**MEMORANDUM FOR: Minnesota MF Hub Lenders**

**SUBJECT: Underwriting Issues\
Circular 02-01**

**DATE: December 19, 2002**

Recently, three related and recurring problems emerged that the MF Hub
would like corrected by affected lenders preparing and submitting
applications:

1.  Base rents without any meals or services inappropriately analyzed in
    "independent" seniors' rental housing;

2.  Over-sized wings of under-sized and over-priced memory care (MC)
    units in assisted living facilities (ALF's); and

3.  Unrealistically low Operating Expense Ratios (OERs) used to
    underwrite ALF's.

Accordingly, we request that applicable projects be closely scrutinized
and underwritten with the following corresponding requirements in mind.

[**Requirement 1**\
]{.underline} Section 221 (d)(4) age-restricted unit types' reflected on
Form HUD 92273's *must* be analyzed using base rents only, with no meals
or services included, and must be *verified and compared* in that
sub-market to the newest seasoned general occupancy units available.

FHA has not insured mortgages on Retirement Service Centers (ReSC's) for
several years. Initially marketed as luxury accommodations for the
elderly, many ReSC's failed and were converted into entry-level ALF's.
The Section 221 (d)(4) program has continued to allow age-restricted
housing for the elderly, so long as ReSC-like project amenities/ costs/
income are excluded from the underwriting, and only strict
"shelter-related" features are included as the focus of the analyses.
Many projects that are labeled "independent" are actually marketed and
managed as exclusive seniors' rental housing for *dependent,* frail
elderly individuals or couples. This apparent paradox has the potential
to render FHA's exclusion of ReSC's from its programs ineffectual, since
many services are offered such residents on site by related and
third-party providers from offsite.

So long as lenders honor the underlying premise of this program
allowance- that only the housing/shelter elements be considered in the
analyses- then this Hub may process such applications. MAP lenders,
please see Paragraphs 3.5 C, 3.8 D and 11.2 J3 of the MAP Guide. But
frequently, lenders prepare and submit, or allow their appraisers to
complete and they then package, Form HUD 92273's that contain comparable
unit rents containing *more than* just shelter-related base rent.
Heretofore, the Hub has re-underwritten these projects at some added
time and expense, reflecting housing-only rents (without meals or
services). Henceforth, we will reject such underwriting, and hold the
lender directly accountable to the borrower for any lengthy re-analysis,
delay, and modifications occasioned by non-compliance with this
requirement.

In analyzing such unit rents, we further require that at least one
general occupancy/non-age-restricted rent comparable, located as near
the subject as possible, be utilized for each different unit type. This
requirement is based upon the belief that general occupancy units that
some elderly prefer often reflect what shelter-only rents prevail in a
given location. Such a comparable should be of recent vintage (less than
10 years old, ideally), but also partially seasoned (at least one lease
renewal or turnover/unit). Underwriting submitted with comparable
rentals that include non-housing services revenue, or that does not
include a general occupancy comparable located nearby as a "cross-check"
on shelter-only rent levels, will be rejected.

**[Requirement 2]{.underline}**\
Memory Care (MC- aka Alzheimer's) units must not exceed 10% of total
units in an assisted living facility (ALF); if they do, they must be
designed and underwritten the same as average-sized and -priced assisted
living units available in that same project.

Several recently processed ALF's included sizeable wards/wings of MC
units in the project. MC units are typically much *smaller* than general
population ALF units in square footage and cost. Due to the specialized
care associated, however, MC units typically garner *higher* monthly
charges. The temptation to underwrite more than 10% of total ALF units
as MC may prove irresistible because of the income/cost dynamics
involved. However, if an excessive proportion of MC units are built in
one project, or an excessive number of MC units in the overlapping
subject market, these small, Spartan units cannot rent for even as much
as larger vacant entry-care ALF units. Consequently, improved market
research and greater care must be exercised in the proper sizing (both
MC wing and individual unit size) and pricing of these specialty units.

Henceforth, this Hub will underwrite no more than 10% of an ALF's total
units at MC charges. In addition, no greater than 10% of an ALF
project's units may be specially designed in relatively smaller square
footage sizes for the purposes of MC. Any Section 232 application
submitted with higher percentages of relatively small MC units, or
higher MC-related charges, will either be rejected or very closely
scrutinized for supporting market study data conclusively justifying the
proposed exception from the 10% limitations.

**[Requirement 3]{.underline}\
**Operating Expense Ratios (OER's) for freestanding ALF's, depending
upon the intensity of services and payroll involved, typically fall in
the 60%-70% range, and should be underwritten accordingly.

Several ALF's have been submitted reflecting OER's more appropriate for
apartment projects in the 40%-55% range. Because of the higher levels of
services offered at all ALF's, and primarily, payroll and materials
costs related to these services, the national average for such
facilities is approximately 65%. FHA 232 processing must reflect what is
typical in operations and the industry norm in operating efficiencies.
It is unrealistic to expect an ALF to operate with the same payroll and
materials as an ordinary apartment project.

Freestanding ALF's must be underwritten with achievable OER's,
sustainable on a long-term stabilized basis (paraphrasing what it says
in several Handbooks on the topic). If the ALF is to be a new
construction wing of a Skilled Nursing Facility (SNF), to be combined
with its higher intensity of operations and costly health-care related
services, then using at least 60% for the ALF segment and 80%-90+% for
the SNF portion would reflect the norm(s). As in existing apartment
program refinance and purchase programs, pro forma underwritten expenses
must be supported by the trailing three years' annual financial
statements.

In order to avoid processing delays, questions relating to this
memorandum's application to specific projects should be directed to
either Tim Gruenes (612-370-3051 x 2252) or Del Relopez (x2274).