6-RFP 541209 Exhibit A Section-108-Undewriting-Manual-Income-Producing-Properties.pdf

Section 108 Underwriting Guidelines for

Income-Producing Projects

HUD Office of Community Planning and Development

Including: Residential, Office, Retail, Industrial and Mixed-Use Real Estate Projects For Section 108

Loan Guarantee Recipients

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines1

TABLE OF CONTENTS

Introduction

Program Overview

Purpose of This Underwriting Guide

Section 108 Project Financing Structures

Context for Underwriting 108-Funded Projects

Execution of Underwriting Function

General Considerations

Property Appraisal

Project Readiness

Third Party Borrower Experience - “Management Capacity”

Management Capacity

Creditworthiness

Sources and Uses Schedule

Rent Roll

Project Capital Development Budget

Operating Income and Expense Budget

Replacement Reserves

Cash Flow Analysis

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines2

TABLE OF CONTENTS (continued)

Loan Sizing

Public Benefit

Proposed Construction Loan Draw Schedule

Proposed Amortization Schedule

Equity Contribution

Evaluation of Guarantees

Completion Guarantee/Performance Bonds

Multiple Sources of Financing / Inter-Creditor Agreements

For Evaluating Project Costs And Financial Requirements

Exhibit B. Underwriter Scope of Work

Exhibit C. Sample Schedule of Other Real Estate Owned

Definition of Terms

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines3

The guaranteed loans are made by investors who purchase “debt obligations” that are guaranteed by HUD. The debt obligations are promissory notes issued by states and local governments, or public agencies (such as redevelopment agencies and housing authorities) designated by a state or local government to be the issuer. Each issuer receives a loan guarantee from HUD and is referred to in this guide as a “Recipient1.” A Subrecipient is a public or nonprofit agency, authority, organization, or for-profit entity authorized under 570.201(o) that is engaged by a CDBG grantee to receive a pass through of CDBG funds to undertake CDBG-eligible activities. For purposes of this guide, the purchaser of the HUD guaranteed debt obligations will be referred to as the “Investor.”

A state or local government that is awarded a loan guarantee under the Section 108 program must pledge its current and future CDBG allocations as security for the guaranteed loan.

Although HUD relies on this pledge of CDBG funds as security, it cannot assume that CDBG funds will always be available. Thus, in order to receive a Section 108 loan guarantee, the Recipient must furnish additional collateral to ensure that the loan guaranteed by HUD is an acceptable credit risk. Examples of additional collateral include liens on real property and pledges of tax increment revenue. This guide, however, focuses, on another category of additional collateral: third party loans.

A Subrecipient is a public or nonprofit agency, authority, organization, or for-profit entity authorized under 570.201(o) that is engaged by a CDBG grantee to receive a pass through of CDBG funds to undertake CDBG-eligible activities.”

The Section 108 Loan Guarantee Program provides state and local government grantees the ability to transform a small portion of their CDBG funds into federally guaranteed loans large enough to spur economic growth and jump-start community revitalization efforts.

Program Overview

Section 108 is the loan guarantee provision of the Community Development Block Grant (CDBG) Program.

It provides CDBG grantees with a source of financing for economic development, housing rehabilitation, public facilities, and other large-scale physical development projects. This flexibility makes it one of the most potent and important public investment tools that HUD offers to states and local governments. The Section 108 Loan Guarantee Program provides state and local government grantees the ability to transform a small portion of their CDBG funds into federally guaranteed loans large enough to spur economic growth and jump-start community revitalization efforts. For more details, see the program’s website at https://www.hudexchange.info/section-108/.

