects \"in cases where

occupancy of the projects is delayed with the result that the

income from the project is not sufficient to pay project expenses

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and payments on the mortgage.\" Hearings Before a Subcomm. of the

House Comm. on Banking and Currency on Various Bills to amend the

Federal Housing Laws, 87th Cong., 1st Sess. (1961) at page 345;

identical statement in S. Rep. No. 287, 87th Cong., 1st Sess.

\(1961\) at page 47.

Section 223(d) was substantially amended by Section 427 of

the Housing and Community Development Act of 1987. The original

operating loss loan program was retained but was split into two

subsections, (d)(1) and (2). A new operating loss loan program

was created and is contained in subsection (d)(3). Under the

original program a mortgagor of a multifamily project with a

mortgage insured by HUD can apply for an operating loss loan

provided that the loss \"occurred during the first 24 months after

the date of completion of the project, as determined by the

Secretary; and . . . in an amount not exceeding the operating

loss.\" The new operating loss loan program found in section

223(d)(3) permits the insurance of a loan:

I n an amount not exceeding 80 percent of the

unreimbursed cash contributions made . . . by the

project owner for the use of the project, during any

period of consecutive months (not exceeding 24 months)

in the first 10 years after the date of completion of

the project, as determined by the Secretary.

Neither the legislative history accompanying the original

passage of section 223(d) in 1961, nor the legislative history

accompanying the substantial amendment of section 223(d) in 1987

directly address the issue to be answered by this memorandum,

i.e., whether a project with a mortgage insured pursuant to

Section 223(f) is eligible for an operating loss loan.

The Housing and Community Development Act of 1974, Pub. L.

No. 93-383 amended Section 223 of the National Housing Act by

adding subsection (f) permitting the insurance of a mortgage

executed in connection with the purchase or refinancing of

existing properties. The legislative history accompanying the

passage of section 223(f) is meager, and it sheds no light on the

question of whether Congress directly addressed the issue of a

section 223(f) project\'s eligibility for a section 223(d)

operating loss loan.

24 C.F.R. 207.32a(f)(5) provides the following eligibility

requirement for properties that apply for section 223(f) mortgage

insurance:

Before filing an application for mortgage insurance,

the project, except one which meets the requirements of

paragraph (k) of this section, must have been fully

completed and at least three years must have elapsed

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from the date of completion or initial occupancy, as

determined by the Commissioner, whichever is later.

(Emphasis added).

The only exception to the three year requirement is, as

referred to in the above quote, with regard to paragraph (k),

relating to a mortgage refinancing a project financed with State

or local assistance. Section 223(f) does not contain a

requirement that a multifamily project (as opposed to a nursing

home) have an existing FHA-insured mortgage in order to be

eligible for a mortgage insured under the section. In fact,

Section 223(f) does not require that there be an existing

mortgage of any kind against the multifamily project, except in

the case of a project located in an older or declining

neighborhood that is applying for mortgage insurance under

section 223(f)(2).

Issues

Issues

The language of Section 223(d) and Section 223(f) as well as

the legislative history do not specifically establish whether

Congress intended to permit operating loss loans for Section

223(f) projects. In order to properly answer your question

concerning a Section 223(f) project\'s eligibility for an

operating loss loan, we believe the following issues are relevant

in order to help us to reach a conclusion.

\(1\) Does completion of a project for purposes of an

operating loss loan only refer to new construction or substantial

rehabilitation work, or could it refer to the lesser

rehabilitation work that is done within the section 223(f)

program: (A) since substantial rehabilitation qualifies for

\"completion of a project\" then why cannot something lesser than

substantial rehabilitation qualify for completion of a project?

\(B\) since the 223(f) handbook refers to insurance upon completion

does this mean that less than substantial rehabilitation which

can occur in connection with the Section 223(f) program also

constitutes \"completion of the project?\"

\(2\) In light of our conclusion regarding the issue above

(as discussed in the \"Analysis\" section of this memorandum) that

completion refers to new construction or substantial

rehabilitation work only, would a project insured under section

223(f) be eligible for a section 223(d)(1), (d)(2) operating loss

loan under the original operating loss loan program?

