HUD 221(d)(4) Ground Up Development Financing
My understanding is that by using a HUD 221(d)(4) loan, you can finance 85%-90% of the total project cost. And while it takes longer to close (8-12 months), that doesn't seem like a terrible drawback given the high leverage that will juice the hell out of your returns.
So why are these loans not something that every multifamily developer uses? What are the downsides that I am probably not aware of? I am not sure what interest rates are exactly, but I believe they are quite low, in the range of 3-5% for new construction.
Can someone clarify how these loans impact the developer's ability to refinance the property repeatedly once it is complete? On a typical deal, the refi's are where you're making the majority of your money, rather than on the rent cash flow, so if it prevents refinancing then I can see why this type of loan is not more commonly used, or even ubiquitous.
For one, the underwriting standards HUD uses are more strict than more traditional lenders, so the debt is being sized using more conservative assumptions. For example I think 7% minimum vacancy for market rate multi family.
Additionally, a developer is not allowed to take a developer fee when taking advantage of this type of financing. They credit it back to you somehow in the form of even higher leverage, would need to speak to the lender to understand in greater detail.
There are also more fees than a traditional loan as well as mortgage insurance which is not part of the “interest rate”. Aka the online term sheet may say rates low as 3.XX%, but there is 60 bps or something of mortgage insurance on top of that, again refer to the lender for more detail.
Thicc ass pre-payment penalties and fees
There's approximately 10 years of prepayment (10%, 9%, 8%, 7%, etc.), with the loan open to prepayment around year 10 (not sure the exact timing of when the clock starts - ie. at first draw, CofO, etc.). But it is important to note that the debt is fully assumable - a major benefit.
Why would anyone take one of these loans given these restrictions? No developer fee? Can only refi with another HUD loan, and you cannot take cash out when you do. Tighter underwriting. What’s the advantage? Just because you can probably put less equity into the deal upfront and the loan’s at a lower than market rate? Since you can’t take cash out when you refi, your entire cash flow is fucked once the building opens so I don’t see the advantage over a traditional construction loan.
Extremely high leverage. When you can get a project to pencil using this, your returns knock other assets out of the park. I’ve underwritten quite a few of these and when it works...it’s awesome. From a developer’s viewpoint it’s advantageous because they can use less equity which means they can potentially do another project.
The people saying you can't get a developer fee are only partially right. In recognition of that HUD allows for something called BSPRA (Builder and Sponsor's Risk Allowance) which increases your loan by millions of dollars in LTC against hypothetical fees. So technically yes all development/GC fees are paid out of equity, but your effective leverage recognizes those fees - it may end up being the only equity you have to raise.
In my experience, the main hurdle is usually the Davis-Bacon wage scale requirement, basically union wages. There are two scales (above/below 4 stories) and the impact depends on your market - in some markets you may be able to pencil it, but in almost all markets once you go above 4 stories it's completely cost-prohibitive.
If you're building a 4-story wrap or some 2-3 story surface parked product in the suburbs with long-term equity, it is 100% worth it. But it's also 100% a bitch to close.
The previous commenters have hit on a lot of the drawbacks and benefits. I would also say the 40/40 term and amortization structure is one of the better selling points. Very few other places you can get a 40-year amortization. On the Developer fee vs BSPRA argument, I think decrebepro summed that up very well. I will say that I'm looking at a term sheet now and BSPRA is about 8.5% of total project costs. When you can factor that into your total replacement costs and your loan amount is 87% of said costs, that a pretty significant boost in loan proceeds.
The biggest drawbacks I'm aware of would be the stricter UW standards, the bureaucracy of HUD, the affordability requirement, Davis-Bacon wages, and the MIP (although I typically see this around 25bps).
By the way, brokers/mortgage bankers love to do these deals because we often make 3-5% on the backend.
Main reasons people avoid it:
1. Prepayment penalties
2. The fact that it takes 8-10 months to close, you have to start way early
3. The upfront sunk costs that are 100% at risk by developer prior to closing which total in low six figures
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