1 �Recipient is a qualified state or local government that qualifies to receive CDBG funds from HUD, also known as “grantee.” As noted above, they participate in either the Entitlement Program (for cities in metropolitan areas over 50,000 in population, designated principal cities of metropolitan statistical areas or urban counties with more than 200,000 people). Under the States and Small Cities Program, states receive funding directly from HUD and provide it to small cities (non-entitled communities), also referred to as units of general local government. https://www.hudexchange.info/resources/documents/Basically-CDBG-Chapter-1-Overview.pdf https://www.hudexchange.info/section https://www.hudexchange.info/resources/documents/Basically-CDBG-Chapter-1-Overview.pdf

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines4

A third party loan is originated when Section 108 guaranteed loan funds are used to make a loan to another entity (i.e., a third party). A typical example is a loan made by a Recipient to a for-profit business pursuant to 24 CFR 570.203(b), where the loan funds will be used to carry out an economic development project. Third party loans made with Section 108 guaranteed loan funds may also be used to finance other project types including, but not limited to: housing rehabilitation, public facilities and improvements (when carried out by a subrecipient)2, and mixed-use development. HUD uses the term “Third Party Borrower” to refer to a third party (such as a for-profit business) that receives a loan from the Recipient.

Together with the pledge of CDBG funds, a third party loan may, in addition to serving as the source of repayment for the Section 108 funds, be sufficient to satisfy HUD’s additional collateral requirements for the related Section 108 guaranteed loan. Consequently, proper underwriting of third party loans by the Recipient can substantially reduce the risk that CDBG funds will have to be used for repayment of the loan.

Purpose of This Underwriting Guide

HUD is providing the following guidelines to assist Section 108 recipients in underwriting third party loans that finance the development of income producing properties. Although compliance with these guidelines is not mandatory, HUD’s acceptance of third party loans as collateral for Section 108 guaranteed loans will be facilitated if they meet these guidelines.

HUD is also providing a companion document, HUD Section 108 Underwriting Guidelines for Business Loans, which provides guidance for underwriting these loans along with assistance for underwriting startup ventures.

INTRODUCTION

2 �A subrecipient, as per 24 CFR Part 570.500 (C) is a public or private nonprofit agency, authority, or organization, or a for-profit entity authorized under 24 CFR §570.201(o), receiving CDBG funds from the recipient or another subrecipient to undertake activities eligible for such assistance under 24 CFR 570 Subpart C, “Eligible Activities.”

24 CFR §570.201(o) relates to how for-profit entities are eligible to serve as subrecipients when they use CDBG funds to provide credit to microenterprises.

The term excludes an entity receiving CDBG funds from the recipient under the authority of §570.204 (Special Activities by Community Based Development Organizations), unless the grantee explicitly designates it as a subrecipient. The term includes a public agency designated by a unit of general local government to receive a Section 108 loan guarantee, but does not include contractors providing supplies, equipment, construction, or services subject to the procurement requirements in 2 CFR part 200, subpart D.

Acquisition and Rehabilitation of a Historic Building, Eugene, Oregon

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines5

Section 108 Project Financing Structures

There are two ways a Recipient can invest Section 108 guaranteed loan proceeds -either by a project that is undertaken by the Recipient or a project that is undertaken by a third party.

Project Undertaken by Recipient The Recipient can directly use proceeds from a Section 108 guaranteed loan to implement eligible housing or community and economic development activities on their own. Under this structure, the Recipient assumes all repayment and guarantee obligations directly. (See graphic below.)

INTRODUCTION

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines6

Project Undertaken by a Third Party In many instances, however, the Recipient re-lends the Section 108 guaranteed loan funds to a third party or to multiple third parties (for example if the Recipient had established a loan fund with Section 108 financing). (See graphic below.)

Context for Underwriting 108-Funded Projects

The first step in making a third party loan is to evaluate the proposed project for compliance with Section 108 program and cross cutting Federal requirements. A third party loan may meet the underwriting guidelines described below but may still be ineligible for funding under Section 108 because it does not meet Section 108 program eligibility requirements such as compliance with CDBG national objectives criteria (NOTE: most CDBG requirements also apply to use of Section 108 guaranteed loan funds). The Recipient must therefore treat compliance with the program requirements as an initial threshold step in the underwriting process or determine compliance prior to the underwriting stage.

