Young's study and other issues associated with portfolio reengineering, and we will look
forward to sharing the results of our work with the Subcommittee as it is completed.
GAP'S 10 CASE STUDY PROPERTIES
Fi gure 1.1: Names and Locations of Case Study Properties
St. Andrews ManoT
Jacltie Robinson Gai;,den
San Francisco, Callfoi
Fannie £) Taylpr Home for the Aged
APPENDIX II APPENDIX II
SENSITIVITY ANALYSIS HELPS EVALUATE
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, we have identified some
limitations of the model and some assumptions that may not reflect the way in which
insured Section 8 properties will actually be affected by portfolio reengineering. To
assess the extent to which the use of different assumptions affects the results of Ernst «S:
Young's study, we performed sensitivity analyses of Ernst & Young's model using two sets
of revised assumptions that we developed on the basis of our discussions with multifamily
industry officials. One scenario reflects assumptions that jire more optimistic
in terms of the cost to the government of portfolio reengineering. The other uses
assumptions that are more conservative or pessimistic. Both of these sets of assumptions
are intended to reflect the range of potential outcomes using the same basic policy
assumptions used in the Elmst & Young study. We recognize that the use of alternative
policy assumptions can produce different outcomes.
For the optimistic scenario, we used financing terms that the lenders we consulted
beheved to be the most favorable that were Ukely to be available, assuming that no FHA
insurance or other credit enhancement is provided. For example, we lowered the range
of interest rates appUcable to the restructured loans fi-om a range of 9.75 to 10 percent to
a range of 8.75 to 9 percent We also revised the debt service coverage ratios, the loan-to-
value requirements, and the loan amortization periods to reflect the views of the lenders.
In some cases, our terms, though viewed by lenders as optimistic, are more conservative
than Ernst & Young's. In addition, a significant difference between our optimistic
scenario and Ernst & Young's analysis is that we reduced all capital costs used by Elmst
& Young by 25 percent
APPENDIX II APPENDIX II
For our pessimistic scenario, we used higher interest rates than Ernst & Young, set higher
standards for debt service coverage ratios and loan-to-value requirements, and increased
the transaction cost and bad debt expense estimates somewhat. We also reduced Ernst
& Young's market rent estimates by 5 percent. We did not ac^ust the capital cost
estimates used in Ernst & Young's study for this scenario.
Under all the scenarios, a substantial number of properties are likely to do well, and other
properties will have difficulty sustaining operations. Specifically, using optimistic
assumptions, between 24 percent to 30 percent of properties fall into the "performing"
category, but between 15 percent and 20 percent fall in the two bottom categories-"full
write-off' or "nonperforming." Using the pessimistic assumptions, between 10 and 14
percent would be "performing" and between 39 percent and 46 percent would be "full
write-offs" or "nonperforming." The FHA claims costs associated with portfoUo
reengineering are estimated to be between $4.9 billion and $5.9 billion using optinustie
assumptions and between $8.2 billion and $9.4 billion using pessimistic ones. The Section
8 subsidy costs are the same as Ernst & Young's using our optimistic assumptions.
Section 8 subsidy costs decrease somewhat using our pessimistic assimxptions, where we
reduced the estimated market rents by 5 percent
APPENDIX III APPENDIX III
ISSUES FACING THE CONGRESS IN ASSESSING
HUD'S PORTFOLIO REENGINEERING PROPOSAL
The Congress faces a number of significant and complex issues in evaluating HUD's"
portfolio reengineering proposal. Key issues include the following.
How to Address HUD's Problems in Managing the Insured Section 8 Portfolio
One key cause of the current problems affecting the insured Section 8 portfolio has been
HUD's inadequate management of the portfolio. HUD's original proposal sought to
address this situation by subjecting 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 necessEiry for properties to operate at the new rents. However, to the extent
that the final provisions of reengineering perpetuate the current system of FHA insurance
and project-based subsidy, HUD's ability to manage the portfoUo will remain a key
concern. Thus, it will be necessary to identify other meaiis of addressing the limitations
that impede HUD's ability to effectively manage the portfolio, particularly in Ught of the
planned staff reductions that will further strain HUD's management capacity.
To What Extent Should FHA Insurance Be Provided for Restructured Loans?
