As shown in figure 1, expenditures for the section 515 program increased throughout the 1970s, peaked in 1979, and fell sharply after that. In recent years, the program has received about $115 million annually and has allocated $55 million for new construction, $55 million for rehabilitation, and $5 million for equity loans. The president’s budget for fiscal year 2003 proposes to eliminate the new construction funding. The number of units added to the portfolio each year has followed the funding curve. During the peak funding years, over 20,000 new units were added to the portfolio annually. Fewer than 5,000 new units have been produced annually since 1995. In 1998, RHS created the Office of Rental Housing Preservation to administer the prepayment program. Mandated in the Housing and Community Development Act of 1992, the office’s tasks include improving the effectiveness and integrity of the agency’s prepayment and preservation processes. As of fiscal year 2001, the average size of an RHS property was 27 units. About 8 percent of the properties, comprising about 5 percent of the units, were owned by small operators, often families, while most of the other properties had a more complex ownership structure—typically a managing partner, who owned 5 percent of the property, and many limited partners with smaller shares. About half of the section 515 units receive RHS rental assistance, which makes up the difference between 30 percent of the assisted household’s income and the unit’s rent. About 14 percent of section 515 units have HUD project or tenant-based section 8 rental subsidies, which cover the difference between tenants’ payments and fair-market rents, as determined by HUD on the basis of an annual survey of rents in over 2,700 market areas. Therefore, in those areas where fair-market rents are typically higher than the rents approved by RHS, section 515 properties with section 8 assistance usually generate more income for the owners. Both RHS and HUD provide project-based rental assistance, meaning that the assistance stays with the unit. HUD’s section 8 voucher program provides tenant-based vouchers, meaning that the assistance stays with the tenant and is portable—households can use vouchers to rent any affordable units that meet HUD’s housing quality standards. In the program’s early years, it was expected that the original loans, which are amortized over 40 or 50 years, would be refinanced before major rehabilitation was needed. However, with prepayment restrictions and limited rental assistance and rehabilitation funds, this original expectation has not been realized. To maintain the properties in good condition, RHS relies on owners to put aside funds in a reserve account. RHS requires borrowers to place 1 percent of the original cost of the properties into the reserve account each year for the first 10 years until 10 percent is held in reserve. The borrower must continue to make contributions to the reserve account to maintain it as withdrawals are made against the account to fund rehabilitation work. RHS is concerned about the adequacy of funding reserves at only 1 percent per year for 10 years and how to determine exactly what must be done on an ongoing basis to preserve each property. While owners are required to set aside a portion of their rent revenue in a reserve account to provide for modernization needs, these reserve accounts have often not been large enough to adequately provide for major rehabilitation. Concerns about the loss of affordable units led Congress to enact legislation designed to keep section 515 properties in the portfolio and to protect low-income tenants from being displaced. Figure 2 details the key legislation. The legislation restricting prepayment of section 515 loans has resulted in litigation. Owners of section 515 properties who wished to prepay the loan pursuant to their original loan agreements and remove their properties from the section 515 program have sued the federal government. The owners claim that the federal government, with the enactment of the legislation and the subsequent refusal by RHS to accept unfettered prepayment, committed a breach of contract and an unconstitutional taking of their properties. The federal government maintains that no such breach occurred. To date, prepayment activity has been minimal. Over 4,550 new properties entered the portfolio since the 1988 prepayment restrictions went into effect. This number far exceeded the number of properties that left the portfolio after prepayment. For example, RHS data for fiscal years 1998 through 2001 show that fewer than 100 properties, on average have left the portfolio each year. Fiscal year 2001 is the only year when the number of prepayments exceeded the number of properties added to the portfolio. However, this exception reflects a decline in funding rather than an increase in prepayments. RHS officials noted that prepayment requests were particularly limited in 1995 after an RHS administrative notice, citing an application processing backlog and limited funding, resulted in discouraging owners from applying for prepayment. Since 1988, the impact of prepayment has been minimized by a statutory restriction on owners who prepay by stipulating that, under certain circumstances, the