Multifamily Housing: Effects of HUD's Portfolio Reengineering Proposal
Released: 1996-11-01T00:00:00

Letter

Introduction

The Department of Housing and Urban Development (HUD), through the Federal Housing Administration (FHA), insures mortgages on both single-family homes and multifamily rental housing properties for low- and moderate-income households. In addition to mortgage insurance, many FHA-insured multifamily properties receive some form of direct assistance or subsidy from HUD, such as below-market interest rates or Section 8 rental subsidies tied to some or all units (Section 8 project-based assistance).

In an effort to resolve long-standing problems with the segment of the insured multifamily portfolio that both has mortgages insured by FHA and receives project-based Section 8 rental subsidies (the insured Section 8 portfolio), HUD during 1995 proposed a major restructuring process that it called “mark-to-market.” In early 1996, HUD made several key changes to its proposal in response to concerns raised by various stakeholders and changed its name for the process from mark-to-market to “portfolio reengineering.” HUD left most of the basic thrust of the original mark-to-market proposal intact, however.

Background

FHA insurance protects private lenders from financial losses stemming from borrowers’ defaults on mortgage loans for both single-family homes and multifamily rental housing properties. When a default occurs on an insured loan, a lender may “assign” the mortgage to HUD and receive payment from FHA for an insurance claim. According to the latest data available from HUD, FHA insures mortgage loans for about 15,800 multifamily properties. These properties contain just under 2 million units and have a combined unpaid mortgage principal balance of $46.9 billion.These properties include multifamily apartments and other specialized properties, such as nursing homes, hospitals, student housing, and condominiums.

HUD’s Section 8 program provides rental subsidies for low-income families. These subsidies are linked either to multifamily apartment units (project-based) or to individuals (tenant-based). According to HUD’s latest available data, about 1.4 million units at about 20,400 multifamily properties receive Section 8 project-based subsidies. Under the Section 8 program, residents in subsidized units generally pay 30 percent of their income for rent and HUD pays the balance. According to HUD’s data, monthly Section 8 payments to HUD-insured properties average about $300 to $500 per unit.

The Insured Section 8 Portfolio

According to HUD, its restructuring proposals apply to 8,636 properties that both have mortgages insured by FHA and receive project-based Section 8 rental subsidies for some or all of their units. In this report, we refer to these properties as HUD’s insured Section 8 portfolio. Data provided by HUD show that, together, these properties contain 859,000 units and have unpaid principal balances totaling $17.8 billion.

For various reasons, HUD chose to exclude from its restructuring proposals properties with project-based Section 8 assistance that are insured under its “moderate rehabilitation” program. HUD estimates that about 167 properties containing about 16,800 units are insured under this program. Figure 1.1 shows how the insured Section 8 portfolio fits into HUD’s overall multifamily housing portfolio.

Excludes properties with HUD-held mortgages.

Excludes 167 properties and about 16,800 units with project-based assistance provided under the Section 8 “moderate rehabilitation” program.

According to HUD’s data, about 45 percent of the insured Section 8 portfolio (3,859 properties) consists of “older assisted” properties. These were constructed beginning in the late 1960s under a variety of mortgage subsidy programs, to which project-based Section 8 assistance (Loan Management Set-Aside) was added later, beginning in the 1970s, to replace other subsidies and to help troubled properties sustain operations. About 55 percent of the insured Section 8 portfolio (4,777 properties) consists of “newer assisted” properties. These were built after 1974 under HUD’s Section 8 New Construction and Substantial Rehabilitation programs and received project-based Section 8 subsidies calculated on the basis of formulas with automatic annual adjustments, which, according to HUD, tended to be relatively generous to encourage the production of affordable housing. Figure 1.2 provides additional data on the insured Section 8 portfolio.

Expiring Section 8 Assistance

The project-based Section 8 assistance for properties in the insured Section 8 portfolio is covered by contracts, many of which are for long terms. Under these contracts, property owners agreed to house lower-income tenants for specified periods in exchange for guaranteed rental subsidies for specified units. In the next few years, many of these contracts will expire. According to the available data from HUD, contracts covering about 69 percent of the project-based Section 8 units in the insured Section 8 portfolio will expire by the end of the year 2000 and contracts covering about 98 percent of the units will expire by the end of the year 2006. (See fig. 1.3.) In the early 1990s, most expiring contracts were renewed for 5-year periods, but the terms of Section 8 contracts have been gradually shortened since then. To improve its budgeting for contract renewals, HUD proposes to renew all contracts for 1-year terms, beginning in fiscal year 1997.

Problems Affecting the Insured Section 8 Portfolio

The insured Section 8 portfolio suffers from three basic problems—high subsidy costs; high exposure to insurance loss; and, in the case of some properties, poor physical condition.

A substantial number of properties in the insured Section 8 portfolio now receive subsidized rents above market levels. Many of these rents substantially exceed the rents charged for comparable unsubsidized units. This problem is most prevalent in (but not confined to) the newer assisted segment of the portfolio, where it stems from the design of the Section 8 New Construction and Substantial Rehabilitation programs. The government originally paid to develop these properties under the two Section 8 programs by establishing rents above market levels and then raising them regularly through the application of set formulas that, according to HUD, tended to be generous to encourage the production of new affordable housing.

The high cost of Section 8 subsidies is reflected in the cost of renewing the existing project-based contracts for the properties in the insured Section 8 portfolio as they expire. HUD is requesting $863 million in budget authority for fiscal year 1997 to renew expiring contracts covering almost 293,000 insured Section 8 units. As its long-term Section 8 contracts expire and its 1-year contracts are renewed annually, HUD estimates that its annual renewal costs will increase steadily in each of the following 9 fiscal years, resulting in an estimated annual renewal cost of about $6.7 billion by the year 2006 and a 10-year cumulative renewal cost approaching $45 billion.

A second key problem affecting the insured Section 8 portfolio is the high risk of insurance loss. Under FHA’s insurance program, HUD bears virtually all the risk in the event of a loan default. According to a recent HUD-contracted study of the Department’s capacity to manage the assisted multifamily portfolio’s financial risk, HUD’s multifamily insurance program depends upon the actions of private parties whose share in the risk and stake in the properties’ financial success may be limited. The study points out that instead of bearing the financial risk of default, private lenders may have a more limited stake in the continuation of mortgages through their servicing rights. Rather than having substantial equity invested in the properties, the owners may possess indirect interests that are hard for HUD to evaluate. Borrowers are often structured into partnerships in which the general partners, who are responsible for the properties’ day-to-day management, may have interests in property management fees through affiliated firms.

HUD’s fiscal year 1994 loan loss reserve analysis evaluated the risk of default and insurance loss for a sample of multifamily properties on the basis of a set of financial, physical, and management data. The properties were categorized as excellent, good, standard, substandard, or doubtful, and degrees of risk were assigned on the basis of these categories. According to the analysis, 48 percent of the older assisted properties and 20 percent of the newer assisted properties had a medium to high risk of default. This risk could increase substantially if the properties’ Section 8 contracts are not renewed or are renewed at substantially lower levels.

Poor physical condition is a third key problem affecting many properties in the insured Section 8 portfolio. A 1993 study of multifamily rental properties with FHA-insured or HUD-held mortgages found that almost one-fourth of the properties were “distressed.” The properties were considered to be distressed if they failed to provide sound housing and lacked the resources to correct their deficiencies or if they were likely to fail financially.

Principal Causes of the Problems

The problems affecting HUD’s insured Section 8 portfolio have several causes. These include (1) program design flaws that have contributed to high subsidies in the Section 8 program and have put virtually all the risk on HUD in the insurance program; (2) HUD’s dual role as both the mortgage insurer and the rental subsidy provider, which has resulted in the federal government’s averting claims against FHA’s insurance fund by supporting a subsidy and regulatory structure that has masked the true market value of the properties; and (3) weaknesses in HUD’s oversight and management of the insured portfolio, which have allowed physical and financial problems at a number of HUD-insured multifamily properties to go undetected or uncorrected. According to a September 1995 paper prepared by the Affordable Housing Preservation Tax Policy Group, a related problem is that the limited-partner investors in many of the properties no longer have an economic incentive to invest, or an interest in investing, additional capital to pay for improvements, such as new roofs, boilers, and updated appliances, which many properties are now starting to need.

HUD’s Proposals to Address Problems With the Insured Section 8 Portfolio

In May 1995, HUD proposed to address the key problems affecting the insured Section 8 portfolio through a process that it called “mark-to-market.” The principal steps in this process were to reset rents to market levels and reduce mortgage debt if necessary to permit a positive cash flow, terminate FHA’s mortgage insurance, and replace project-based Section 8 subsidies with portable tenant-based subsidies.

