COVID Aftereffects Slow HUD Deal Volume

Mounting financial pressures on operators, combined with rising interest rates, leads to protracted transaction process.

By Matt Valley

A significant drop-off in the production of HUD 232/223(f) loans — popular with borrowers acquiring or refinancing skilled nursing, assisted living and memory care facilities — has lowered expectations for overall deal volume in the HUD LEAN Section 232 mortgage insurance program for fiscal year (FY) 2022. 

The consensus among HUD lenders is that the total dollar amount in annual loan closings will fall short of the $3.9 billion notched in FY 2021. HUD’s fiscal year runs from Oct. 1 to Sept. 30.

“HUD has seen dramatic reductions in the number of applications that it has received and has issued far fewer firm commitments for transactions than in past years,” says Jason Smeck, seniors housing and healthcare production director at New York City-based Lument.

Through the first 33 weeks of FY 2022, HUD received 227 loan applications, down from 368 for the same period a year earlier. The number of commitments issued by HUD fell from 262 to 186 year over year, and the number of loan closings dropped from 205 to 198.

Smeck says three factors have combined to slow both the number of applications received and the firm commitments issued by HUD.

“While the pace and severity of COVID-19 infections have declined dramatically over the past 18 months, the industry still has largely not recovered from the impacts of the pandemic. The economic factors that are making headlines nationally — inflation and employment — are amplified in the skilled nursing and assisted living sectors,” explains Smeck. 

“Inflationary impacts eat away at margins that are already tight. And the availability of staff means that if you can find the staff, you are paying them substantially more. If you cannot find the staff, in many situations you must operate your building at less than full capacity,” continues Smeck.

Secondly, HUD’s leadership team has historically used trailing 12-month project performance as a bellwether for the lender’s underwriting, explains Smeck. “That means a project’s financial performance in late 2020 and early 2021, among the darkest days of the pandemic, would continue to impact a lender’s underwriting analysis even for projects closing in HUD’s FY 2022.

Thirdly, improvements in census take months to show up in the financial performance, Smeck points out. “A project that has returned to ‘fill-up’ mode may have five new residents this month, but that improvement won’t be reflected in financial statements for at least two months.”

Michael Gehl, chief investment officer of FHA lending for NewPoint Real Estate Capital, agrees that the most compelling storyline thus far in FY 2022 has been the drop-off in HUD 232/223(f) loan production.

“If you annualize the 223(f) closings in the first half of fiscal year 2022, the full year loan volume will be approximately $1.6 billion, which is less than 50 percent of the 223(f) closings in HUD’s fiscal years of 2020 and 2019,” points out Gehl.

The 223(f) program is tailor-made for stabilized properties, particularly after a bridge loan has been secured and a new operator has improved performance, according to Gehl. 

“With the challenges brought on by the pandemic, not only from a census perspective but also on the expense side, there are fewer stabilized or repositioned assets eligible for HUD financing to take out the in-place bridge financing.”

As of early May, there were 115 applications at HUD on temporary hold, meaning these are deals not ready for underwriting due to the financial downturn caused by COVID.

Major bridge builder

Erik Howard, executive managing director of business development and marketing for Baltimore-based Capital Funding Group, echoes Gehl’s sentiments. 

“Most 223(f) loans are the end result of bridge loans that were put in place to provide financing for a facility or portfolio purchase. Typically, the value creation expected at the operating level would allow for a HUD refinancing within 12 to 24 months following those closings. For a number of borrowers, the profitability required to fully retire their bridge debt has taken longer to achieve due to staffing and occupancy challenges, thus slowing the pipeline for, and closings of, 223(f) loans,” explains Howard. 

Capital Funding Group believes it is uniquely positioned to capture more of the 223(f) business. “Having closed in excess of $3 billion in bridge loans since the beginning of the pandemic, we have a tremendous pipeline and HUD deal flow,” says Howard.

Helping fill a void

What has helped keep deal volume from falling off the table up to this point is the (a)(7) market, which is the refinancing of existing HUD 232 loans, says Gehl. For the first half of FY 2022, over 50 percent of the $1.7 billion in closed HUD 232 loans were (a)(7) transactions. 