\(3\) In light of our conclusion regarding issue no. 1 (as

discussed in the \"Analysis\" section of this memorandum) that

completion refers to new construction or substantial

rehabilitation work only, would a project with a section 223(f)

insured mortgage be eligible for a section 223(d)(3) operating

loss loan under the new operating loss loan program?

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Analysis

Analysis

1\. The first issue requires a determination as to whether

the phrase \"completion of a project,\" as used in Section 223(d),

(i.e. a project is eligible for an operating loss loan if the

loss occurred within the requisite number of years following

\"completion of the project\") only refers to new construction or

the substantial rehabilitation of an existing project, and not to

the lesser rehabilitation work done within the Section 223(f)

program. A multifamily project\'s eligibility for both the

section 223(d)(1), (d)(2) program and the section 223(d)(3)

program is tied to \"the date of completion of the project, as

determined by the Secretary.\"

As quoted earlier in this memorandum, the Senate Committee

Summary accompanying the bill creating the original operating

loss loan program stated that it was the intent of Congress to

cover the loss that may occur in those \"cases where occupancy of

the projects is delayed with the result that the income from the

projects is not sufficient to pay project expenses and payments

on the mortgages.\" It is very important to note that a newly

constructed project is starting from a zero occupancy base, and

it takes time to reach a level of occupancy that is sufficient to

pay project expenses and service the debt. In the case of

substantial rehabilitation the existing structure is partially or

totally gutted, which results in the displacement of most, if not

all of the project residents. The reoccupancy of the project

following the completion of the substantial rehabilitation is

subject to the same delays faced by a newly constructed project.

By way of contrast, we have been informed by Kerry Mulholland of

your staff that the lesser rehabilitation work done in connection

with the Section 223(f) program should result in the displacement

of no more than an insignificant number of tenants. In fact,

since the section 223(f) program does not require any

rehabilitation work to be done to the project in order for the

project to be eligible for an insured mortgage, it is entirely

possible that there may be no tenant displacement whatsoever. As

we stated earlier, one of the principal concerns of Congress at

the time that it created the operating loss loan program was the

loss that can result from a delay in the occupancy of a new

project. Therefore, it does not appear that the same

Congressional concern, i.e, delay of occupancy, would be as

relevant for the section 223(f) mortgage insurance program as it

would for programs involving new construction or substantial

rehabilitation since the Section 223(f) program does not

typically involve renting up issues.

The regulations for the section 223(f) program were first

published in 1975. The Final Rule with HUD\'s responses to public

comments was published in 40 FR 43898 on September 24, 1975. No

public comments were received relative to a need for providing

operating loss loans for section 223(f) projects. However, there

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is the following statement in the preamble that does shed some

light on the Department\'s interpretation of the word completion:

We consider that it is the authority and intent of the

section 223(f) program to provide mortgage insurance

for purchase or refinancing of existing housing which

has been completed and which is an economically viable

rental project. (Emphasis added).

The Department is stating that the section 223(f) program is

intended to provide mortgage insurance for existing, previously

completed projects that are in full operation and have already

attained economic viability. Unlike new construction and

substantial rehabilitation cases where there could be

significant delays in the renting up of the project, a project

insured under section 223(f) must already be economically

viable and, therefore, without a rent-up problem. Therefore, it

would appear reasonable to interpret the term \"completion of a

project\" in the Section 223(d) program to mean the completion of

new construction and substantial rehabilitation, and not the

completion of minor repairs incident to the closing of an

existing, economically viable project under Section 223(f), which

project would typically not have the rent-up problems associated

with a new or substantially rehabilitated project, but rather

would be already \"economically viable.\"