The basic idea behind HUD’s mark-to-market proposal was to address the three key problems and their causes by decoupling HUD’s mortgage insurance and project-based rental subsidies and subjecting the properties to the forces and disciplines of the commercial market. HUD originally proposed to do this by (1) eliminating project-based Section 8 subsidies as existing contracts expired (or sooner if the owners agreed), (2) allowing owners to rent their apartments for whatever amounts the marketplace would bear, (3) facilitating the refinancing of FHA-insured mortgages with smaller mortgages if needed for the properties to operate at the new rents, (4) terminating FHA’s insurance on the mortgages, and (5) providing the residents of assisted units with portable Section 8 rental subsidies that they could use to either stay in their current apartment or move to another one in accordance with their wishes or financial needs.

HUD recognized that many owners could not cover their expenses and might eventually default on their mortgages if their properties were forced to compete in the commercial marketplace without their project-based Section 8 subsidies. The mark-to-market proposal therefore included several alternatives for restructuring the program’s FHA-insured mortgages to bring properties’ income and expenses into line. These alternatives included selling the mortgages, engaging third parties to work out restructuring arrangements, and paying full or partial FHA insurance claims to lenders to reduce the mortgage debt and monthly payments. Each of these alternatives would likely expose HUD to claims against FHA’s insurance fund, but HUD estimated that over the long term this approach would cost the government less than maintaining the status quo.

The proposed mark-to-market process would likely affect properties differently, depending on whether their existing rents were higher or lower than market rents and whether they needed funding for capital items, such as deferred maintenance. If the existing rents exceeded market value, the process would lower the mortgage debt, thereby allowing the property to operate and compete effectively at lower market rents. If the existing rents were below market value, the process would allow the owner to increase the rents, potentially providing more money to improve and maintain the property. HUD recognized, however, that some properties would not be able to generate enough income to cover their expenses even if their mortgage payments were reduced to zero. In these cases, HUD proposed using alternative strategies, including demolishing the property and subsequently selling the land to a third party, such as a nonprofit organization or government entity.

Although both the Senate and the House held hearings on the mark-to-market proposal, no consensus was reached as to whether it or some other approach should be adopted. No action was taken, in part because reliable information was not available on the properties and their surrounding commercial rental markets. Potential stakeholders raised questions about the proposal that could not be answered, including the following: (1) What are the physical and financial conditions of the properties that make up the insured Section 8 portfolio? (2) What different effects would the proposal have at different types of properties? (3) Would the government realize net savings or incur additional costs in the long run? (4) To what extent would low-income residents be displaced or have to pay higher rents? (5) To what extent could such residents find suitable and affordable alternative housing if they chose to or had to? (6) To what extent would possible income tax consequences and other negative effects on owners cause them to oppose the proposal and hamper HUD’s efforts to implement it? and (7) To what extent would owners with substantial time left on their Section 8 contracts disinvest and let their properties deteriorate? Without this information, it was difficult to predict the overall effects of HUD’s mark-to-market proposal on the properties, their owners, the residents, and the federal government. HUD contracted with Ernst & Young LLP in 1995 to obtain up-to-date information on market rents and the physical condition of properties in the insured Section 8 portfolio, develop a financial model to show how HUD’s proposal would affect the properties, and estimate the subsidy and insurance claims costs associated with the proposal. (See ch. 2 for our analysis of Ernst & Young’s study.)

In April 1996, before Ernst & Young completed its study, HUD modified the original mark-to-market proposal in several ways in response to concerns raised by industry officials and resident groups about various issues, such as the elimination of project-based subsidies and the termination of FHA insurance, and changed the name of the process from mark-to-market to portfolio reengineering. HUD left the basic thrust of the original proposal intact but made several key changes. These included (1) giving priority attention for at least the first 2 years to properties with subsidized above-market rents while continuing to discuss approaches with stakeholders for solving capital needs at properties with expiring contracts and subsidized below-market rents; (2) allowing state and local governments to decide whether to continue Section 8 project-based rental subsidies at individual properties after their mortgages are restructured or switch to tenant-based assistance; and (3) allowing owners to apply for FHA insurance on the newly restructured mortgage loans. HUD’s portfolio reengineering proposal further differed from the original mark-to-market proposal in that it (1) put more emphasis on proactively using third parties to restructure and resolve problems with mortgages before properties’ project-based Section 8 contracts expire; (2) better protected current residents from displacement by providing those in assisted apartment units with “enhanced vouchers” that would pay the difference between 30 percent of their income and the market rent for their building (even if that rent exceeded the normal Section 8 limits) and by providing rental assistance to currently unassisted residents if restructuring increased their rent to more than 30 percent of their income; and (3) reflected HUD’s willingness to work with the Congress on developing mechanisms to take into account the tax consequences to the owners of properties whose mortgage debt would be forgiven as part of the restructuring process. More recently, HUD has also proposed deferring action on properties that would not be able to generate enough income to cover their operating expenses after reengineering until strategies have been developed to address the needs of their residents and of the communities in which the properties are located.

Objectives, Scope, and Methodology

To assist the Congress in evaluating HUD’s proposal for reengineering the insured Section 8 multifamily housing portfolio, we examined the (1) problems affecting the properties in the portfolio and HUD’s proposals for addressing them; (2) results and reasonableness of a HUD-contracted study carried out by Ernst & Young LLP that assesses, on the basis of a national sample of 558 randomly selected properties, the effects of HUD’s proposal on the portfolio; and (3) key issues facing the Congress in assessing HUD’s proposal. In addition, as discussed in appendix I, we examined the characteristics of 10 properties included in Ernst & Young’s study and the impact of HUD’s proposal on them.

To obtain information on the problems affecting the properties in HUD’s insured Section 8 portfolio and HUD’s proposals for dealing with them, we reviewed relevant reports issued by GAO, HUD’s Office of Inspector General (OIG), and HUD. We also reviewed HUD documents discussing the Department’s mark-to-market and portfolio reengineering proposals, as well as comments on the proposals provided by groups representing the multifamily housing industry and residents. We also discussed the proposals with HUD and industry officials and participated in four forums that HUD held in early 1996 to discuss problems pertaining to the insured Section 8 properties and options for addressing them.

To evaluate the results and reasonableness of Ernst & Young’s study, we were briefed by staff from Ernst & Young and HUD on the approaches that Ernst & Young planned to use to carry out its study and on the actual methods used. The briefings included discussions about Ernst & Young’s sampling and statistical methods, market surveys for estimating the market rents for the insured Section 8 properties, site inspections for estimating the properties’ deferred maintenance and capital needs, and the financial model for determining the effect of portfolio reengineering on the properties and estimating the costs and savings associated with reengineering.

We reviewed selected aspects of Ernst & Young’s sampling and statistical methodology. For example, we reviewed the computer programs that Ernst & Young used to select sample projects and reviewed the statistical methods that the firm planned to use to estimate population totals from the sample. We also reviewed the presentation of information derived from the sample in Ernst & Young’s May 2, 1996, report.

When data are missing for sampled projects, a potential exists for the results of the sample to create a biased representation of the entire population of projects. In addition, assigning values on the basis of the observed sample mean can cause the sampling errors to be somewhat understated. We checked the completeness of the data collected for Ernst & Young’s sampled projects. Only one project subject to portfolio reengineering was excluded from the study. For the 558 projects included in the study, the data collection was generally complete. About 85 percent of the projects in the final sample had complete data. For the remaining projects, one or more of the following were missing: (1) data from financial statements, (2) data on tenants’ payments, and (3) data on deferred maintenance. Tenant payment data were missing most frequently—about 12 percent of the time. Financial statement data and deferred maintenance data were missing no more than 3 percent of the time. When data were missing for a project, Ernst & Young assigned a value to it based on the average of the known sample properties or industry standards. (The overall reasonableness of Ernst & Young’s study is discussed in ch. 2.)

To evaluate Ernst & Young’s estimates of market rents, we reviewed the firm’s methodology for performing market surveys and, as discussed in greater detail below, contracted with three licensed real estate appraisal firms to estimate the market rents for 10 properties in Ernst & Young’s sample.

To assess Ernst & Young’s estimates of deferred maintenance needs and capital costs, we met with Ernst & Young officials to understand the firm’s methodology and underlying assumptions. We also obtained and analyzed related data collection documents used in the firm’s study, including the instructions to those conducting on-site property inspections and the completed inspection forms and supporting documentation for the 10 properties independently assessed by the contract appraisers. We also discussed Ernst & Young’s methodology with industry representatives and provided Ernst & Young’s estimates for the 10 properties to the respective owners and managers and to the contract appraisers. We asked those who reviewed Ernst & Young’s estimates to comment on the reasonableness and accuracy of the estimates; to state whether they generally agreed or disagreed with the estimates; and if they disagreed with an estimate, to provide specific information on the adjustments needed and the reasons for the adjustments.

