Aftereffects of Shutdown Linger

HUD 232 lenders work through financing backlog, but projections vary on total loan production for FY 2019.

By Matt Valley

Like all federal agencies, the U.S. Department of Housing and Urban Development (HUD) has felt the ripple effects of the longest partial government shutdown in U.S. history that began in late December 2018 and lasted for 35 days. HUD’s Section 232 mortgage insurance program — used primarily to finance nursing homes and to a far lesser extent assisted living facilities — was forced to hit the pause button. 

All HUD regional and field offices, as well as the agency’s headquarters, were closed during that stretch with only limited exceptions. While the private sector firms that contract with HUD for underwriting services remained on the job, there was no loan committee available at HUD to approve deals during that 35-day period.

Months later the HUD 232 program, which closed 317 loans totaling $3.6 billion in fiscal 2018, is still playing catch-up. The question now is whether loan production in fiscal 2019 will match, exceed or fall below last year’s production. (HUD’s fiscal year runs from Oct. 1 to Sept. 30.) The short-term outlook from seasoned lenders in the program varies.

“I think volume is going to be down 10 to 15 percent for the mortgage insurance program as a whole in fiscal 2019, and it’s primarily because of the government shutdown, not necessarily because there is less business,” says Ed Foulon, senior vice president and chief underwriter, FHA, for Cleveland, Ohio-based KeyBank Real Estate Capital. “Even though HUD was closed a little more than a month, the government shutdown put it behind the eight-ball by about 45 to 60 days.”

Michael Gehl, chief investment officer for North Bethesda, Maryland-based Housing & Healthcare Finance LLC, expects lenders in the HUD 232 program to close approximately 250 deals totaling $3.3 billion in fiscal 2019. That would mark an eight percent drop in loan volume on a year-over-year basis.

Steve Kennedy, senior managing director, with Columbus, Ohio-based Lancaster Pollard, is more optimistic. Despite the hiccup in the loan approval process caused by the government shutdown, Kennedy forecasts total loan production in fiscal 2019 across the HUD 232 program will end up similar to fiscal 2018.

“I think you’ll see that the second half of this fiscal year will be more robust with regard to HUD deal volume and closings compared with the first half,” says Kennedy. As of April 12, there were 136 loan applications in the underwriting review stage at HUD, and another 57 in the queue but not assigned, an indication of a healthy deal pipeline.

Lancaster Pollard recently provided private equity investment group Tryko Partners LLC with a HUD 232/223(f) loan in the amount of $17.3 million to refinance Willow Springs, a 180-bed skilled nursing facility in Brick, New Jersey. The deal capped off a busy few months for the firm. From Jan. 25 — the date the government shutdown ended — through March, Lancaster Pollard closed 16 deals totaling $224 million in transactions through the HUD mortgage insurance program.

Nikhil Kanodia, head of production for FHA lending at New York City-based Greystone & Co., says he believes the HUD 232 program is on the cusp in terms of loan production. “My sense is that the rest of the year is going to be a lot more active, and I think HUD is going to see a lot more volume this fiscal year than last year.”

Takeaways from first-half action

Even though the 121 loans closed through mid-April is down from 150 during the same period a year ago, largely due to the government shutdown, the total dollar volume in loan closings has not decreased commensurate with the decline in number of deals, says Gehl.

The reason is that nursing home deals are tracking at about $15.5 million per financing transaction so far this year versus $12.4 million in 2018, a 25 percent increase, Gehl points out. Stronger-performing portfolios and some larger single-asset transactions have helped make up for decline in number of transactions.

Drew Ades, senior vice president of Capital One Multifamily Finance, has two takeaways based on the deal flow in the HUD 232 program in the first half of fiscal 2019. 

“The first is that the program has always been dominated by new acquisitions and refinancing, so these numbers reflect that trend (see table). We have gone through a period of sustained low interest rates, so it is not surprising to see production skewed to projects new to the program as opposed to the refinancing of existing HUD loans,” says Ades.

“The amount of new construction activity also reflects the underlying fundamentals of the market and vacancy rates within the existing stock, and is in line with historical trends for the program,” adds Ades.

Only eight of the 121 deals that closed in the HUD 232 program through April 12 pertained to new construction or rehabilitation projects. The remaining 113 loan closings were either for refinancing or acquisitions. 

Construction financing for the ground-up development or rehabilitation of a senior living facility remains a small piece of the HUD 232 lending pie, says Gehl. That could be due to several factors such as the Davis-Bacon Act’s prevailing wage requirements applicable to HUD-insured housing, the lengthy timeline for executing a construction loan, or the difficulty of constructing a new nursing home in states where a Certificate of Need is required.

Tracking performance

Foulon doesn’t expect KeyBank, which closed 50 deals for a whopping $812.7 million in fiscal 2018, to replicate that transaction volume this year. That annual loan amount, propelled in large part by a huge portfolio deal, was the highest ever for a single lender in the HUD Lean program, Foulon notes. “It was sort of an anomaly.” Foulon is quick to add, however, that KeyBank is on track to close approximately 43 deals totaling $550 million in fiscal 2019.