It might be argued that Handbook 4565.1 \"Mortgage Insurance

For The Purchase Or Refinancing Of Existing Multifamily Housing

Projects Section 223(f)\" which provides in paragraph 6-15 that

\"Commitments shall be issued on an Insurance Upon Completion

Basis only,\" somehow refutes a view that when Section 223(d) is

referring to \"completion of the project\" it is not referring to

the less than substantial rehabilitation work done under section

223(f). We do not, however, agree with such an argument. The

Handbook statement is not intended to serve as a characterization

of the section 223(f) program; rather it reflects the fact that

the documents that are used for the commitment and closing of a

section 223(f) insured mortgage are the same or very similar to

those that are used in insurance upon completion cases for new

construction and substantial rehabilitation cases, making

understandable the utilization of similar terminology. Further,

as quoted in an earlier section of this memorandum,

24 CFR 207.32a(f)(5) sets out the requirement for Section

223(f) projects that, with the exception of certain projects

financed with state or local assistance, \"at least three years

must have elapsed from the date of completion or initial

occupancy\" of the project prior to the filing of an application

for mortgage insurance. The \"initial occupancy\" of the project

is treated as a co-determinant for eligibility along with the

\"date of completion.\" Though not necessarily simultaneous with

each other, completion of construction and initial occupancy are

definitely associated with the original construction of the

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project and not minor repairs incident to closing. Thus, the

Section 223(f) program is inconsistent in its treatment of the

phrase \"completion of the project,\" referring to one thing in the

Handbook and another in the regulation. We, therefore, do not

believe the handbook reference to \"completion of the project\"

refutes our view that as used in the Section 223(d) program the

term \"completion of the project\" refers to new construction or

substantial rehabilitation only.

It is our conclusion that the time period for telling

whether an Operating Loss Loan is permissible for a given

project, i.e., 2 years under section 223(d)(1) and (d)(2), and 10

years under section 223(d)(3), runs from the date of completion

of the new construction, or the completion of substantial

rehabilitation, and cannot run from the date the less than

substantial rehabilitation work done in connection with section

223(f) insurance is completed.

2\. The answer to our second issue is now based upon our

conclusion in issue no. 1 that the term \"completion\" only refers

to new construction or substantial rehabilitation. Section

223(d)(2)(B) states that for a project to be eligible for a loan

made under the original operating loss loan program, \"the

operating loss shall have occurred during the first 24 months

after the date of completion of the project, as determined by the

Secretary.\" We again refer you to 24 CFR 207.32a(f)(5), which

sets out the requirement that, with the exception of certain

projects financed with state or local assistance, \"at least three

years must have elapsed from the date of completion or initial

occupancy\" of the project (whichever is later) prior to the

filing of an application for mortgage insurance under section

223(f). Because we have determined that the term \"date of

completion\" refers to the date of completion of new construction

or substantial rehabilitation, and section 223(d)(2)(B) limits

the time period for an operating loss loan to the first 24 months

following completion, and since HUD\'s regulations require that

three years must have elapsed from the date the project was

completed before that project is eligible for insurance under

section 223(f), it is our conclusion that a project insured under

section 223(f) is not eligible for a section 223(d)(1), (d)(2)

operating loss loan.

3\. Our third issue is also based upon our conclusion that

the term completion refers to either the new construction or

substantial rehabilitation of the project. The section 223(d)(3)

operating loss loan program is intended to cover 80% of the

unreimbursed cash contributions made by the project owner, and

may not be greater than the operating loss for the applicable

period of time. If there was no operating loss there can be no

loan, even if the owner made cash contributions that were

unreimbursed. However, the statute permits the loan to cover a

period of time not exceeding 24 months that falls within the ten

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year period following completion of the project. There is no

legislative history that ties this program to a loss suffered

during the initial occupancy of the project, and therefore, even

if a project was economically viable upon completion it would

still be eligible for a (d)(3) loan if it suffered an appropriate

loss within the ten year period following completion.

Section 223(d)(4) contains certain requirements applicable

to all operating loss loans. The subsection states that any loan

must: \"(C) be limited to a term not exceeding the unexpired term

of the original mortgage; and (D) be insured under the same

section as the original mortgage.\" In our opinion the key term

in 223(d)(4) is \"original mortgage.\" For example, it is possible

that a project with a mortgage insured under section 223(f) that

was completed more than three years but fewer than eight years

ago, and that was economically viable at the time the 223(f)

mortgage was endorsed for insurance, might begin to suffer

operating losses in the eighth and ninth years following

completion. A critical issue relates to what the term \"original

mortgage\" refers. If the term \"original mortgage\" refers only to

the mortgage that secured the note for the loan made at the time

the project was originally built or substantially rehabilitated,

a section 223(f) insured mortgage (which is not permitted to be

used in conjunction with new construction or substantial

rehabilitation) would not be eligible for a section 223(d)(3)

operating loss loan because the \"original mortgage\" (if it still

existed) would have been paid off and replaced by the section

223(f) insured mortgage. On the other hand, if the term

\"original mortgage\" has been interpreted by HUD to mean the

\"outstanding first mortgage\" on the project, a section 223(f)

insured mortgage would constitute an original mortgage. It is

our opinion, for the reasons set forth below, that the term

\"original mortgage\" means the \"outstanding first mortgage.\"