To review Ernst & Young’s financial model for assessing the effects of portfolio reengineering on the sample properties, we obtained a copy of the model and discussed the assumptions used in it with Ernst & Young staff. Because the model contains hundreds of data fields, formulas, and assumptions, we did not attempt to examine every data element or verify every formula or calculation. Rather, we focused on assessing the structure of the model and reviewed its key data elements and the logic of what we considered to be its major assumptions. We also discussed the financing and operating assumptions used in the model with officials of various organizations that have expertise in underwriting and/or servicing mortgages on multifamily housing properties (including Fannie Mae, Freddie Mac, the Reilly Mortgage Group, and GMAC Commercial Mortgage Corporation). Our assessment of the model is discussed in chapter 2. As discussed in chapter 2, we used information obtained from these experts to perform sensitivity analyses that assess the effects of changes in the assumptions on the model’s results. We also used data from Ernst & Young’s sample to estimate certain costs. These estimates apply to the 8,363 projects from which the sample was drawn. Had we made estimates for the number of properties that Ernst & Young assumed to be affected by portfolio reengineering (8,563 properties), our estimates of the totals would have been about 2 percent higher. As discussed earlier, HUD now believes that 8,636 properties would be affected by its proposal.

We did not verify the accuracy of the data that Ernst & Young derived from HUD’s data systems for use in its study except for certain data pertaining to the 10 case study properties. We found that the final data used in Ernst & Young’s study for these properties were generally consistent with the data we obtained. HUD’s OIG conducted a more detailed assessment of the data that Ernst & Young derived from HUD’s information systems. The OIG tested 69 of the 189 data elements that Ernst & Young used for 56 projects. The OIG found differences between the data it obtained and the data Ernst & Young used for 423 of the 3,864 data elements it reviewed, 114 of which the OIG determined to be significant. The OIG shared the results of its analysis with Ernst & Young and HUD. Ernst & Young officials informed us that they had used the OIG’s results to improve the study’s data.

We provided comments to HUD and Ernst & Young about issues that arose throughout the study’s design and implementation. HUD and Ernst & Young officials were generally responsive to our concerns, replacing their original sample, for example, with one that they could analyze using appropriate statistical methods.

We obtained data on the characteristics of 10 properties included in Ernst & Young’s sample and assessed the effects of HUD’s proposal on the properties. We selected these properties judgmentally from a list of properties in Ernst & Young’s sample. The 10 properties are not statistically representative of the properties in either HUD’s insured Section 8 housing portfolio or Ernst & Young’s sample. We selected the 10 properties to reflect differences in geographical location (they are located in six states and the District of Columbia), assisted rent levels, and physical condition (as indicated in physical inspection reports from HUD). We did not have information on many characteristics of the properties—such as how their assisted rents compared with the market rents they could command, who resided in them, and what types of housing markets they were located in)—when we selected the properties.

To obtain data on the properties’ characteristics, we visited each property and interviewed its manager and/or owner. We also obtained data on the properties’ characteristics from HUD’s field office and property records. We provided the basic data we obtained on each property to the property owner or manager for review and verification. To develop estimates of the market rents that the properties could command and assessments of the effects that portfolio reengineering would have on the properties, we contracted for the services of three licensed real estate appraisal firms with experience in assessing properties insured or assisted by HUD: Goyette Roark Appraisal Services; Maiden, Haase & Smith, Ltd.; and Miller Appraisal Review. The firms provided us with a report on each of the properties they reviewed. We also obtained comments on each appraisal report from the property’s owner or manager. The results of the reports are summarized in appendix V.

We identified and formulated our observations on the key issues facing the Congress through our review of (1) HUD’s proposals, (2) comments on HUD’s proposals and alternative proposals prepared by various parties representing the views of those who would be affected, (3) testimony provided at several congressional hearings and our discussions with housing and lending industry officials and with the owners, managers, and selected tenant representatives at the 10 case study properties.

We provided a draft copy of this report to HUD for its review and comment. HUD provided written comments on the draft, and these comments are presented and evaluated in chapter 2 and appendix VI. We conducted our review from August 1995 through September 1996 in accordance with generally accepted government auditing standards.

Evaluation of the Results and Reasonableness of the Portfolio Reengineering Study Conducted for HUD by Ernst & Young

In May 1996 Ernst & Young reported on the results of its study analyzing the effects of HUD’s original mark-to-market proposal on insured Section 8 properties. Ernst & Young’s study indicates that for most of the properties subject to portfolio reengineering, the assisted rents are greater than the estimated market rents. In addition, according to the study, the properties have significant amounts of immediate deferred maintenance and short-term and long-term capital needs. The study further indicates that about 80 percent of the properties would need to have their debt reduced in order to continue operations after reengineering. For approximately 22 to 29 percent of the properties, writing down the existing debt to zero would not reduce their costs enough for them to cover their operating expenses and/or address their deferred maintenance and capital needs. Ernst & Young’s report does not present information gathered during the study on the costs of portfolio reengineering to the government—that is, on how the costs of providing Section 8 assistance would change and what the likely claims against FHA’s insurance fund would be. Our analysis of these data indicates that although the costs of Section 8 assistance would eventually be lower under portfolio reengineering than under the current renewal policies, little or no Section 8 savings would be achieved over the next 10 years if all Section 8 properties were reengineered when their current Section 8 contracts expire. Furthermore, Ernst & Young’s data indicate that the cost of insurance claims associated with the reengineering proposal during the 10-year period would amount to between $6 billion and $7 billion.

Ernst & Young’s financial model provides a reasonable framework for projecting the overall results of portfolio reengineering, such as the number of properties that would need to have their debt reduced. Furthermore, we did not identify any substantive problems with the model’s sampling and statistical methodology. However, some assumptions used in the financial model may not reflect the way in which insured Section 8 properties would actually be affected by portfolio reengineering. In addition, our comparison of Ernst & Young’s data with the information we gathered on our 10 case-study properties raises questions about one key data element—the estimated costs of deferred maintenance and capital needs. Specifically, the owners or managers of the 10 properties and the independent appraisers we retained questioned the model’s cost estimates for deferred maintenance at the properties, generally indicating that the estimates were too high.

To assess the extent to which the use of different assumptions would affect the results of Ernst & Young’s study, we performed sensitivity analyses of Ernst & Young’s model using two sets of revised assumptions that we developed through our discussions with multifamily housing industry officials. One scenario reflects assumptions that are more optimistic in terms of the cost to the government of portfolio reengineering. The other uses assumptions that are more conservative or pessimistic. Under all scenarios—Ernst & Young’s results and the optimistic and pessimistic variations—a substantial number of properties would likely do well and others would have difficulty sustaining operations.

Study Was Designed to Provide Updated Data

In early 1995, when HUD proposed the mark-to-market initiative, the Department did not have current or complete information on the insured Section 8 portfolio to use as a basis for developing assumptions about, and estimates of, the costs and effects of the proposal. For example, HUD lacked reliable, up-to-date information on both the market rents that the properties could be expected to command and the properties’ physical condition—two variables that strongly influence the effects on properties of the mark-to-market proposal. Information on market rents and physical condition is also needed to estimate (1) the change in Section 8 subsidy costs if assisted rents are replaced with market rents and (2) the claims against FHA’s insurance fund if mortgage debt is reduced to allow the properties to operate at market rents. Because HUD did not have current data on the market rents and physical condition of the properties in the insured Section 8 portfolio, the Department had to rely on data collected for HUD’s 1990 multifamily stock study. An update to this study assessing changes in the stock since 1990 was scheduled to begin in the fall of 1995, but the results were not expected to be available for some time.

To obtain interim data to better assess the likely outcomes of the mark-to-market proposal, HUD contracted with Ernst & Young LLP in 1995 for a study of a random sample of HUD-insured properties with Section 8 assistance to (1) determine the market rents and physical condition of the properties and (2) develop a financial model to show the effects of the proposal on the properties and to estimate the costs of the subsidies and claims associated with the proposal. The study was conducted on a sample of 558 properties out of 8,363 properties and extrapolated to the total population of 8,563 properties identified by HUD at that time as representing the population subject to portfolio reengineering. The study was planned to take about 2 months and be completed in 1995. However, the study took longer than estimated, in large part because of delays in completing the physical inspections and the fiscal year 1996 federal budget impasse, which required many government agencies, including HUD, to shut down operations for various periods last fall and winter. HUD and Ernst & Young released the report summarizing the study’s findings on May 2, 1996.

Study Finds That Many Properties Would Require Restructuring

Ernst & Young’s report provides current information comparing assisted rents at the properties with market rents, assessing the physical condition of the properties, and estimating the effects on the properties of HUD’s reengineering proposal as it existed while the study was under way. Hence, the study’s results do not reflect the effects of changes that HUD made to its proposal in early 1996. Ernst & Young’s report estimates that the majority of the properties have assisted rents that exceed market rents and significant amounts of immediate deferred maintenance and future capital needs. The analysis also indicates that about 80 percent of the properties would not be able to continue operations without debt restructuring.

Most Properties Would Have to Adjust to Less Income

Ernst & Young conducted market surveys to estimate market rents at the properties. The properties whose assisted rents currently exceed market rents would generate less rental income after reengineering; therefore, they would likely have difficulty meeting their existing debt service requirements when their rents were adjusted to market levels. Ernst & Young’s study estimates that a majority of the properties—between 60 and 66 percent—have above-market rents and between 34 and 40 percent have below-market rents. Most of the properties with assisted rents that exceed market rents are newer assisted properties. Conversely, most of the properties with assisted rents that are less than market rents are older assisted properties. During fiscal years 1997 through 1999, most of the properties whose Section 8 contracts are scheduled to expire are older assisted properties, whereas from fiscal year 2000 and beyond, most of the properties with such contracts are newer assisted properties.