An issue with short-term-and potentially long-term-cost implications is whether HUD
should continue to provide FHA insurance on the restructured loans and, if so, under
what terms and conditions. If FHA iiisurance is discontinued when the loans are
restructured as originally planned, HUD would likely incur higher debt restructuring costs
because lenders would set the terms of the new lojms, such as interest rates, to reflect
the risk of default that they would now assume. The primary benefits of discontinuing
APPENDIX III APPENDIX III
insurance are that (1) the government's dual role as mortgage insurer and rent subsidy
provider would end, eliminating the management conflicts associated with this dual role,
and (2) the default risk borne by the government would end as loans were restructiu-ed.
However, the inunediate costs to the FHA insurance fund would be higher than if
insurance and the government's liability for default costs were continued.
If, on the other hand, FHA insurance were continued, another issue is whether it needs to
be provided for the whole portfolio or could be used selectively. For example, should the
goverrunent insure loans only when owners cannot obtain reasonable financing without
this credit enhancement? Also, if FHA insurance were continued, the terms and
conditions under which it is provided would affect the govermnent's future costs. Some
lenders have indicated that short-term (or "bridge") financing insured by FHA may be
needed while the properties transition to market conditions, after which time
conventional financing at reasonable terms would be available. Thus, the goverrunent
could insure loans for 3 to 5 years, in Ueu of the current practice of bearing default risk
for 40 years. Finally, the current practice of the government's bearing 100 percent of the
default risk could be changed by legislation requiring state housing finance agencies or
private-sector parties to bear a portion of the insurance risk.
Should Rental ^\ssistance Be Proiect-Based or Tenant-Based
In addressing the problems of the insured Section 8 portfolio, one of the key issues that
will need to be decided is whether to continue project-based assistance, convert the
portfolio to tenant-based subsidy, or use some mix of the two subsidy types. On one
hand, the use of tenant-based assistance can make projects more subject to the forces of
the real estate market, which can help control housing costs, foster housing quality, and
promote resident choice. On the other hsuid, by linking subsidies directly to property
units, project-based assistance can help sustain properties in housing markets that have
APPENDIX III APPENDIX III
difficulty in supporting unsubsidized rental housing, such as inner-city and nu-al locations.
In addition, those residents who would likely have difficulty finding suitable alternative
housing, such as the elderly or disabled and those hving in tight housing markets, may
prefer project-based assistance to the extent that it gives them greater assurance of being
able to remain in their current residences.
What Protection Should Be Given to Households at Reengineered Properties
If a decision is made to convert Section 8 assistance fi-om project-based to tenant-based
as part of portfoho reengineering, decisions must also be made about whether to provide
additional displacement protection for current property residents. HUD's April 1996
reengineering strategy contains several plans to protect residents affected by rent
increases at insured properties. For example, residents currently living in project-based
Section 8 units that are converted to tenant-based subsidy would receive enhanced
vouchers to pay the difference between 30 percent of their income and the market rent
for the property in which they live, even if it exceeds the area's fair market rent ceiling.
The residents of reengineered properties who currently live in units without Section 8
subsidy would receive similar assistance if the property's new rents require them to pay
more than 30 percent of income. Such provisions are clearly important to help limit
residents' rent burdens and reduce the likelihood of residents being displaced, but they
also reduce Section 8 savings, at least in the short run. The E]rnst & Young study's cost
estimates assume that HUD would cover Section 8 assistance costs for existing residents,
even if a property's market rents exceed fair market rent levels set by HUD. However, it
does not include any costs for providing Section 8 subsidy to residents who are currently
APPENDIX III APPENDIX III
To What Extent Should Properties With Assisted Rents Below Local Market Rents Be
Included in Portfolio Reengineering
The decision about which properties to include in portfolio reengineering will likely
involve trade-offs between addressing the problem of high subsidy costs and addressing
the problems of poor physical condition and exposure to default. On one hand,
reengineering only those properties with rents above market levels would result in the
greatest subsidy cost savings. On the other hand, 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 hkelihood of default.
However, including such properties would decrease estimated Section 8 subsidy cost
savings. Although HUD's latest proposal would irutially focus on properties with rents
above market, it notes that many of the buildings with below-market rents are in poor
condition or have sigruficant amounts of deferred maintenance, which will need to be
addressed at some point.