Through its bridge-to-HUD lending program, KeyBank makes its living in the HUD 232 space largely by financing portfolios, oftentimes stemming from mergers and acquisitions, says Foulon. “We do more portfolios than any other HUD lender, and a lot of that is because of our balance sheet. I’m not talking four or five properties, but rather 10, 15, 20 or 25 properties. That’s our sweet spot.”

Greystone will likely double its loan production on a year-over-year basis in fiscal 2019, says Kanodia. In fiscal 2018, the company closed 20 loans totaling $298.5 million. “We’re close to $360 million of closed deals in the current fiscal year,” Kanodia said in mid-May. “We’ve got a lot of momentum and I feel pretty confident, assuming HUD can manage its pipeline well, which it is.”

The deals coming to fruition today are the result of the seeds Greystone planted a few years ago largely through its bridge-to-HUD program, explains Kanodia. With a balance sheet lending capacity of close to $3 billion in the healthcare real estate space, Greystone has the ability to make bridge loans to borrowers for a period of one to three years and hold those loans on its balance sheet. 

In a typical scenario, a borrower may approach Greystone with plans to turnaround an underperforming skilled nursing facility. The bridge loan is used to acquire the property, and once it is stabilized the borrower seeks to exit the bridge loan by obtaining a 35-year, fixed-rate, non-recourse loan through the HUD 232 program.

Housing & Healthcare Finance closed 19 deals for slightly under $250 million through the HUD Lean program in fiscal 2018. Gehl expects the company to close just under 40 deals for approximately $400 million in fiscal 2019.

Erik Howard, managing director of real estate finance at Baltimore-based Capital Funding LLC, says the company is having a “great year” production-wise. In April alone, Capital Funding closed almost $100 million in bridge-to-HUD loans. That helped boost Capital Funding’s total loan volume through April of fiscal 2019 to $248 million across 21 transactions. 

For all of fiscal 2019, Howard projects that Capital Funding’s total loan production will exceed $600 million, up from $502.6 million in fiscal 2018. 

“The processing pipeline remains very robust. Between deals that are committed and in process with HUD, we think that we’re going to do another half a billion dollars in fiscal 2019. We have a couple of large transactions that we’re working on as well right now that probably won’t close in fiscal 2019, but it will give us a nice head start going into 2020,” says Howard.

Capital One, which closed 17 loans totaling $227.3 million in the HUD 232 program during fiscal 2018, is on pace to eclipse last year’s loan production, says Ades. “Year-to-date we’ve closed eight deals for just over $100 million, and we currently have seven deals for just over $70 million into HUD. So right now, we are just shy of last year’s production by number of deals and we are just past the halfway point in the fiscal year.”

Surprise swing in rates

Borrowers and lenders have watched the 10-year Treasury yield, the benchmark for permanent, fixed-rate financing in commercial real estate, swing significantly over the past several months. The rate stood at about 2.4 percent at the close of business on Friday, May 17, down from 3.2 percent in early November 2018. 

Six months ago, the general consensus was that long-term rates would continue to rise due to the strength of the U.S. economy. The thinking was that the U.S. was near full employment and that would force employers to pay higher wages to attract workers, which would in turn lead to higher consumer prices. 

But in December the stock market slumped due to the threat of the government shutdown and fears of a global economic slowdown. Against that backdrop, jittery investors found a safe haven in U.S. Treasuries, causing the 10-year Treasury yield to fall.

“Conventional wisdom on the direction of rates has clearly changed over the past year. If we were to see an even more significant rate drop, that could lead to a tick-up in potential production of (a)(7) loans,” says Ades. A 232/223(a)(7) loan is the refinancing of an existing HUD loan.

“We expect acquisition and refinance deals to remain the bulk of production,” adds Ades.

Gehl of Housing & Healthcare Finance says the strategies of most borrowers weren’t impacted by the swings in the 10-year yield over the past year. “Even when we were at 3.2 percent, we were still in a low interest rate environment versus historical averages, so the idea of locking in low rates still holds today. When rates were moving up, a few borrowers did feel a sense of urgency, but that has subsided with the Federal Reserve freezing interest increases and the fall in the 10-year yield.”

What’s next?

Capital Funding’s Howard observes an uptick in smaller M&A transactions as smaller owners exit the skilled nursing business amid the growing complexity of the industry. At the same time, he’s seeing a continued divestiture of skilled nursing assets among some of the larger owners such as REITs.

“Now that the 10-year yield has drifted lower, we do think borrowers are looking at the situation and thinking they may get another bite at the apple at some fantastic rates. And so, I think that you are going to see a very strong fiscal 2020 from the HUD program as a number of these portfolios roll through.”

Over the next few years, Kennedy anticipates that borrowers will increasingly utilize HUD’s supplemental loan program, or so-called 232/241(a) loans. These insured second mortgages finance repairs, additions and improvements to existing healthcare properties already insured by HUD. The program is intended to keep a property competitive and extend its economic life. 

Owners of today’s newly built skilled nursing or assisted living facilities will eventually need to reinvest in their properties, and may even need to expand, says Kennedy. “That’s where the 241(a) program comes in nicely. The borrower does not have to refinance its existing HUD loan to take advantage of the program.” The non-recourse financing also features an attractive interest rate subject to market conditions.