The properties whose assisted rents are more than 120 percent above market levels are of special concern because they would likely experience substantial decreases in rental income. The Ernst & Young study estimates that between 41 and 47 percent of the properties have such rents.

Physical Condition Needs Are Large and Strongly Influence Results of Portfolio Reengineering

Ernst & Young hired an engineering firm, Louis Berger & Associates, to identify the properties’ comprehensive capital needs. In order to obtain new loans, the property owners will need sufficient resources to address immediate deferred maintenance as well as future capital needs.

As table 2.1 shows, Ernst & Young’s study indicates a widespread need for capital—between $9.2 billion and $10.2 billion—to address the properties’ capital needs. The study defines capital needs as the costs of the improvements needed to bring the properties into adequate physical condition to attract uninsured, market-rate financing. Three categories of capital needs are defined: (1) immediate deferred maintenance, or the estimated costs to bring all operating systems up to market conditions and lenders’ underwriting standards, (2) the short-term capital backlog, or the estimated expired costs for subsystems and components with a remaining useful life of 5 years or less, and (3) the long-term capital backlog, or the estimated expired costs for subsystems and components with a remaining useful life of more than 5 years. The immediate and short-term capital costs are a significant factor in determining the impact of portfolio reengineering on the properties.

The study estimates that the properties have only approximately $1.3 billion to $1.6 billion in replacement reserves (i.e., funds set aside to cover future capital needs) and other cash reserves that could be used to address their capital needs, resulting in total net capital needs of between $7.7 billion and $8.7 billion. The average cost per unit of the total capital needs, less the reserves, is estimated to be between $9,116 and $10,366.

The study indicates that while the older assisted properties have a high level of capital needs, the newer assisted properties also require a significant investment. For example, the older properties have needs ranging between $3.8 billion and $4.4 billion for immediate deferred maintenance and short-term capital backlog, and the newer properties have needs ranging between $2.5 billion and $3.1 billion. On a per-unit basis, these amounts average between $8,665 and $10,217 for the older properties and between $6,201 and $7,491 for the newer ones.

Study Indicates a Significant Level of Debt Restructuring Would Be Needed

The study was designed to use information on market rents and the properties’ physical condition gathered by Ernst & Young, as well as financial and Section 8 assistance data from HUD’s data systems, in a financial model designed to predict the proposal’s effects on the portfolio as a whole. Specifically, the model estimates the properties’ future cash flows over a 10-year period, assuming that the loans will be reengineered (marked to market) when their current Section 8 contracts expire. The model classifies the loans into four categories—performing, restructure, full write-off, and nonperforming—that reflect the effects of reengineering on the properties. A property’s placement in one of the four categories is based on the extent to which the income from the reengineered property would be able to cover its operating costs, debt service payments, and immediate deferred maintenance and short-term capital expenses.

If portfolio reengineering were implemented, Ernst & Young estimates that about 80 percent of the properties—with current estimated unpaid principal balances ranging from $12.6 billion to $14.5 billion—would have to have their existing mortgage debt reduced. In addition, approximately 22 to 29 percent of the properties would not meet all of their needs even if their debt were written down to zero. The study further estimates that between 11 to 15 percent of the properties would not even be able to cover all of their operating expenses. Table 2.2 provides an overview of the results.

Model’s Results Raise Questions About Savings That Might Be Achieved

Ernst & Young’s model estimated the subsidy costs for HUD’s insured Section 8 portfolio before and after reengineering and the claims against FHA’s insurance fund entailed in writing down the mortgages and addressing the deferred maintenance needs at the properties. However, Ernst & Young’s May 2, 1996, report does not present this information. According to HUD’s Deputy Assistant Secretary for Operations, HUD plans to use Ernst & Young’s cost data in developing future budget estimates relating to portfolio reengineering, but it never intended that the cost data be included in Ernst & Young’s May 1996 report or that the model generate budget estimates. For various reasons, the cost estimates in HUD’s fiscal year 1997 budget request and in Ernst & Young’s study differ. For example, the budget request assumes that many loans will be reengineered before the related Section 8 contracts expire, while Ernst & Young’s study assumes that reengineering will occur after the contracts expire. In addition, according to HUD, the budget assumes that Section 8 subsidy costs increase at a faster rate than Ernst & Young’s study.

In the model, the claims costs include (1) the amount of debt reduction needed for each property to sustain its operations at market rents and (2) funding for some or all of the property’s immediate deferred maintenance and short-term capital needs. However, the claims costs cannot exceed the unpaid principal balance of the loan at the time of its restructuring. For a property whose estimated capital needs exceed its loan’s unpaid principal balance, any unresolved capital needs are tracked in the model. In addition, the claims costs are based on an evaluation, for each property, of the loan amount that the property could support using standard financial underwriting standards without the continuation of FHA insurance.

Short-Term Reductions in Section 8 Assistance Costs Would Be Unlikely

Our analysis of these data indicates that although the costs of providing Section 8 rental assistance would decrease over the long term, little or no aggregate savings in Section 8 rental assistance costs would accrue over the next 10 years if, as the model assumes, all insured Section 8 properties were reengineered when their current Section 8 contracts expire. These data indicate that, for the period from fiscal year 1996 through fiscal year 2005, there may be little difference in the aggregate costs of Section 8 assistance under the current program and under portfolio reengineering: If project-based assistance is continued at current levels (including inflation), the costs in present value terms are estimated to be between $27.2 billion and $31.0 billion.

The cost of Section 8 assistance after reengineering is estimated to be between $26.5 billion and $29.8 billion.

A primary reason for the similarity in cost estimates is that the model assumes projects would be reengineered when their current Section 8 contracts expire. This assumption reflects HUD’s contractual obligations, which the Department has repeatedly indicated that it will not abrogate. Because the contracts for many properties with below-market rents will expire during the first part of the 10-year period and the properties would therefore be reengineered early in the process, the costs of providing Section 8 assistance would increase during the early years but then begin to decrease as more projects with above-market rents were reengineered in the later years. In fiscal year 2005, after virtually all of the projects have been reengineered, the Section 8 assistance costs are estimated to be between $1.9 billion and $2.2 billion per year on a present value basis. The model indicates that annual savings of between $298 million to $493 million (between 13 to 19 percent) could subsequently be achieved if reengineering were implemented in place of the current program.

However, Ernst & Young’s model does not reflect the changes that HUD made to its proposal in early 1996. Some of the changes offer the potential for additional Section 8 cost savings. For example, HUD is proposing to use a proactive approach to portfolio reengineering, under which it would encourage owners to terminate their Section 8 contracts voluntarily before the contracts expire and go through the reengineering process. However, it is not clear to what extent HUD will succeed in attracting owners to restructure before their Section 8 contracts expire or what additional incentives HUD may have to offer to achieve this goal.

In addition, HUD now plans to focus initially on reengineering properties with above-market rents. To the extent that portfolio reengineering focuses on such properties, the savings would increase. For example, Ernst & Young’s data indicate that the 10-year costs of providing Section 8 assistance for properties with above-market rents would be between $21.2 billion and $25 billion under the current program compared with between about $18.5 billion and $21.5 billion if the loans for such properties were restructured when their Section 8 contracts expire. In addition, some further savings would result if, as Ernst & Young’s model assumes, mortgage interest subsidies were terminated when projects were reengineered. Ernst & Young estimates that without reengineering, mortgage interest subsidies would range from about $841 million to $1.1 billion (in present value terms) over the next 10 years. However, most properties that receive interest subsidies are believed to have below-market rents.

Insurance Claims Costs Would Likely Be High

Our analysis of Ernst & Young’s data indicates that, under portfolio reengineering, the claims against FHA’s multifamily insurance funds—for mortgage write-downs and deferred maintenance and other capital needs for properties with mortgages that need restructuring—would be substantial. The mortgage balances for such properties—including those in the full write-off and nonperforming categories whose mortgages would be fully written off—would need to be reduced by between 61 and 67 percent. Over the next 10 years, according to Ernst & Young’s data, this reduction would result in claims costs, calculated on a present value basis, of between $6 billion and $7 billion. If, however, HUD’s proactive approach were successful, the costs of claims to cover mortgage write-downs could be higher than indicated in Ernst & Young’s study because (1) the loans would be restructured earlier when the unpaid principal balances were higher and (2) the present value of the claims occurring in the earlier years would be higher. However, HUD believes that without a proactive approach, owners would disinvest in the properties. Such disinvestment would have an adverse impact on the properties’ physical condition, resulting in higher claims costs at a later date.

The claims payments estimated in Ernst & Young’s study indicate substantial loan loss rates for the government. For example, the portfolio reengineering claims for properties with assisted rents that exceed market rents are estimated to be between $4.8 billion and $5.8 billion and the related unpaid principal balances at the time of restructuring are estimated to be between $6.9 billion and $8.1 billion. The estimated loss rate would be between 67 and 75 percent. Table 2.3 provides the claims, unpaid principal balances, and loss rates for the properties subject to portfolio reengineering.

