It’s been said that change is inevitable and your ability to adapt determines your level of success. True for both individuals and organizations, so keep this axiom in mind when reading this article.
In the spring of 2012, the U.S. Department of Housing and Urban Development (HUD)/Federal Housing Administration (FHA) released significant proposed changes to the regulations governing the Sec. 232 program, commonly referred to as the HUD LEAN program. This program insured debt for nursing homes, assisted living and board and care facilities of over $5.47 billion in its 2012 fiscal year.
As part of these regulatory changes, HUD proposed new loan closing documents and changes to loan monitoring requirements. After the agency solicited comments from the senior living industry and responded to many of the proposed concerns, the new regulations were published in the Federal Register in the fall of 2012. After an extension of three months, all new loan documents are effective for LEAN transactions receiving a firm commitment issued on or after July 12, 2013.
For borrowers who currently possess HUD/FHA-insured debt or are contemplating such a route, it is important to understand how these new requirements may impact business practices and operational risks.
Borrower Regulatory Agreement Changes
The Healthcare Regulatory Agreement-Borrower has always been a cornerstone document in HUD/FHA-insured transactions, because, among other things, it contains language governing the distribution of profits for a HUD/FHA-insured borrower. HUD’s convention for regulating such distributions is coined surplus cash. HUD authorizes the distribution of surplus cash as calculated in the HUD Form 93486.
A unique characteristic of this new regulatory agreement is that it modifies the surplus cash distribution rules that apply to for-profit borrowers as compared to nonprofit borrowers. For-profit borrowers are now permitted to distribute surplus cash as many times as they wish throughout the fiscal year. Although, they must reconcile these intermittent distributions at both the half-year and year-end to ensure compliance with HUD’s surplus calculation. If it is determined that surplus cash is negative, then the shortfall must be repaid to the project within 30 days.
On the other hand, nonprofit borrowers must be categorized into one of two groups─those that are authorized to take distributions or those that are not. For nonprofit borrowers that are not authorized to take distributions, all surplus cash is deposited into a residual receipts account, out of which distributions require prior written consent from HUD. For nonprofit borrowers that are authorized to take distributions, the distribution of surplus cash can only occur twice per year, at the mid-year and year-end. Additionally, for this category of nonprofit borrowers, distributions are contingent upon the following conditions:
- The operator is in good standing with the licensing agency and there are no open compliance issues or a special focus facility designation.
- There are no unresolved audit findings.
- The borrower and operator are in compliance with their respective regulatory agreements.
- There are no loan defaults or outstanding notices of noncompliance from HUD.
- The balance of the residual receipts accounts remains equal to no less than six months of required debt service payments, including payments for mortgage insurance premium and escrow or reserve deposits.
The nuance and significance of the Healthcare Regulatory Agreement-Borrower document makes it all the more important for owners and boards, particularly of multiple facilities, to arrange their organization in a thoughtful manner. Creative structuring and thorough advice from a lender and legal counsel can often minimize the impact this document has on how an organization functions throughout the year.
Operator Regulatory Agreement Changes
If a borrower also operates a facility then the borrower must sign both the Healthcare Regulatory Agreement-Borrower and the Healthcare Regulatory Agreement-Operator documents. If the real estate entity is separate from the operating entity then they each sign the applicable agreement.
The new regulations state that the operator must be a single-asset entity, which is a change to the current requirements. HUD has made clear through the regulations that they will permit directors to grant waivers of this requirement, particularly in states where obtaining a new license is difficult. A second change is that every operator must create a risk management program. HUD’s exact expectations for such a program remain unclear, but it is believed that the lender will bear primary responsibility for evaluating the sufficiency of measures a borrower has put in place to manage risk. This could include monitoring potential lawsuits or survey plans of correction. A third change is that operators must notify electronically, within two business days, their lender and HUD representative of any negative notices from a governmental authority. Examples include a G-level or higher survey finding, a civil money penalty relating to the property or any investigation involving fraud. A fourth change worth noting surrounds transfer pricing concerns over the contracting of goods and services. In situations where a borrower is acquiring goods and services whose cost exceeds 5% of the facility’s gross annual revenue, the borrower must solicit written cost estimates. Records of these written estimates must be maintained by the project and are subject to HUD’s examination.
Understandably, HUD’s changes to this document aim toward encouraging prudent and proactive management of risks and expenses. While such borrower traits are important to any lending institution, they are principally important to HUD given that by granting mortgage insurance HUD/FHA is assuming a project’s default risk. In most other lending mechanisms, project owners assume some degree of personal liability. Nevertheless, keeping track of these various requirements can prove painstaking; therefore, when choosing a HUD lender, a borrower should look for a lender that keeps in-house servicing staff that specializes in FHA-insured loan monitoring.
Operator Security Agreement Changes
Although several changes were made to the Operator Security Agreement, the most significant change is that the operating entity must now pledge its assets as collateral to secure the borrower’s loan. HUD’s impetus for this change is that creditworthiness resides in the overall business operations, not just the real estate. This new requirement, however, may prove problematic or unpalatable for many arms-length third party operators.
For nonprofit or for-profit borrowers , it is important to understand how these new HUD LEAN requirements may impact business practices and operational risks.
Loan Monitoring Changes
Several key loan monitoring requirements also have recently changed. First, nursing homes are no longer subject to HUD Real Estate Assessment Center’s physical plant inspections as HUD now defers to a state’s or the Centers for Medicare and Medicaid Services’ annual survey results. For assisted living facilities, HUD will defer to a state’s survey where HUD feels the state’s oversight is sufficient. Second, historically HUD has required audited annual financial statements of only the HUD/FHA-insured borrowing entity (i.e., the borrower or mortgagor), which is the entity that owns the real estate assets. This requirement is unchanged, but an additional requirement of quarterly and year-to-date, operator-certified financial statements has been added. In situations where the operating entity is separate from the real estate entity, the annual audit still only applies to the real estate entity, but the quarterly and year-to-date financial reporting requirement also applies to the operating entity. This change is applicable to all HUD/FHA-insured facilities.
Other notable changes were made to the documents governing transactions that incorporate a management agent, an operating lease, a master lease and accounts receivable financing. If these are applicable to your organization, you’re encouraged to download the new forms from HUD’s website and contact your lender or legal counsel to discuss.
Keep in mind that the interest rate levels and terms of HUD/FHA-insured loans have been unmatched in the marketplace over the last several years, contributing to the LEAN program’s soaring popularity and record volumes. Nevertheless, HUD requirements are intricate and occasionally change; therefore, borrowers should always seek an experienced HUD LEAN lender that possesses the requisite expertise to guide them successfully through the life of a loan.
Tom Grywalski is a vice president with Lancaster Pollard in Philadelphia. He may be reached at firstname.lastname@example.org.
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