Additionally, the Recipient should incorporate guidance from “24 CFR Part 570, Appendix A to Part 570 - Guidelines and Objectives for Evaluating Project Costs and Financial Requirements” when using guaranteed loan funds to carry out economic development projects (See Exhibit A).

This underwriting guide incorporates the HUD guidance in Appendix A.

Third Party Loan Underwriting is the process of evaluating the creditworthiness or risk of providing financing to a specific borrower for a specific project. The underwriting process

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines7 evaluates both the financial feasibility and the risks of making a loan to a third party. The objectives of these underwriting guidelines are to ensure:

�Borrower has the experience and capacity to undertake the project starting with the financing phase and continuing through to development and then to project operations.

�Borrower has a successful accomplishment record of developing and operating similar projects.

�Market conditions support the revenue, expense, and occupancy projections.

�Project development costs are accurately projected.

�Cash flow will be adequate to cover the debt service on the loan with a reasonable cushion.

�Collateral value is sufficient to cover loan loss in the case of non-payment.

Execution of Underwriting Function

The Recipient should utilize a qualified underwriter, either in-house or via a contracted services agreement. The term “Underwriter” refers to the person or entity that acts on behalf of the Recipient and is responsible for determining the financial feasibility of and assessing the risk associated with making a third party loan.

Section 108 recipients may elect to carry out the underwriting function in a variety of ways, including:

�In-house staff underwriting �Contracted underwriting services with an outside entity �Combination of in-house and contracted underwriting services.

The loan underwriting guidance that follows is intended to be of assistance to the community regardless of whether the underwriting will be conducted by in-house staff or by engaging outside professional assistance.

If the Recipient plans to operate one or more loan programs with a significant loan volume, it may make sense to develop internal staff capacity. On the other hand, if the Recipient plans to make only a small number of loans or just a single loan, it could be more cost-effective to use outside expertise.

Recipients that do not have the in-house capacity to underwrite loans may pursue a variety of options, including:

�Use the expertise of another department or agency such as an economic development department, public housing authority, or a redevelopment authority that has experience financing income-producing real estate projects.

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines8

�Work with a qualified outside source such as a Community Development Financial Institution (CDFI), a Community Development Entity (CDE), a credit union, or a firm that specializes in underwriting commercial real estate loans.

�Engage a banker, former banker or other expert as an underwriting consultant.

Some communities employ a hybrid model where staff members review the loan applications against certain criteria while outside experts also prepare a credit analysis report or serve on a loan review committee. In some cases, outside assistance could be used to set-up systems, policies, and procedures to assist staff through the first few loans while training them to take over the function. In the case of particularly large and/or complex Section 108 projects, even when the community has staff members capable of conducting the underwriting, it may be wise to obtain outside assistance for an additional review.

The underwriting function typically requires someone with direct underwriting experience. The duties of the loan underwriter typically include, but are not limited to:

�Assess creditworthiness of prospective borrowers by completing review of company and personal financial statements;

�Evaluate historical trends, financial statements, cash flow projections, management performance, market and industry conditions, capital structure and collateral analysis;

�Order and analyze reports (credit, environmental, appraisal, and property evaluations);

�Prepare Credit Memo which provides summary of underwriting, risks and mitigating factors and proposed loan terms and conditions for Credit Committee and �Perform other various functions such as loan covenant monitoring, annual review of loan client financial statements and risk rating.

Exhibit B “Sample Scope of Work for Section 108 Loan Underwriter” of these guidelines includes additional information on the duties and recommended skill set of staff performing the underwriting function.

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines9

GENERAL CONSIDERATIONS

As noted earlier in this guidance, the project to be financed with the third party loan must satisfy HUD program requirements (e.g., CDBG national objectives criteria) and demonstrate consistency with the Recipient’s community development objectives and program design.

