Ratings

There are key differences that affect ratings on bonds supported by historical Section 8 contracts and the contracts HUD is entering into today, specifically appropriation risk, contract term and the rent increase mechanism. In the original program, Section 8 funding was typically set-aside at the outset of the contract for its entire term, significantly reducing appropriation risk. The term of the contract was often equal to bond maturity and termination risk was restricted to poor owner performance. Rents were originally increased according to an annual adjustment factor. In later years, HUD instituted rent ceilings, which had the impact of severely restricting, and even freezing, rent increases.

More recent financings are for developments with contracts that have expired and been extended under the Multifamily Assisted Housing Reform and Affordability Act of 1997 (MAHRA). These contracts are subject to annual appropriation and tend to be for shorter terms, intensifying termination risk. While appropriations need to be made for this type of contract each year, appropriation risk is not a limiting factor to low to mid-investment grade ratings due to the essentiality of federally subsidized housing. Termination risk is more of an issue that needs to be analyzed on a case-by-case basis. Standard & Poor's has seen contract terms as short as one year and as long as twenty years. Generally, Standard & Poor's looks more favorably on longer-term contracts, but whether the term is one year or 20 years, termination risk can be offset if the project meets the standards set forth under MAHRA for contract extension, as long as the owner is legally obligated to apply for contract extensions.

The expectation that contracts will be extended is strengthened by language in MAHRA that the HUD Secretary shall extend at the owner's request subject to appropriation under such terms and conditions that the Secretary deems appropriate. The legislation permits the HUD Secretary the option of not renewing due to poor financial or operational performance of the project owner on the subject development, as well as other HUD subsidized projects. Therefore, Standard & Poor's will evaluate whether the owner and property will meet Standard & Poor's, as well as HUD's standards of performance throughout the life of the transaction. In addition, the HUD REAC score at the time of the rating, and on an ongoing basis, is an indication of HUD's assessment of the owner. A deterioration of the REAC score below 75 could be an early signal of the failure of the owner to operate the property at a level needed to maintain the contract.

Other factors that add to the overall credit quality of the transaction help to make the case for the essentiality of the project, as well as its ability to withstand contract termination, include if:

• The project caters to HUD's targeted tenancy, especially, the elderly;
• The project could potentially operate without subsidy; and
• A potential sale of the property upon contract extension could generate sufficient funds to retire the bonds.

In situations where the owner has a viable plan for converting a Section 8 subsidized property to unsubsidized status over the life of the transaction, Standard & Poor's will consider ratings up to low investment-grade for bonds meeting conversion criteria, as follows:

• The feasibility of the transition from subsidized to unsubsidized status at the targeted rent levels should be substantiated in an independent third-party report;
• Projects should be owned and operated by an experienced affordable housing organization with a proven track record or have oversight of a state or local HFA or PHA;
• The owners should present Standard & Poor's with a written transition plan, which is, in effect, a plan of actions to be taken in conjunction with the expiration of the Section 8 contract. The plan should incorporate the methodology that the owners will use to ensure the successful conversion of the property within the shortest possible time frame.
• Cash flow scenarios should be run showing payment of bonds in the event that the Section 8 contract is extended and in the event that the project converts to AHP status.

Scenario 1 assumes successful relocation of existing tenants and releasing of units during a transition period assumed to begin upon expiration of the HAP contract. The length of the transition is assumed to be the greater of two years or four times the absorption rate for similar properties in the market. During the transition period, the project needs to meet at a minimum only the debt service coverage for HAP contracts. At the end of the transition period, the project must meet the AHP debt service coverage levels. Reserves should not be relied on in meeting the coverage levels.

Scenario 2 anticipates great difficulty in relocating the existing tenants and re-renting the units. The Section 8 tenants are only assumed to vacate the units at the historical turnover rate for the property.

Under both scenarios, a vacancy rate of at least 5% should be assumed, as well as a 30-day period to turn around a unit for occupancy once it has been vacated. Once the Section 8 contract has expired, project income will consist of the tenants' portion of the rent (30% of income) based on the historical rent roll of the property.

Ratings on Section 8 conversions will include only properties where most attributes fall within the "excellent" category. Standard AHP debt service coverage levels will apply, most likely at the higher end of each category.

For the Section 236 interest reduction payment program (IRP), financing activity tends to be for single-asset structures involving the bifurcation of the mortgage loan and the creation of debt supported solely from IRPs. Unlike prior Section 236 financings, which relied upon total project revenues to meet operating costs and debt service payments, these transactions rely only on the Section 236 payments. The tenant portion of a project's income is not pledged to the IRP bondholders.

Because of the structure of these financings and the track record of the program, real estate risk is virtually nonexistent, but still a factor. Even though the IRP revenue stream is not subject to appropriation risk, expected ratings are at the 'A' rating level due to the risks of HUD's contract termination or subsidy reduction. The termination events involve elements of real estate risk that are generally not consistent with higher rating levels. Higher ratings may be possible only with very strong participants, if certain other risks can be fully covered, or for pooled financings.

Primary credit considerations include:

• Sufficient legal or other protections to mitigate any potential termination or reduction of the IRP by HUD;
• Proper regulatory oversight to ensure the project's continued eligibility for IRP;
• An experienced, capable oversight agency able and willing to provide this oversight;
• Appropriately sized reserves to cover any funding delays; and
• Debt service coverage to provide reserve replenishment, if necessary.

IRP assistance, by statute, is paid to mortgagees on behalf of mortgagors to maintain the viability of a low-income housing resource. These payments are not, and may not be paid directly to project owners. HUD wants to be sure that assistance goes to projects that provide habitable low-income housing for qualified tenants, so they require an "acceptable" public agency to provide regulatory oversight for the project. The amount the project receives is not tied to occupancy; the requirement is only that the units are in habitable condition and rented to qualified tenants. The key is the oversight, which ensures the project's eligibility to receive the IRP.

The assistance is calculated based on basic and market rents. The amounts are set forth in the amortization schedule in the original Section 236 mortgage and are fixed for the life of the mortgage. The total amount to be received is the "budget authority," and the amount scheduled to be received in any particular federal fiscal year is the "contract authority." Section 236 budget authority is not subject to annual appropriation. Bonds supported by the IRP should have maturity no later than the maturity of the IRP subsidy.

Assistance is paid in arrears after the filing of form HUD-3111 "Mortgagee's Certification and Application for Interest Reduction Payments." The expectation is that the mortgagee would legally pledge the IRP to the bond trustee for payment to bondholders. The bond trustee would be instructed to file this form in a timely fashion under the bond documents, with payment coming directly to the trustee. If payment goes to the mortgagee, proper protections would need to be in place to ensure timely and full remittance to the trustee. If the request is received by the 20th of a month, payment is wired usually by the first of the following month (and ordinarily not later than the fifth). No precise history exists about late payment from HUD, but since HUD Central and not the regional offices pay the subsidy, there are not the delays sometimes seen in the payment of Section 8 subsidies.

Standard & Poor's will look for public agency representations that the upfront and ongoing physical needs of the property will be met fully as a result of the financing. As part of the condition assessment, Standard & Poor's will look for evidence from the public agency of sufficient demand to make the project viable going forward. Standard & Poor's may also request third-party reports (engineering and environmental) to support the current and future condition of the project, as well as a market study and appraisal to gauge demand and financial viability. Any property insurance policies or business interruption insurance policies will be reviewed to ensure proper coverage, eligible uses, and the sufficiency of the provider's rating level. Site visits will be part of the ratings process as determined on a case-by-case basis. Where the quality of the property or the capacity of the oversight agency is in question, a site visit is warranted to gain necessary information.