At Mid-Year, HUD Volume Takes Expected Dip

by Jeff Shaw

High interest rates, rising expenses curb transactions, cast spotlight on bridge loans.

By Matt Valley and Jeff Shaw

To borrow a baseball phrase, the rallying cry among lenders in the HUD Lean Section 232 mortgage insurance program used to finance nursing homes and assisted living facilities is “Wait ’Til Next Year.” The combination of rising interest rates and volatility in the capital markets has led to a slump in deal volume, but lenders see this situation as a temporary setback. 

Transaction activity has actually been waning the past few years. Deal volume totaled $2.95 billion in fiscal year (FY) 2022, down 25 percent from the prior year. 

“With a few months remaining in HUD’s 2023 fiscal year (which ends Sept. 30), if the HUD 232 program hits $2 billion that could be considered a win,” says Patrick Shearer, director, seniors housing lending, Greystone. 

“It is going to depend on interest rates moderating, which will moderate the spread for Ginnie Mae mortgage bond rates over the 10-year U.S. Treasury yield. It is also going to depend on moderation in the business level challenges of occupancy and expense pressures, particularly from labor,” adds Shearer.

Through the first 30 weeks of FY 2023, lenders in the HUD Lean program closed 112 loans, a 37 percent decrease year-over-year. Of those 112 transactions, 91 were 232/223(f) loans that were new to the program and used to refinance or purchase seniors housing properties. The remaining 21 were 232/223 (a)(7) loans, which were refinancings of existing HUD loans. 

The number of loan modifications (interest rate reductions) completed during the first 30 weeks of FY 2022 was 66 compared with zero for the same period in FY 2023.

Lenders active in the HUD Lean program aren’t surprised by these falling numbers.

“In last year’s review we pointed to a drastic reduction in new applications to signal that we expected production volume to dramatically decline in HUD’s FY 2023,” says Jason Smeck, a director specializing in HUD and seniors housing at Lument. “We cited factors such as HUD’s adherence to the trailing 12-month performance as a driving factor in a lender’s underwriting, lagging property financial performance as the nation transitioned out of the pandemic, and the length of time it takes for census improvements to move the needle on financial statements. All continue to hold true and are now amplified by the rapid increase in mortgage rates over the past 12 months.”

High rates mute performance

While there are many factors that led to low HUD volume in seniors housing, the increase in interest rates over the past year to fight inflation is No. 1 on most experts’ lists.

“The 223(a)(7) product is interest-rate-sensitive,” says Michael Gehl, chief investment officer for FHA lending at NewPoint Real Estate Capital. “As rates rise, the numbers just don’t work for savings to the borrower — it’s really a math exercise. Throughout the year, as rates continued to rise, the math did not work anymore and the shift from (a)(7)s to 223(f)s moved dramatically.”

While HUD hasn’t altered its underwriting standards, the long, slow recovery from the pandemic has taken a toll on some properties. With HUD requiring three subsequent months of a 1.45X debt-service coverage ratio at loan application, owners of struggling properties simply don’t meet the requirements.

“That makes it more difficult to finance assisted living facilities that would have generally been down-the-fairway deals a year ago,” says Shearer.

Thankfully, many of those secondary factors are showing signs of improvement, notes Alison Lemle, managing director and chief underwriter at VIUM Capital.

“Expenses, fueled by record increases in inflation and interest rates, have risen notably faster than revenue over the last year. Fortunately, expense increases have begun to normalize while occupancy has gradually increased. Perhaps most notably, Medicaid reimbursement rebasing is starting to occur for skilled nursing facilities in many states, which captures much of the increase in costs they experienced over the last couple of years,” according to Lemle.

“Skilled nursing tends to make up about two-thirds of the HUD portfolio, so this bodes well for HUD 232 application submission volume in the second half of FY 2023 and closings in FY 2024,” continues Lemle. “Seniors housing assets (assisted living, memory care) will take a little longer to restabilize and obtain HUD’s required coverage.”

Bridge lending gets squeezed

With HUD loans becoming less and less available for seniors housing borrowers, a burning question remains: What happens to all the bridge-to-HUD loans that were issued in better economic times?

“There is a significant number of bridge-to-HUD loans outstanding,” says Lemle. “Performing loans with relatively patient lenders will ultimately find a permanent financing home with HUD. However, bridge-to-HUD lenders that are dependent on third-party banks and other lenders for their bridge capital are feeling the strain of not being able to extend loans that need more seasoning due, in part, to recent expense pressures across the income statement.”

Many borrowers using bridge-to-HUD financing are facing the biggest enemy they can right now: unpredictability. This has made lenders more cautious, according to Smeck.

“The ability to forecast the timing and certainty of stabilization for seniors housing and skilled nursing property performance has been incredibly difficult for bridge lenders over the past few years,” says Smeck. “The skilled nursing and assisted living industries have faced shutdowns, infections, staffing shortages, cost inflation and margin compression since the start of the COVID pandemic.”

Shearer agrees, adding that the bid-ask spread between buyers and sellers even makes it difficult for owners to sell their way out of the problem.

“The interest-rate environment has made it such that getting assets that would have qualified for reasonably attractive bridge loan terms is much more difficult, if not impossible, to get done today. The rate environment has also made it more difficult to underwrite straightforward turnaround scenarios where a reasonable increase to the expense efficiencies would make the deal HUD-eligible. Now those efficiencies aren’t enough to get the deal to work.”

Despite all these challenges, the seniors housing financial experts all expressed optimism for HUD lending volume to rebound. Interest rates won’t stay high forever, and occupancy and rents are on the rise as savvy owners and operators adjust to the new environment.

“We continue to have very solid relationships across the country with fantastic owners that are operating in a difficult market,” says Smeck. “Our deal activity in light of the difficult operating environment has been solid.”

“Obviously, lenders and borrowers never like to see such a rapid rise in the cost of debt,” adds Gehl. “That being said, when you look at an 11 to 13 percent cap rate asset like skilled nursing, the debt-service coverage there is still ample for borrowers, even with the run-up in interest rates. The HUD product has always been a way to put their capital structure to bed for a long period of time and focus on operations. That has not changed.”

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