GAO’s Evaluation of the Model and Its Results

Ernst & Young’s financial model provides a reasonable framework for projecting the overall results of portfolio reengineering, such as the number of properties that would need to have their debt restructured and the related costs of insurance claims. In addition, as discussed in appendix III, we did not identify any substantive problems with Ernst & Young’s sampling and statistical methodology. However, some assumptions used in Ernst & Young’s financial model may not reflect the way in which insured Section 8 properties would actually be affected by portfolio reengineering. Our comparison of Ernst & Young’s data with the information we obtained on 10 case study properties raised questions about one key data element—the estimated costs of deferred maintenance and capital needs.

Cash Flow Model Provides the Basis for Evaluating the Outcome of Portfolio Reengineering

Ernst & Young’s financial model is a 10-year cash flow model that computes the net operating incomes for each property before, during, and after the rents are set at market levels. That is, the model produces annual revenues, operating costs, and replacement reserve requirements (i.e., amounts that need to be set aside to cover future capital needs) and calculates net income on the basis of these amounts. The initial cash flows are based on data, adjusted for inflation, from the properties’ audited financial statements for 1994. The model assumes that income and tenant payments will grow by 3 percent a year and expenses by 4 percent a year. The higher growth rate for expenses was intended to provide more conservative estimates. The model assumes that market rents will be phased in over 9 months, beginning 3 months after the first Section 8 contract for each property expires, and that the operating costs for some properties will be reduced. HUD’s rental assistance, included in the model as part of revenues, is based on the existing project-based subsidies, adjusted for inflation, until 3 months after the first contract expires. After the restructuring, the model assumes, residents will receive tenant-based assistance (certificates or vouchers) covering the estimated market rents at the properties. However, the assistance is no longer linked to specific properties, and the residents could choose to relocate.

For each of the 10 years covered, the model computes both a net operating income and an adjusted net operating income. The net operating income represents the total revenues less the operating expenses, whereas the adjusted net operating income is further reduced by the amount required annually for a replacement reserve. Each property is then subjected to two tests of its loan’s performance when the first Section 8 contract expires to determine whether the cash flows provide sufficient income for the property to cover (1) the current debt service (mortgage payment) excluding any interest subsidy currently available and (2) the immediate deferred maintenance and short-term capital backlog costs. If a loan passes both tests, it is categorized as performing. Loans that are not classified as performing are analyzed further to determine whether their appropriate portfolio reengineering category is debt restructure, full write-off, or nonperforming.

Financial Model Is Reasonable, but Some Assumptions Are Questionable

In general, Ernst & Young’s financial model provides a reasonable framework for analyzing the impact of HUD’s portfolio reengineering proposal on the insured Section 8 portfolio. However, some of its assumptions may not reflect the way in which insured Section 8 properties would actually be affected by portfolio reengineering. In addition, some of the model’s assumptions may not be apparent to readers of Ernst & Young’s May 1996 report. The market rents projected for 10 case study properties by Ernst & Young and by the contract appraisers were generally consistent. However, our comparison of the immediate deferred maintenance needs identified at the 10 properties by Ernst & Young and by the contract appraisers and our discussions with the owners or managers of the properties indicated that the study’s results may not always accurately reflect conditions at these properties. More detailed discussions of the differences between Ernst & Young’s and the contract appraisers’ assessments of the 10 case study properties are presented in appendixes I and V.

Market Rents Appear Reasonable, but Deferred Maintenance Costs Raise Questions

As part of our review, we contracted with three licensed real estate appraisal firms for assessments of 10 HUD-insured Section 8 properties included in Ernst & Young’s sample. The appraisers’ tasks included studying the local markets in which the properties are located and determining what market rents the properties would be able to command. As table 2.4 indicates, for 8 of the 10 properties, the estimated market rents that Ernst & Young developed in its market surveys are reasonably close to (i.e., within 10 percent of) the rents developed by the appraisers we retained.

For two properties, however, there are significant differences. Ernst & Young’s estimates of the market rents for St. Andrew’s Manor and Terrace Gardens are more than 20 percent lower than the contract appraisers’ estimates. This difference reflects, in large measure, Ernst & Young’s use of a different methodology to estimate market rents in neighborhoods consisting primarily of assisted properties—where few, if any, comparable properties with market rents were identified. In these cases, Ernst & Young assumed that because the neighborhoods were essentially maintained by non-market-driven forces, there were no markets for unassisted rents other than those controlled by the local housing authorities. Thus, Ernst & Young based its estimates of market rents on the rents subsidized by the local housing authorities. In contrast, the appraisers believed that there were comparable properties that could be used to estimate market rents for the two properties.

While Ernst & Young and the contract appraisers arrived at generally consistent estimates of market rents for the 10 case study properties, they developed widely differing estimates of the properties’ capital needs. In general, Ernst & Young projected significantly higher costs. These differences occurred, in part, because Ernst & Young and the contract appraisers used different approaches for assessing capital needs.

Ernst & Young retained a firm to conduct engineering studies at the properties. As discussed earlier, Ernst & Young’s assessment of a property’s capital needs included three components: the immediate deferred maintenance, short-term capital backlog, and long-term capital backlog. In the model, Ernst & Young assumed that funding would be provided to cover the immediate deferred maintenance and short-term capital needs at the time the property was reengineered (up to a full write-down of the property’s mortgage). The short-term capital needs cover the “estimated expired costs” rather than the full replacement costs of the items with remaining useful lives of 5 years or less. For example, a $15,000 roof with an original useful life of 15 years would, when it was 11 years old, have estimated expired costs of $11,000, which would be included in the property’s short-term capital backlog. The additional funding needed to replace the roof in 4 years would be funded by annual replacement reserves factored into the property’s annual cash flows. Thus, the reserves cover part of the short-term capital backlog and the replacement of systems and components that have remaining useful lives of more than 5 years. Ernst & Young’s approach for estimating capital needs involved reviewing a property’s major subsystems and unit components and then estimating, for each, the original useful life, remaining useful life, replacement cost, and need for repairs or replacement. This information was used to calculate the property’s immediate deferred maintenance needs and short-term capital backlog. According to Ernst & Young, the estimates included in the study represent the (1) costs for items that require immediate attention, (2) costs for items that may still be operable but have outlasted their planned useful life,and (3) expired costs (depreciation) for items that are expected to need replacement in the next 5 years.

In general, the contract appraisers based their estimate of a property’s capital needs on their assessment of the repairs and renovations required for the property to operate as a market-rate property after reengineering. This approach relies primarily on an evaluation of the property relative to others in the same market, whereas Ernst & Young’s approach depends, in part, on useful-life standards. The appraisers based their assessment on their review of the property’s previous physical inspections and on their own physical inspection. The appraisers were not, however, tasked with performing engineering studies.

Because of these methodological differences, direct comparisons of Ernst & Young’s and the appraisers’ estimates are difficult. In our view, the most comparable estimates are for immediate deferred maintenance needs; these estimates for 10 properties appear in table 2.5. Ernst & Young’s estimates are taken from the firm’s May 2, 1996, report.

In commenting on this comparison, Ernst & Young officials indicated that their firm’s estimates of deferred maintenance needs are likely to be higher than those of the contract appraisers because they include costs not only for the major subsystems and components that need major repair or are in poor condition but also for items such as appliances and heating and air-conditioning systems that are still functioning but have outlasted their useful life. Ernst & Young’s estimates assumed that investors or lenders would want to replace such items. To demonstrate the effect of this assumption on their firm’s estimates of deferred maintenance needs, Ernst & Young officials provided us with an analysis showing how the exclusion of such items would change the estimates. This additional information showed that using useful-life standards generally resulted in higher cost estimates than using, as the contract appraisers did, the actual condition of systems and components and comparisons of the appraised property with other properties in the local real estate market.

Table 2.6 adjusts Ernst & Young’s estimates for the 10 properties’ immediate deferred maintenance needs, eliminating the global assumption that items exceeding their estimated useful life would be replaced. This adjustment reduced Ernst & Young’s estimates, in some cases substantially. For example, the estimate for Murdock Terrace in Dallas, Texas, was adjusted from $5.7 million to $2.1 million when the replacement costs for items that were still operable but had exceeded their useful life were excluded.

Even after adjusting Ernst & Young’s estimates, we found that, for some properties, Ernst & Young’s estimates still differed substantially from those of the contract appraisers. For example, Ernst & Young’s estimate of the immediate deferred maintenance needs at Jacksonville Townhouse in Jacksonville, Florida, remained at $797,402, while the appraiser did not identify any deferred maintenance needs. The property’s owner and manager also strongly disagreed with Ernst & Young’s cost estimates for immediate deferred maintenance, especially the estimate of $360,018 to replace heating and air-conditioning systems. The manager said the main system is only 3 years old and is covered by a maintenance contract and that the cost of work in the individual units, which Ernst & Young had estimated at $295,492 (or $3,545 a unit), is more than four times higher than necessary. He said that the heating and air-conditioning systems had recently been replaced in 35 units at a cost of $800 per unit.