What Process or Processes Should Be Used to Restructure Mortgages
Selecting a mortgage restructuring process that is feasible and that balances the interests
of the various stakeholders will be an important, but difficult, task. Various approaches
have been contemplated, including payment of full or psirtial insurance claims by HUD,
mortgage sales, 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 (HFAs) or teams composed of
representatives from HFAs, 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
APPENDIX III APPENDIX III
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
the interests of owners or to the public policy objectives of the housing. On the other
hand, with the proper incentives, third parties' financial interests could be aligned with
those of the federal government to help minimize claims costs.
To What Extent Should the Federal Government Finance Rehabilitation Costs
Who should pay for needed repairs, and how much, is another important issue in setting
restructuring policy. As discussed previously, the Ernst & Young study found a
substantial amount of unfunded immediate deferred maintenance and short-term capital
replacement needs across the insured Section 8 portfolio, particularly in 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
proposes that a substantial portion of the rehabilitation and deferred maintenance costs
associated with restructuring be paid through the affected properties' reserve funds and
through FHA insurance claims in the form of debt reduction. Others have suggested that
HUD use a variety of tools, such as raising rents, restructuring debt and providing direct
grants, but that per-unit dollar Umits be set on the amount that the federal government
pays, with the expectation that any remaining costs be paid by the property
owners/investors or obtained from some other source.
APPENDIX III APPENDIX III
How Should HUD Address the Large Number of Properties That Would Have Difficulty
According to Ernst and 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 additional financial assistance is not provided to
these properties, a large number of low-income residents would face displacement. While
HUD has not yet developed specific plans for addressing these properties, it appears
likely that different approaches may be needed, depending on a property's specific
circumstances. 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 them.
To What Extent Should the Government Provide Tax
Relief to Owners Affected by Portfolio Reengineering
HUD's portfolio reengineering proposal is likely to have adverse tax consequences for
some project owners. These tax consequences can potentially result from either
reductions in the principal amounts of property mortgages (debt forgiveness) or actions
that cause owners to lose the property (for example, as a result of foreclosure). We
have not assessed the extent to which tax consequences are likely to result from portfolio
reengineering. However, HUD has stated that it believes tax consequences can 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 stated that it is willing to discuss with the Congress mechanisms to
APPENDIX III APPENDIX III
take into account tax consequences related to debt forgiveness for property owners who
enter into restructuring agreements.
Will the Demonstration Program Cover the Full Range of Options and Outcomes
The multifamily demonstration program that HUD recently received congressional
authority to implement provides for a limited testing (on up to 15,000 multifamily units) of
some of the aspects of HUD's multifamily portfoho reengineering proposal. As such, the
program can provide needed data on the impacts of reengineering on properties and
residents, the various approaches that may be used in implementing restructuring, and the
costs to the goveriunent before a restructuring program is initiated on a broad scale.
However, because of the voluntary nature of the program, it may not fully address the
broad range of impacts on the properties or the 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 third-party joint venture entities because of concerns
they may lose their properties and/or suffer adverse tax consequences. Another potential
limitation on the program is that the funding provided to modify the multifamily loans
may not be sufficient to cover the linuted number of units authorized under the
Mr. Shays. I want to begin this process by understanding a little
about — I want to share with you my sense of part of this challenge,
and then I want you to correct me, because I think I will need to
My sense was that the attitude of Congress years ago was that
we could create housing that would service the poor and that even-
tually this housing would revert to the private owners, who
would — and in a sense, we have increased the housing supply; each
year we would add to the housing supply, we would provide new
projects. In a certain period of time they would go into the private
sector, but we would constantly have this new flow of housing.
That is one sense that I had.
Another sense was that from the developers' standpoints, a num-
ber made an absolute killing by getting these contracts, getting
one — in a sense, a guarantee from the Federal Government they
would get certain tax write-offs from the State government, they
would be able to take out of the project on day one a significant
sum that they would then have as their own. They would get a
fairly large mortgage, go to HUD with the argument that this
mortgage needed to be — they needed a certain income level to pay
In other words, my sense is that the developers basically, not the
nonprofit developers but the private sector developers, some were
able to take out a lot early on, then during the course of the 20
years, maintain the property with very little income to themselves,
with the hope eventually that they would then be able to take over
these projects. That obviously is true in areas where they want to
take them over.
I can think of a site in downtown Stamford that is commercial,
that you could put a high-rise 14-story building on. As soon that
mortgage is paid off and they can take control of it, they are going
to tear it down and they are going to build a high-rise. I can think
of others in the district where nobody would want the project and
it would just revert to HUD.
