FHA Financing with REITs: Time to Reap the Benefits
Traditionally, Real Estate Investment Trusts (REITs) have had difficulty obtaining debt financing via the U.S. Department of Housing and Urban Development (HUD)/Federal Housing Administration (FHA) programs due to discrepancies between FHA requirements and REIT characteristics in regard to income distributions. Therefore REITs have not been able to reap the substantial benefits derived from using FHA as a permanent financing structure. Chief among the benefits of FHA financing are the long term, fixed interest rate and nonrecourse element—all very attractive features to seniors housing owners. Now, due to recently released updates to the HUD LEAN processing handbook, the program is substantially more accessible as a long-term financing option for REITs that utilize project level debt.
Historically, HUD limited the distribution of excess cash flow to semi-annually. This did not fit the REIT distribution requirements as REITs typically distribute cash flow monthly. However, due to recent changes to the HUD LEAN handbook allowing monthly distributions, REITs can now use the program and not run afoul of any Internal Revenue Service (IRS) distribution requirements. Additionally, HUD amended some internal rules regarding debt seasoning to allow REITs to use HUD to refinance properties that were purchased with cash.
Background on REITs
A REIT is a company that purchases real estate assets and leases the assets to one or more operators. REITs began in the 1960s as a method to allow investors to earn returns from commercial real estate investments typically only available to companies with large resources. REITS are compensated through the receipt of lease payments made by the operator and via the ultimate sale of properties. The different categories of REITs include health care, retail, residential and office. Health care REITs own real estate such as independent and assisted living facilities, nursing homes, hospitals and medical office buildings.
To maintain its REIT status, a company must distribute a minimum of 90% of its annual taxable income to shareholders in the form of dividends. By not retaining its earnings, a REIT is therefore able to avoid U.S. income taxes, which in essence makes REITs a real estate version of the equity structure that mutual funds provide. Many investors prefer to purchase securities that pay dividends monthly as opposed to quarterly because they allow for an even amount of dividends received month-to-month and because they can reduce volatility.
HUD LEAN Changes
Recently announced changes to HUD LEAN processing now allow REITs to take advantage of the benefits of HUD financing. Transactions for which a firm commitment has been issued on or after July 12, 2013 are eligible. The changes, set forth in regulation 24 CFR 232.254, state that a borrower is now allowed to make and take distributions of mortgaged property, to the extent and as permitted by the law of the applicable jurisdiction, provided that:
- The calculation shall be made no less frequently than semi-annually, meaning monthly distributions are now permitted.
- The borrower must demonstrate positive surplus cash (total cash minus total current obligations). To the extent surplus cash is negative, the borrower must repay any distributions taken during such calculation period within 30 calendar days, unless a longer time period is approved by HUD.
- The borrower shall be deemed to have taken distributions to the extent that surplus cash is negative, unless in conjunction with the calculations of surplus cash, the borrower provides to HUD documentation evidencing, to HUD’s reasonable satisfaction, a lesser amount of total distributions.
Two-Year Look Back for REITs
HUD has determined that REITs may not be required to initiate line-of-credit financing to establish existing indebtedness. This is because REITs make arm’s-length business decisions to purchase, construct or acquire projects using investor contributions, cash or equity instead of debt. The two-year look back provision will reduce the administrative burden of initiating a line of credit for the purpose of being paid off with FHA-insured mortgage proceeds pursuant to the following:
- REITs that completed purchase transactions within two years of the date of application may be treated as a special instance of a purchase transaction when the following conditions are met:
- The purchase price only includes HUD-eligible costs.
- The transaction was completed at arms-length.
- The sales transaction was completed at market value (Office of Residential Care Facilities (ORCF)-approved appraisal), and;
- Documentation of organizational structures clearly indicates that there is no identity of interest (IOI) between or among individuals actually involved on both sides of the transaction.
- For purchase transactions meeting the two-year look back provision criteria, the maximum insurable loan will be determined by the loan-sizing criteria, but cannot exceed 80% of ORCF-appraised value or the cost of the acquisition.
REITs not meeting these two-year look back criteria will be required to demonstrate debt, such as through a line-of-credit that covers reimbursed acquisition costs, similar to other corporate entities. They will also be required to submit their FHA application as a refinance transaction.
Summit Healthcare REIT, Inc. is a public, non-traded REIT headquartered in Lake Forest, Calif., that has recently transitioned from an industrial REIT to a health care REIT. As part of that process, Summit recently purchased seven nursing and assisted living (AL) facilities and paired with national and regional operators to run the facilities. Summit bought the facilities using conventional bank financing with the intention of ultimately obtaining permanent financing through the FHA program.
Four of the facilities are located in Oregon: Fernhill Estates (a 47-bed skilled nursing facility (SNF)), Pacific Gardens Estates (a 73-bed SNF), Sheridan Care Center (a 48-bed SNF) and Farmington Square Medford (a 71-bed AL and memory care facility). The other three facilities are located in North Carolina: Cateret House (a 64-bed AL facility), Hamlet House (a 60-bed AL facility) and Cleveland House (a 72-bed AL facility).
The result was seven loans totaling $36.9 million that were nonrecourse and carried long terms and low interest rates. In addition, the seven loans provided funds for a total of over $550,000 in repairs and improvements and funded each facility’s replacement reserves. The FHA-insured loans allowed Summit to refinance its temporary bridge debt into a permanent, cost effective structure that benefits the shareholders of the REIT and positions all the facilities well for the future.
The Summit Healthcare REIT, Inc. example clearly demonstrates how a REIT is able to reap the rewards of FHA financing due to the recent HUD LEAN handbook changes. Going forward, an increasing amount of health care REITs are likely to do the same.