Because the estimates of capital needs that Ernst & Young presented in its study were difficult to compare directly with those of the contract appraisers, we provided both estimates to the owners and managers of the 10 case study properties for their review and comment. The owners and managers generally disagreed with Ernst & Young’s estimates. For the most part, they said that the estimates were too high and did not accurately reflect the physical condition of the properties. In some cases, the owners and managers questioned some of the underlying assumptions used in developing the estimates and identified cost estimates that they considered too high—in some cases, almost twice as high as they would estimate. For example, one property manager agreed that all of the property’s operating systems needed major rehabilitation. However, his detailed estimate of about $3 million, including a $500,000 allowance for overruns, was about 50 percent lower than Ernst & Young’s estimate of nearly $5.7 million. The contract appraiser for that property also believed that Ernst & Young’s estimate was excessive. He stated that the neighborhood’s standards and rental rates would not justify the renovation costs identified by Ernst & Young. When Ernst & Young adjusted its estimate by removing the replacement costs of items that had exceeded their useful life but were still in working condition, the revised estimate of $2.1 million was more in line with the property manager’s assessment of the property’s physical condition.

Another property manager said that Ernst & Young’s estimate was “grossly overstated and in no way accurately represent the condition of the property” because it did not appear to reflect a $2 million rehabilitation that was done in 1991 and 1992. While Ernst & Young estimated immediate deferred maintenance needs of $362,349 for this property, the manager said there were no deferred maintenance needs and the contract appraiser identified no deferred maintenance or other repairs needed for the property to compete in the marketplace. Ernst & Young’s adjusted estimate of the immediate deferred maintenance needs for this property was $128,535.

According to an official from the engineering firm retained by Ernst & Young, with whom we discussed the owners’ and managers’ assessments of Ernst & Young’s cost estimates, the owners’ cost estimates may be understated. He said, for example, that current owners may be less concerned than new investors with comparing their property to others in the surrounding market and may therefore not plan for some changes that new owners would want to make. He said the estimates used in Ernst & Young’s study represent the costs of meeting the standards of the industry and of the surrounding market.

Other comments provided by owners and property managers and our review of the estimates indicated that Ernst & Young’s estimates may not take into account all of the ongoing maintenance at the properties, such as the cyclical replacement of carpets and other unit items, preventive maintenance performed under contracts, recent improvements, and improvements that were under way at the time of Ernst & Young’s inspections. For example, one manager said that Ernst & Young’s study did not reflect the actual condition of the property’s heating and air-conditioning systems because it included the full replacement cost of $253,000 for the heating system in its estimate of the property’s immediate deferred maintenance needs. However, the manager noted that when the engineering firm retained by Ernst & Young inspected the property in January 1996, the system’s renovation was well under way. The manager said the renovated heating system has a life expectancy of 30 years. According to Ernst & Young, this difference occurred because the study used a “point-in-time” methodology. This approach included only improvements that had been substantially completed at the time of the inspection and specifically excluded those that were planned or ongoing. Consequently, even though the inspector noted that work on the heating system was occurring in most units and would be completed within 2 months, the estimate does not reflect this work because it was not substantially completed.

We identified some additional limitations in Ernst & Young’s approach that may affect the accuracy of the firm’s capital needs estimates. For example, officials from Ernst & Young and the engineering firm acknowledged that although they intended to base these estimates on inspections of 10 percent of each property’s randomly selected units, they were not always able to do so because of management, tenant, or timing considerations. At 7 of the 10 case study properties, Ernst & Young’s inspectors examined fewer than 10 percent of the units. Also, Ernst & Young calculated cost estimates for unit items, such as cabinets, appliances, and heating and air-conditioning components, by multiplying the estimated immediate cost per unit by the total number of units at the property. However, in some cases this approach may not have been reliable because of differences among units. For example, at one of the case study properties, which has 112 apartments with kitchens and 92 assisted living units without kitchens, Ernst & Young’s estimate of the property’s immediate deferred maintenance needs included the costs of replacing kitchen cabinets in all of the units.

Questions Exist About Some Assumptions That Can Affect the Study’s Results

Through our discussions with representatives of multifamily housing lending organizations and other multifamily housing industry officials and through our own analysis, we identified some assumptions used in the financial model that may not (1) reflect the way in which insured Section 8 properties would actually be affected by portfolio reengineering or (2) be apparent to readers of Ernst & Young’s May 1996 report but are important to understanding the study’s results.

Ernst & Young’s assumptions about the transition period for reengineered properties may be overly optimistic. During this period, a reengineered property changes from an assisted property with rental subsidies linked to its units to an unsubsidized property competing in the marketplace for residents. The model estimates that the entire transition will be completed within a year after the first Section 8 contract expires. In addition, the model assumes that during this year, the property’s rental income will move incrementally towards stabilization over 9 months. The lenders with whom we discussed the reasonableness of the model’s major assumptions considered a transition period of 1 to 2 years more likely. They also anticipated a less stable transition than the model assumed, with less income and more costs. An Ernst & Young official told us that the 9-month period was designed to reflect an average transition period for reengineered properties. While recognizing that the transition period for some properties would be longer, he believed that for others it could be shorter. In Ernst & Young’s financial model, the first test of a loan’s performance under portfolio reengineering assumes the elimination of the interest subsidy that many older assisted properties currently receive. Specifically, the model compares the net operating income under market rents with the current debt service, excluding any interest subsidy provided with the current loan. This assumption puts fewer loans in the performing category than would appear there if the subsidies were assumed to continue. According to Ernst & Young, the model excludes the current interest subsidies under portfolio reengineering because it assumes that subsidies would not exist under true market conditions. However, such an assumption implies a change in the terms of loans to which both borrowers and lenders have agreed. Hence, while this assumption might be appropriate for restructuring loans on which defaults would occur if the terms of the loans were not changed, it is not, in our view, appropriate for identifying the loans that need restructuring. As long as the borrowers continue to meet the terms of these loans, HUD cannot, as an official indicated, unilaterally discontinue the interest subsidy payments on them. Typically, the interest subsidies reduce interest payments on the loans to 1 percent. If Ernst & Young’s model assumed that interest subsidies would continue, some additional properties would be classified as performing. This change would decrease the model’s estimates of the claims costs associated with portfolio reengineering but would entail the Department’s continuing to incur interest subsidy costs.

The debt service coverage ratios, loan-to-value ratios, and amortization periods used in the model provide for higher levels of mortgage debt than the lenders we contacted generally understood to be available. If their understanding is correct, the model’s assumptions would provide for lower claims than might actually result. For example, the lenders we contacted generally believed that most lenders would want to see at least 1 year’s worth of operations at the stabilized level before approving a loan. Without such a stabilized period of operations, they believed, many commercial lenders would consider the properties too risky to provide long-term commercial financing at standard terms. Some officials believed that venture capital firms might be the only firms interested in properties whose operations had not stabilized after reengineering. In any case, they believed that the financing terms available for reengineered properties without proven track records would be more conservative than standard financing terms. The lenders believed that the 1.20 debt service coverage ratio and the 1.0 loan-to-value ratio used in the model would not likely be available for loans on many reengineered properties, particularly given the uncertainties concerning (1) how these properties would operate in a market-rate environment and (2) whether, what type of, and what levels of Section 8 assistance would be available in the future. They believed that higher debt service coverage ratios and lower loan-to-value ratios would be more likely. In addition, they believed that 30-year loan amortizations might not be available. The lenders indicated that 25-year loan amortizations were typical for commercial loans. In commenting on the views of the lenders we contacted, an Ernst & Young official stated that the underwriting criteria would take into account not only the debt service coverage and loan-to-value ratios and the amortization periods but also the level of capital provided through the short-term capital needs estimates and annual replacement reserves, as well as the interest rates, operating expenses, and revenues estimates. He believed that these factors would provide lenders with more comfort about the ability of properties to make the transition to a market environment. When obtaining the views of the lenders, we provided them with information on the full range of underwriting assumptions used by Ernst & Young, including those relating to the funding for capital needs, interest rates, revenues, and operating expenses. The Ernst & Young official also noted that Ernst & Young’s terms assumed the Congress would continue to subsidize residents with Section 8 tenant-based assistance under a multiyear program. Finally, the Ernst & Young official noted that the financial model used 1.0 as a loan-to-value ratio so that the model would calculate the mortgage amounts for reengineered properties on the basis of their debt service coverage ratios rather than their loan-to-value ratios.

The model assumes that replacement reserves must cover the estimated annual replacement costs for all major property systems. In contrast, the lenders we spoke with generally require replacement reserves for capital items for a set period of time—such as over the life of the loan or over the life of the loan plus 2 years. Thus, Ernst & Young’s approach requires higher replacement reserves than the private sector may require. The requirements for replacement reserves affect annual cash flows and the funding available to support mortgage debt. For example, in Ernst & Young’s study, if a property’s hot water systems were evaluated to have a remaining useful life of 25 years, the annual replacement reserve would include prorated amounts for the full cost of replacing the hot water systems. However, if the restructured loan were for 15 years, the lenders we spoke with believed that annual funding for replacing the hot water systems typically would not be required. Some replacement reserve items funded in Ernst & Young’s study, such as walls and foundations and parking lots, have useful lives of more than 50 years.