As previously stated, the Section 223(d) program was created

by the Housing Act of 1961. Section 223(d), in its original

version, provided that when a project with an FHA insured

mortgage suffered an operating loss, as defined therein, the

Commissioner could:

P ermit the excess of the foregoing expenses over the

project income to be added to the amount of such

insured mortgage, and extend the coverage of the

mortgage insurance thereto, and such additional amount

shall be deemed to part of the original face amount of

the mortgage.

The Housing and Urban Development Act of 1968 P.L. 90-448

deleted the language from the 1961 Act and substituted:

I nsure under the same section as the original

mortgage a loan by the mortgagee in an amount not

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exceeding the excess of the foregoing expenses over the

project income. Such loan shall (1) bear interest. . .

at not to exceed the per centum per annum currently

permitted for mortgages insured under the section under

which it is to be insured, (2) be secured in such

manner as the Secretary shall require, and (3) be

limited to a term not exceeding the unexpired term of

the original mortgage.

The Committee Summary of the Act contained in H. Rep. No. 1585,

90th Cong., 2nd Sess., reprinted in 1968 U.S. Code Cong. & Admin.

News 2873, 2912, stated that section 223(d) was being amended:

T o permit an insured project loan covering a 2-year

operating loss to bear interest at the current rate in

effect at the time of its insurance, instead of at the

time of the original mortgage loan.

With the recent increase in interest rates,

lenders have become extremely reluctant to grant a loan

to cover a 2-year operating loss on a project where

this additional loan is limited to the interest rate of

the original loan.

The language from the 1968 amendment to section 223(d) that

we quoted in the preceding paragraph was incorporated by the 1987

amendment to section 223(d), with minor modification, into

section 223(d)(4). Therefore, in light of the above history

evidencing Congress\' use of the word \"original mortgage,\" as

relating to the outstanding first mortgage it is our conclusion

that when the current statutory version of section 223(d) uses

the term \"original mortgage,\" it is referring to the \"outstanding

first mortgage.\" In the limited context of a section 223(f)

project the outstanding first mortgage is the Section 223(f)

mortgage. Therefore, the term \"original mortgage,\" does not

preclude a Section 223(f) project from receiving an operating

loss loan under Section 223(d)(3), i.e., the new operating loss

loan program.

Assuming that a Section 223(f) project meets the fundamental

eligibility criterion for a Section 223(d)(3) operating loss

loan, i.e., the loss occurred within ten years from \"completion

of the project\" as that phrase has previously been discussed in

this memorandum, we believe that a distinction must still be made

between Section 223(f) projects in which the operating loss

occurred before the Section 223(f) insurance, and projects where

the loss occurred after the Section 223(f) insurance. In the

former case, the project is, in our view, not eligible for an

operating loss loan. That is because to qualify for Section

223(f) insurance, a determination must be made that the project

is \"economically viable.\" We do not believe Congress intended

for HUD to insure a project as \"economically viable,\" and then to

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permit an operating loss loan for losses that occurred before the

Section 223(f) insurance. In the case, however, where the

operating loss occurs after the Section 223(f) insurance, but

within ten years from the date of completion of the project,

i.e., new construction or substantial rehabilitation, it is our

view that the project is eligible for an operating loss loan.

We wish to point out that neither the Section 223(d) statute

nor its legislative history require the inclusion of any specific

multifamily insurance program in the section 223(d)(3) operating

loss program. Section 223(d)(1) provides HUD the discretion

necessary to exclude section 223(f) from eligibility for a

section 223(d)(3) operating loss loan when it states that \"the

Secretary is authorized to insure operating loss loans of certain

projects\" and when it grants the Secretary the right to provide

insurance in his \"discretion and upon such terms and conditions

as he may prescribe.\" This \"discretion\" in Section 223(d)(1)