rents for tenants not be increased for as long as they remain in the units. During fiscal years 1999 through 2001, the owners of 283 properties prepaid their loans. Following prepayment, 86, or about 30 percent, of these properties left the program without restrictions because RHS determined that these properties were not needed in the market area and their departure would not adversely affect housing opportunities for minority households. The loans for 197, or about 70 percent, of the properties were prepaid with restrictions on the rents of RHS-assisted households that would remain in effect as long as these households continued to reside in the properties. The owners of 88 other properties applied for prepayment but decided, instead, to accept RHS incentives to stay in the program for 20 more years. Table 1 shows the prepayments by fiscal year. If the statutory requirement covering loans made before December 15, 1989, were changed to allow prepayment without restriction after 20 years from the date of the loan, we estimate that prepayment could be an option for the owners of 3,872, or about 24 percent, of the 16,366 section 515 properties. This estimate is based on our analysis of three factors that we could measure and that RHS and industry representatives agree would limit the potential for prepayment and conversion to market-rate rents. However, a number of economic constraints on individual properties, which we could not readily measure, would be likely to limit the number of actual prepayments even further. Nevertheless, despite these potential constraints, RHS officials are concerned that owners who are dissatisfied with RHS’s procedures and statutory requirements could apply to leave the program if the opportunity arose even if prepayment were not economically advantageous. As shown in Figure 3, as of January 1, 2002, there were 3,772 section 515 properties that had served low-income households for 20 years or were financed before 1979 and were never subject to a 20-year low-income use restriction. In our analysis, we found that owners of 946 of these properties could consider applying for prepayment. The loans on another 6,457 properties were eligible for prepayment; however, the properties were still subject to a 20-year use restriction expiring between January 1, 2002, and December 15, 2009. We also found that over the next 8 years owners of 2,926 of these properties would be able to consider prepayment after they meet the 20-year restriction. The loans made on 6,137 properties on or after December 15, 1989, were not eligible for prepayment because the statute in effect when the loans were made precluded prepayment. Our estimate of the number of properties whose owners could consider prepaying is based on three factors that RHS and industry representatives believe limit the potential for prepaying. These factors are as follows: Ownership by a nonprofit organization or public entity. Prepaying mortgages in an attempt to gain financially through converting to market- rate rents could conflict with these organizations’ basic mission of providing high-quality, affordable housing for low-income families. Heavy dependence on RHS rental assistance that would cease upon prepayment. Industry experts and RHS officials in headquarters and the states we visited emphasized that, except in areas where growth has brought unexpected prosperity, high dependence on RHS rental assistance is a strong indicator that a property would have a difficult time maintaining adequate cash flow without such assistance. Location in a county where the population declined in the 1990s. Such properties most likely would not be able to obtain significantly higher rents in the private market than they are receiving under federal subsidies because the relative lack of population growth reduces demand for housing and keeps rents from rising. After adjusting for these factors, we determined that the owners of 3,872 properties, or 24 percent of the total properties, could consider prepaying their loans. The number of loans that actually would be prepaid depends on several property-specific factors that we could not readily measure. Factors affecting prepayment potential include whether individual property owners (1) could operate without the subsidized direct loans, (2) had property located in areas where high rental demand has raised market rents above RHS rents, (3) had the funds or financing to meet future capital needs, and (4) could meet any tax requirements they would incur. For example, in 1986, tax laws were changed to eliminate accelerated depreciation. Owners who entered the program before the 1986 tax law change enjoyed the benefits of accelerated depreciation by annually writing off a larger portion of the original value of the property on their tax return than was permissible after the tax law change. In some cases, owners have fully depreciated their property, leaving them a zero cost basis, instead of the original value of the property, when determining their capital gains liability. While these owners enjoyed the write-off benefits associated with the tax savings, their current tax burden can significantly reduce the remaining proceeds. As a result, some owners are staying in the program to avoid the tax consequences.