The Section 8 costs for reengineering are estimated only for the residents who currently receive Section 8 project-based assistance. In contrast to HUD’s original proposal, which was the basis of Ernst & Young’s study, HUD’s current proposal includes the residents who do not receive Section 8 project-based assistance but would qualify for assistance when market rents were applied.

Sensitivity Analysis Can Assist in Evaluating the Range of Possible Outcomes

Any estimates of the outcomes and costs of portfolio reengineering are likely to be subject to some error because they rely on predicting the reactions of numerous owners, lenders, and residents. In addition, as discussed above, some assumptions used in Ernst & Young’s financial model may not accurately reflect the effects of portfolio reengineering on insured Section 8 properties or, at a minimum, are subject to debate. To assess the extent to which the use of different assumptions affects the results of Ernst & Young’s study, we performed sensitivity analyses of Ernst & Young’s model using two sets of revised assumptions that we developed through our discussions with multifamily housing industry officials. One scenario reflects assumptions that are more optimistic in terms of the cost to the government of portfolio reengineering. The other uses assumptions that are more conservative or pessimistic. Taken together, these sets of assumptions are intended to reflect the range of potential outcomes resulting from the basic policy assumptions used in Ernst & Young’s study. We recognize that using alternative policy assumptions could produce different outcomes.

Appendix IV provides information on the assumptions used in Ernst & Young’s study and in our optimistic and pessimistic analyses. Because the owners and managers and the contract appraisers generally believe that the capital costs for the 10 case study properties were significantly lower than those Ernst & Young estimated, we reduced all capital costs used by Ernst & Young by 25 percent in our optimistic scenario. We did not adjust Ernst & Young’s capital costs in the pessimistic scenario.

As table 2.7 indicates, under both the optimistic and the pessimistic alternatives, as well as under Ernst & Young’s original assumptions, a substantial number of properties are likely to do well and other properties will have difficulty sustaining operations. For example, under the optimistic assumptions, between 24 and 30 percent of the properties fall into the performing category, but between 15 and 20 percent fall into the two bottom categories—full write-off or nonperforming. Under the pessimistic assumptions, between 10 and 14 percent are in the performing category and between 39 percent and 46 percent are in the full write-off or nonperforming category.

As table 2.8 indicates, the cost of FHA insurance claims associated with portfolio reengineering are estimated to be between $4.9 billion and $5.9 billion under optimistic assumptions and between $8.2 billion and $9.4 billion under pessimistic ones. Because we used the same market rents for our optimistic scenario as Ernst & Young assumed, the 10-year costs of Section 8 assistance are the same. However, the 5-percent reduction in rents assumed in the pessimistic scenario lowered these 10-year costs by between $0.9 billion and $1.0 billion.

As previously discussed, these subsidy estimates assume that loans are restructured when their first Section 8 contract expires. However, as noted, HUD is now proposing a proactive approach under which owners would agree to restructure their loans before the first Section 8 contract expires. In addition, HUD is proposing to initially restructure only loans for properties whose assisted rents exceed market rents, thereby providing for decreases in subsidies.

Conclusions

Although questions have arisen about some of the data and assumptions used in Ernst & Young’s study, we nevertheless believe that the study represents an important step in understanding the effects of reengineering on and the condition of the properties in HUD’s insured Section 8 portfolio. Quantitative, statistically reliable information based on case-by-case analyses of the properties, such as that produced by the study, can assist the Congress in evaluating HUD’s proposal and comparing it to other reengineering alternatives.

As the Congress and HUD continue to address issues associated with portfolio reengineering (see ch. 3), we believe that opportunities exist for HUD to make further use of Ernst & Young’s data and to carry out additional analyses of the insured Section 8 portfolio. One important task will be to incorporate the results of Ernst & Young’s study into HUD’s budget estimates under portfolio reengineering. Other areas that merit additional analysis are the effects of including or excluding various segments of the portfolio in reengineering; the cost implications of continuing versus discontinuing FHA’s insurance after reengineering and of using project-based versus tenant-based assistance; and the options for dealing with those properties that fall into the nonperforming or full write-off categories after reengineering. In addition, given the uncertainties about the capital costs used in the study, further analysis of the physical condition and related capital needs of the insured Section 8 portfolio is needed. The update to HUD’s 1990 multifamily stock study, currently under way, should help to address this open issue.

Agency Comments and Our Evaluation

In commenting on a draft of this report, HUD said the report provided an excellent summary of the portfolio reengineering proposal and its likely impact on the insured multifamily portfolio. HUD also noted, among other things, that differences in the estimates of deferred maintenance and capital needs developed by Ernst & Young and by the contract appraisers are due to differences in the methodologies used. (HUD’s comments are reproduced in app. VI). While agreeing that differences in the estimates are due, in part, to differences in the methodologies, we continue to question certain aspects of Ernst & Young’s approach, including (1) the assumption that working systems and components will be replaced if their estimated useful lives have expired and (2) the inclusion in the capital needs estimates of the cost of work that is under way but not yet completed. The fact that Ernst & Young’s estimates for 7 of the 10 case study properties that GAO reviewed were based on inspections of fewer than 10 percent of each property’s units also adds to the uncertainty of the estimates. For these reasons, as noted in our conclusions, we believe that further analysis is needed of the physical condition and capital needs of the insured Section 8 portfolio.

HUD’s comments also indicate that HUD inferred from the comments provided by the lenders we contacted that they were not fully informed of the methodology and assumptions used in the Ernst & Young model. In fact, we provided the lenders we spoke to with information on the full range of underwriting assumptions used by Ernst & Young.

In addition, HUD commented that the estimated costs of restructuring HUD’s multifamily portfolio that we derived from Ernst & Young’s model do not conform with federal budget rules and scoring methodology and do not reflect all aspects of HUD’s current portfolio reengineering proposal. As stated in the report, the data we present on the cost of restructuring HUD’s multifamily portfolio are intended to reflect the results of Ernst & Young’s financial model, including the assumptions used by Ernst & Young. We recognize that the cost estimates do not conform with federal budget rules and scoring methodology and do not reflect all aspects of HUD’s current portfolio reengineering proposal. Both of these points are discussed earlier in the chapter and were clearly stated in the copy of the draft provided to HUD for comment.

Key Issues Facing the Congress on HUD’s Portfolio Reengineering Proposal

The Congress faces a number of significant and complex issues in evaluating HUD’s portfolio reengineering proposal. How these issues are resolved will, to a large degree, determine the extent to which the problems that have long plagued the portfolio are corrected and prevented from recurring, as well as the extent to which restructuring results in savings or costs to the government. Key issues include the following: To what extent should FHA provide insurance for restructured loans? Should rental assistance be project-based or tenant-based? What protection should be given to households at reengineered properties? To what extent should the federal government finance the costs of rehabilitation? What actions should be taken to address problems in HUD’s management of the insured Section 8 portfolio? To what extent should properties with assisted rents below market rents be included in portfolio reengineering? What processes should be used to restructure mortgages? What should be done to help the large number of properties that would have difficulty sustaining operations? To what extent should the government provide tax relief to owners affected by portfolio reengineering? Will the recently enacted portfolio reengineering demonstration program cover the full range of options and outcomes?

To What Extent Should FHA Provide Insurance for Restructured Loans?

An issue with short- and long-term cost implications is whether HUD should continue to provide FHA insurance for the restructured loans and, if so, under what terms and conditions. If HUD were to discontinue the insurance when restructuring the loans, as it originally planned, it would likely incur higher debt restructuring costs because lenders would set the terms of the new loans (e.g., interest rates) to reflect the risk of default that they would now assume. The primary benefits of discontinuing FHA insurance are that (1) the government’s dual role as mortgage insurer and rental subsidy provider would end, eliminating the management conflicts associated with this dual role, and (2) the risk of default borne by the government would end as the loans were restructured.

If FHA insurance were continued, another issue is whether it would need to be provided for the whole portfolio or could be used selectively. The government could, for example, insure loans only when owners could not obtain reasonable financing without insurance. Also, if FHA insurance were continued, the terms and conditions under which it is provided would affect the government’s future costs. Some lenders have indicated that short-term (or “bridge”) financing insured by FHA might be needed while the properties make the transition to market conditions, after which time conventional financing at reasonable terms would be available. Under such an arrangement, the government could insure loans for 3 to 5 years, instead of bearing the risk of default, as it now does, for the life of the loans—generally 40 years. Finally, legislation could require a portion of the risk of default, now borne entirely by the government, to be assumed by state housing finance agencies or private-sector parties.

Should Rental Assistance Be Project-Based or Tenant-Based?