covers the Secretary\'s authority to insure operating loss loans

under the original operating loss loan program, and the new

program created by the 1987 legislation. Further, the Department

is given additional latitude in restricting eligibility for the

new operating loss loan program by section 223(d)(3)(D), which

states that \"the project shall meet all applicable underwriting

and other requirements of the Secretary at the time the loan is

to be made.\" Consequently, in our opinion, Congress has granted

HUD the discretion necessary to exclude projects with section

223(f) insured mortgages from eligibility for section 223(d)(3)

operating loss loans, but does not mandate their exclusion. To

the extent that you do not want to provide operating loss loans

for Section 223(f) projects for losses that have occurred after

the Section 223(f) insurance, all you would need is a reason that

is not \"arbitrary and capricious,\" for not extending the

operating loss loan program to cover such situations.

Conclusion

Conclusion

It is our opinion that the phrase \"completion of the

project,\" as it is used in section 223(d), means the completion

of the original construction or substantial rehabilitation of the

project, and does not mean the completion of the lesser amount of

rehabilitation that is associated with a section 223(f) mortgage.

At the time that the original operating loss loan program was

created, Congress was principally concerned about projects that

experienced operating losses due to the delay in the initial

occupancy of the project. In the preamble to the section 223(f)

regulations the Department stated \"that it is the authority and

intent of the section 223(f) program to provide mortgage

insurance for purchase or refinancing of existing housing which

has been completed and which is an economically viable rental

project.\" Unlike new construction or substantial rehabilitation

projects which start from a zero or very low occupancy base, the

lesser amount of rehabilitation work done in connection with an

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economically viable section 223(f) insured project results in

either minor or no displacement of the existing tenant base.

Consequently, in light of the Congressional focus on losses due

to delays in initial occupancy for the section 223(d) program and

the preamble statements accompanying the regulations for the

section 223(f) program, it is our opinion that when section

223(d) refers to completion of the project it refers to the

completion of either the original construction of the project, or

the completion of its substantial rehabilitation, and not to the

lesser than substantial rehabilitation work that may be done in

conjunction with a Section 223(f) project.

Because we have interpreted the term \"date of completion\" to

mean the date of completion of new construction or substantial

rehabilitation, and since section 223(d)(2)(B) limits the time

period for an operating loss loan to the first 24 months

following completion, and in light of 24 C.F.R. 207.32a(f)(5)

which requires that three years must have elapsed from the date

the project was completed before that project is eligible for

insurance under section 223(f), it is our conclusion that a

project insured under section 223(f) is not eligible for a

section 223(d)(1), (d)(2) operating loss loan.

Operating loss loans insured under either section 223(d)(1)

and (2), or section 223(d)(3) must meet the additional

requirements found in section 223(d)(4)(C) and (d)(4)(D) which

state that an operating loss must: \"(C) be limited to a term not

exceeding the unexpired term of the original mortgage; and (D) be

insured under the same section as the original mortgage.\" After

reviewing the legislative history for both the original section

223(d) statute and the amendments that Congress has made thereto,

it is our view that Congress intended the term \"original

mortgage\" to mean the \"outstanding first mortgage\" against the

project. For a Section 223(f) project, the \"outstanding first

mortgage\" is the Section 223(f) mortgage.

In our view, a project with a section 223(f) insured

mortgage is not statutorily excluded from eligibility for a

section 223(d)(3) operating loss loan, unless the operating loss

occurred before the Section 223(f) insurance. If the loss

occurred before such insurance, we do not believe an operating

loss loan is legally permissible. We base this view on the fact

that a project cannot qualify for Section 223(f) insurance unless

the project is deemed \"economically viable.\" We do not believe

Congress intended to permit HUD to insure a project as

economically viable under section 223(f), and then to permit

operating loss loans for losses that occurred before the

insurance. If a project experiences an operating loss in the ten

year eligibility period covered by Section 223(d)(3), and such

loss occurred after the Section 223(f) insurance, it is

technically eligible for an operating loss loan. Neither the

Section 223(d) statute, nor its legislative history, however,

11

require the inclusion of any specific multifamily insurance

program in the section 223(d)(3) operating loss program.

Therefore, in our opinion, Congress has granted HUD the

discretion necessary to exclude such projects from being

eligible for section 223(d)(3) operating loss loans. You would,

of course, need to have a reason that is not arbitrary and

capricious for such an exclusion.