Straighten me out: Once the mortgage is paid off, there is no
subsidy in the sense that HUD has to take care of — the mortgage
is paid for, but then you are stuck with a facility with people who
need a place to live and nobody wants to run the facility. Straight-
en me out, and I will ask the witnesses that follow to straighten
me out as well.
Ms. England- Joseph. I will start, and Rick and Christine can
help me out. I probably would use a slightly different tone in the
way I would describe
Mr. Shays. What is the other element? I was embarrassed to
even mention it, since I should know it. I had a year-long hearing
on it. When you get a tax credit that States could collect in terms
of credits, what do we call that?
Ms. England-Joseph. The low-income housing tax credit.
Mr. Shays. And they basically took advantage of the low-income
housing tax credit?
Ms. England-Joseph. There may be some properties that origi-
nally were section 236 properties or section 221(d)(3) properties
that ultimately sold to new owners, and during that process, tax
credits may have been
Mr. Shays. Only in that case. OK.
Ms. England- Joseph. But in this discussion we probably should
separate the low-income housing credit from the discussion.
In terms of Congress and the intent behind Congress and pre-
vious administrations with these programs, both what we call older
assisted programs that were developed in the early 1960's and then
what we call newer assisted, but not so new, that were built start-
ing in the mid-1970's the intent was largely what you are suggest-
ing, to increase the stock of available low-income housing for poor
people. But largely the intent was to have the private marketplace
come forward and provide that housing, build and finance that
housing, manage and own that housing; and the Government
was — through insurance and through various other activities, but
initially through FHA insurance — was intending to provide a credit
enhancement. It was intending to say, we know there is a risk here
and we want to insure that risk, but we don't want to be a part
of owning this property; we want the private marketplace to own
and manage it.
Mr. Shays. This happened while I was a State legislator in the
1970's. But in 1983 we discontinued this model, correct?
Ms. England-Joseph. In the sense that we have no properties
that were built after 1983 in these two programs.
Mr. Shays. My sense is that you would have to be an idiot not
to recognize that when the mortgage was due and someone was
free to take the property and do with it as they wanted, they would
have many different options. They could try to renegotiate with
HUD or try to go into the private sector, correct?
Ms. England-Joseph. Right. Although I think the intent behind
this was to maintain the stock for a long period of time, and that
is why there were section 8 project-based assistance that ultimately
were linked with these properties, with long contracts that were in
some cases 30-plus years in length. That was intended to try to
guarantee a stream of income into these properties so that the
property owner would see the benefit, obviously, of maintaining
this as a property for low-income populations.
The difficulty came in when these properties began to decline or
for many reasons, not the least of which was, when developers got
into these programs, there was a tax benefit, but the tax laws
changed and ultimately it wasn't the same benefit as existed when
they first entered this program.
In terms of tone, I wanted to be sure that I emphasized that the
way you were describing the role of developers and maybe why
they got into this program might imply some malice intent or some
ulterior motives, and I think other than perhaps financial benefit
in terms of tax benefits, there is really no indication from the work
that GAO has done that would say that largely developers went
into this because they were trying to bilk the Government. I think
there was serious intent on the part of many developers to provide
affordable, low-income, hopefully high-quality housing.
Mr. Shays. Let me, though, ask you, didn't they get a windfall
in the beginning years?
Mr. Hale. I think you are right, Mr. Chairman.
Mr. Shays. Be clear. The law is the law, and I am not saying
they broke the law. I am just saying that we had an absurd cir-
cumstance where people were able to take out a large sum in the
beginning and then they had to struggle to keep these projects op-
erating, even with the high rents that they received.
Mr. Hale. I think your point is a very important one. You are
right, a number of developers were able to make a substantial
amount of money. That is the way the program operated.
But the other half of that problem and the one that we face now
is that some of those same owners now do not have a lot of finan-
cial incentives to maintain the property. They have achieved a lot
of their benefits, and that places the Government in the difficult
situation of having mortgage insurance and potential defaults on
the one hand and continuation of section 8 subsidies on the other
Mr. Shays. Anything else before I go to Mrs. Morella? I am going
to come back but I want to make sure my sense is consistent with
your sense. I am exposing some of my ignorance, but in the proc-