One of the key issues to be decided in addressing the problems of the insured Section 8 portfolio is whether to continue project-based subsidies, convert the portfolio to tenant-based assistance, or combine the two types of assistance. On the one hand, using tenant-based assistance can make projects more subject to the forces of the real estate market, potentially helping to control housing costs, foster housing quality, and promote residents’ choice. On the other hand, using project-based assistance, which links subsidies directly to rental units, can help sustain properties in housing markets that have difficulty supporting unsubsidized rental housing, such as inner-city and rural locations. In addition, residents who would likely have difficulty finding suitable alternative housing, such as the elderly or disabled and those living in a tight housing market, might prefer project-based assistance to the extent that it would give them greater assurance of being able to remain in their current residence.

What Protection Should Be Given to Currently Assisted Households?

If a decision is made to convert the Section 8 program from project-based to tenant-based assistance as part of portfolio reengineering, decisions must also be made about whether to protect the current residents from displacement. HUD’s April 1996 reengineering strategy contains several plans to protect the residents affected by rent increases at insured properties. For example, the residents of Section 8 units that were converted from project-based to tenant-based assistance would receive an enhanced voucher to pay the difference between 30 percent of their household’s adjusted income and the market rent for their unit even if the market rent exceeded the area’s fair market rent ceiling. The residents of reengineered properties who live in units without project-based subsidies would receive similar assistance if reengineering increased their rent to more than 30 percent of their household’s adjusted income. Such provisions would limit residents’ rent burden and reduce the likelihood of displacement, but they would also lower the anticipated savings in assistance costs, at least in the short run. The cost estimates in Ernst & Young’s report assume that HUD would continue to assist the residents of currently subsidized units even if the market rent exceeded the fair market rent set by HUD. However, the report’s cost estimates do not include any allowance for assisting the residents of currently unsubsidized units.

To What Extent Should the Government Finance Rehabilitation Costs?

Who should pay for needed repairs, and how much, is another important issue in setting restructuring policy. As discussed previously, Ernst & Young’s study found substantial unfunded immediate deferred maintenance and short-term capital replacement needs across the insured Section 8 portfolio, particularly among the older assisted properties. Ernst & Young’s data indicate that between 22 and 29 percent of the properties in the portfolio could not cover their immediate deferred maintenance and short-term capital needs even if their mortgage debt were fully written off. HUD has proposed to use the affected properties’ reserve funds and, as necessary, claims against FHA’s insurance funds to pay for a substantial portion of the rehabilitation and deferred maintenance costs associated with restructuring. Others have suggested that HUD use a variety of tools— such as raising rents, restructuring debt, and providing direct grants—but that dollar limits be set on the federal government’s payment per unit, with the expectation that some other source, such as the owner or investor, will pay any remaining costs.

What Should Be Done to Address Problems in HUD’s Portfolio Management?

A key cause of the current problems affecting the insured Section 8 portfolio has been HUD’s inadequate management of the portfolio. As discussed in chapter 1, weaknesses in HUD’s oversight and management have allowed physical and financial problems at a number of the multifamily properties insured by HUD to go undetected or uncorrected.HUD’s original proposal sought to address these problems by subjecting the properties to the disciplines of the commercial market by converting project-based subsidies to tenant-based assistance; adjusting rents to market levels; and refinancing existing insured mortgages with smaller, uninsured mortgages, if necessary, for the properties to operate at the new rents. However, to the extent that the final provisions of reengineering perpetuate the use of FHA insurance and project-based subsidies, HUD’s ability to manage the portfolio will remain a key concern. Other means will have to be found to address the limitations impeding HUD’s management of the portfolio, particularly in light of the planned staff reductions that will further strain HUD’s management capacity.

To What Extent Should Loans for Properties With Below-Market Rents Be Reengineered?

Deciding which properties to include in portfolio reengineering will likely involve trade-offs between reducing the high costs of subsidies, on the one hand, and improving the poor physical condition of the properties and lowering the government’s exposure to default, on the other hand. Reengineering only those properties with rents above market levels would produce the greatest savings in subsidy costs. Yet HUD has indicated that also including those properties with rents currently below market levels could help improve these properties’ physical and financial condition and reduce the likelihood of default. However, including such properties would decrease the estimated savings in Section 8 subsidy costs. Although HUD’s latest proposal would initially focus on properties with above-market rents, it notes that many of the buildings with below-market rents are in poor condition or have significant amounts of deferred maintenance that will need to be addressed at some point.

What Processes Should Be Used to Restructure Mortgages?

Selecting a mortgage restructuring process that is feasible and balances the interests of the various stakeholders will be an important but difficult task. Various approaches have been contemplated, including the payment of full or partial insurance claims by HUD, the sale of mortgages, and the use of third parties or joint ventures to design and implement specific restructuring actions at each property. Because of concerns about HUD’s ability to carry out the restructuring process in house, HUD and others envision relying heavily on third parties, such as state housing financing agencies or teams composed of representatives from these agencies, other state and local government entities, nonprofit organizations, asset managers, and capital partners. These third parties would be empowered to act on HUD’s behalf, and the terms of the restructuring arrangements that they work out could to a large extent determine the costs to, and future effects of restructuring on, stakeholders such as the federal government, property owners and investors, mortgage lenders, residents, and state and local government housing agencies. Some, however, have questioned whether third parties would give adequate attention to owners’ interests or to housing’s public policy objectives. Despite these questions, HUD believes that third-party arrangements could be structured to align third parties’ financial interests with those of the federal government to help minimize claims costs.

What Should Be Done to Address Properties That Have Difficulty Sustaining Operations?

According to Ernst & Young’s assessment, between 22 and 29 percent of HUD’s insured portfolio would have difficulty sustaining operations if market rents replaced assisted rents. Furthermore, between 11 and 15 percent of the portfolio would not even be able to cover operating costs at market rents. If these properties did not receive additional financial assistance, a large number of low-income residents would face displacement. While HUD has not yet developed specific plans for addressing the problems at these properties, different approaches may be needed, depending on the circumstances at individual properties. For example, properties in good condition in tight housing markets may warrant one approach, while properties in poor condition in weak or average housing markets may warrant another. Further analysis of these properties should assist the Department in formulating strategies for addressing their problems.

To What Extent Should the Government Provide Tax Relief to Owners?

HUD’s portfolio reengineering proposal would be likely to have tax consequences for the owners of some projects. These tax consequences could result either from reductions in the properties’ mortgage principal (debt forgiveness) or from actions that would cause owners to lose their property (for example, as a result of foreclosure). We have not assessed the extent to which tax consequences would be likely to result from portfolio reengineering. However, HUD has stated its belief that tax consequences could be a barrier to getting owners to agree to reengineer their properties proactively. While HUD has not formulated a specific proposal for dealing with the tax consequences of portfolio reengineering, it has expressed its willingness to discuss with the Congress mechanisms to take into account the tax consequences of debt forgiveness for property owners who enter into restructuring agreements.

How Comprehensive Will the Demonstration Program Be?

The multifamily demonstration program that HUD recently received congressional authority to implement provides for limited testing of some aspects of HUD’s multifamily portfolio reengineering proposal. Such testing can provide needed data on the effects of reengineering on properties and residents, the approaches that may be used in implementing restructuring, and the costs to the government before a restructuring program is initiated on a broad scale. However, because the program is voluntary, it may not test the full spectrum of effects that portfolio reengineering could have or the full range of restructuring tools that the Department could use. For example, owners may be reluctant to participate in the program if HUD plans to enter into joint ventures with third parties because they may be concerned about losing their properties and/or suffering adverse tax consequences. Another potential limitation of the program is that, according to HUD, the funding provided to modify the multifamily loans may not be sufficient to cover the limited number of units authorized under the demonstration program. In September 1996, the Congress made changes to the demonstration program in legislation on HUD’s fiscal year 1997 appropriation (P.L. 104-204).

Observations

HUD’s portfolio reengineering initiative recognizes a reality that has existed for some time—namely, that the value of many of the properties in the insured Section 8 portfolio is far lower than the mortgages on the properties suggest. Until now, this reality has not been recognized and the federal government has continued to subsidize the rents at many properties above the level that the properties could command in the commercial real estate market.

As the Congress evaluates the options for addressing this situation, the fundamental problems that have affected the portfolio and their underlying causes will be important to consider. Any approach that is implemented should address not only the high costs of Section 8 subsidies but also the government’s high exposure to insurance loss, the poor physical condition of some of the properties, and the underlying causes of these long-standing problems with the portfolio. As the previous discussions of several key issues indicate, questions about the specific details of the reengineering process, such as which properties to include and whether or not to provide FHA insurance, will require weighing the likely effects of various options and the trade-offs involved when a proposed solution achieves progress in one area at the expense of another. Changes to the insured Section 8 portfolio should also be considered in the context of a long-range vision of the federal government’s role—and the size of that role, given the current budgetary climate—in providing housing assistance, and assistance generally, to low-income individuals.

Addressing the problems of HUD’s insured multifamily portfolio will inevitably be costly and difficult, regardless of the specific approaches implemented. The overarching objective should be to implement the process as efficiently and cost-effectively as possible, recognizing not only the interests of the parties directly affected by restructuring but also the impact on the federal government and the American taxpayer.