“That product is particularly sensitive to interest rates as borrowers are looking to lower their interest rates and/or extend their loan terms, thereby reducing their monthly payments. As the 10-year Treasury yield has risen over 130 basis points since the beginning of the year, a number of those transactions will not ‘pencil out’ anymore. The combination of the drop in 223(f) volume with the expected decline in (a)(7) activity in the second half of the year should bring loan volumes down in 2022 versus prior years,” according to Gehl.

Howard says rising interest rates will continue to drive demand for the HUD program as borrowers seek to convert floating-rate bridge loans to permanent, fixed-rate, HUD-insured loans. 

Credit standards tighten

Scott Thurman, senior managing director and head of production for FHA healthcare at New York-based Greystone, says the reason for the significant decrease in loan applications can be summed up in one word: “performance.” 

“Everybody has acknowledged that HUD has tightened its credit box as far as what it is looking for when it comes to performance at the property level. For example, you need to have a minimum debt-service coverage coming in for 12 months. So, if you have a COVID incident at your facility, your occupancy could crash and then you would need to recover from that.” 

While HUD has been busy tightening its policies, operators have had their hands full dealing with staffing and other expense control issues that could very well be affecting their bottom line and giving them a good reason to hold off on refinancing, says Thurman.

Some states, like Illinois, are stepping up to the plate with additional funding for staffing, according to Thurman. In late May, Illinois Gov. J.B. Pritzker signed a bill into law that increases the state’s $2.5 billion in annual nursing home funding by $700 million. 

According to the Chicago Tribune, to qualify for bonus reimbursements, nursing homes will have to meet at least 70 percent of federal staffing level guidelines, and payments will also be based on the home’s quality star rating from the Centers for Medicare & Medicaid Services.

“Everybody right now is forgetting that the skilled nursing facilities were on the frontlines during the pandemic. No one understood how to deal with it.  And now the skilled nursing industry is taking the brunt of the blame,” says Thurman, referring to some of the negative media coverage of nursing home sector during the pandemic. 

“The one consistency about this industry is just the resilience. They take [criticism], and they are dedicated to the care that they need to give. They keep figuring out a way to make it happen.”

Veteran of many cycles

Andrew Erkes, president of Chicago-based Cambridge Realty Capital, believes the most significant storyline to emerge in the HUD space this year has been the rise in interest rates. He points out that the primary activity of the HUD LEAN 232 program since its launch in 2008 has been refinancing. “From the time the HUD LEAN program started, interest rates basically trended downward or were stable and very low. Now you’ve got a little different ballgame here, and it’s not a set of circumstances under LEAN that has been experienced before.”

Borrowers with existing (a)(7) loans will be less inclined to refinance in a rising interest rate environment, emphasizes Erkes. He also expects the loan modification activity to dry up in this environment. “Those are pure interest rate plays. A lot of deals that could get done did get done when rates were as low as they were. Now you are dealing with an opposite movement in rates, so it will be interesting.”

To Erkes’ point, there were 46 loan modifications completed in the first 33 weeks of this fiscal year compared with 194 during the same period a year ago.

Erkes, who entered the mortgage business fresh out of college in 1978, is unfazed by the current uptick in interest rates. In the late 1970s, the interest rates on construction loans were north of 20 percent, he recalls. By the way, HUD’s focus back then was primarily on development, not refinancing.

“HUD had a special subsidized Ginnie Mae takeout program, so you would go get your HUD commitment, and Ginnie Mae would give you a 7.5 percent mortgage, but only after the building was built,” says Erkes.

A choppy road ahead

The assisted living and skilled nursing industries remain under the national microscope post-COVID, according to Lument’s Smeck. “What state and federal regulatory changes will impact the industry? What do changes mean to reimbursement levels, staffing and expense control? When will staffing recover and normalize in these communities? These are just a few of the questions that will continue to have great impacts on the industry and on production within the HUD 232 mortgage insurance program.”

During a first-quarter earnings call for Omega Healthcare Investors (NYSE: OHI), the REIT’s Senior Vice President of Operations Megan Krull noted that the American Health Care Association estimated a loss of 241,000 nursing home employees, or 15.2 percent of the workforce, since February 2020, including an additional 2,500 jobs in March 2022. 

Due to the workforce shortages, nursing and agency expense continues to be elevated, according to Krull. “Agency expense on a per-patient-day basis for our core portfolio for fourth-quarter 2021 was more than six times what it was in 2019. This, in turn, continues to have an impact on occupancy with self-imposed admission bans due to staffing shortages, delaying an even better occupancy recovery.”