Therefore, before investing its time and resources to underwrite a third party loan request in depth, the Recipient should perform a threshold review that identifies whether the proposed project meets Section 108 program requirements and Recipient program criteria , as follows:

�Proposed use of the Section 108 guaranteed loan funds complies with Section 108 requirements (national objectives criteria, public benefit standards, etc.)

�Proposed loan amount falls within any loan amount range established by the Recipient

�Proposed use of funds by the Third Party Borrower meets the Recipient’s community development objectives and satisfies other program criteria (e.g., project located in target geographical areas)

A thorough and complete underwriting conclusion must include an assessment of the components described in the following sections of this guide.

�Project Feasibility and Readiness

�Borrower Experience and Management Capacity

�Borrower Financial Capacity and Creditworthiness

�Project Financial Analysis

�Collateral and Loan Repayment Guarantees

GENERAL CONSIDERATIONS

Affordable Housing Project, Los Angeles County, California

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines10

PROJECT FEASIBILITY AND READINESS

If the threshold review indicates the processing of Third Party’s loan request may proceed, the next step would be for an underwriter to assess the proposed project to ensure it is feasible and ready to move forward into the development stage.

Market Analysis

The performance of income-producing real estate depends largely on local factors and economic conditions that may affect the supply and demand for the income-producing real estate project for which funds are being requested. Performing this analysis will assist in defining the project’s market area and assessing the current market conditions, as well as how the particular market where the development is proposed will respond to the project. The entity conducting the market analysis must be knowledgeable about the local real estate market conditions including:

�Market rent levels �Occupancy rates �Terms of tenant improvements and/or leasing concessions �Management fees �Property taxes �Operating expenses for comparable properties �Market competition (existing and planned developments of similar type in market area)

Each market analysis must contain a precise, data-driven evaluation of the project’s feasibility including the prospect for long-term performance of the property given demographic trends and economic factors. For example, for office and retail development, the statement must include an estimate of the demand for each type of space in the expected year of market entry.

For residential developments, this analysis must analyze whether sufficient demand exists in the market for the type of units proposed as well as affordability analysis on the rents proposed.

Due to the need for specialized knowledge, lenders typically engage an outside firm to conduct market analyses. While the lender identifies and hires the firm, the Third Party Borrower is typically required to pay for the analysis. Therefore, in the case of a Section 108 guaranteed loan application, the Recipient should look to select a firm that specializes in conducting market analyses for the specific type of project, which is being considered for a loan. Most lenders, including banks, credit unions, and CDFIs commission market studies for projects that may be applying for 108 financing. If available, the Recipient may also consider using such a market study.

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines11

Property Appraisal

The underwriter must select a qualified, licensed, and/or certified appraiser that has expertise and experience with current market conditions to complete a property valuation in accordance with loan underwriting standards.

The Underwriter will review the appraiser’s qualifications and technical sufficiency including the verification of a current certification and license number for the state where the property is located. The appraiser must have experience appraising similar type properties to those that he or she will appraise for the Recipient’s Section 108 loan guaranteed loans. The Recipient should reserve the right to reject an appraiser.

The appraisal must include the current or “as-is” market value of the project property, as well as the prospective or “as-completed” market value. Market values for proposed construction or renovation, partially leased or vacant buildings, non-market lease terms, and other developments with unsold units must include appropriate deductions and discounts.

It is a generally accepted industry practice that the appraisal must be completed not more than six (6) months prior to the loan closing. After the borrower satisfies all Section 108 underwriting and compliance considerations, the lender will set a date for Loan Closing whereby the loan is recorded, all loan documentation is executed, and loan funds are released per the terms and conditions of the note and security agreement.

Project Readiness

Zoning, Permits and Licenses Prior to closing on a Section 108 guaranteed loan, the Recipient’s Underwriter must have confirmation that the Third Party Borrower’s project property meets all zoning requirements and is classified as either a legal conforming or a legal non-conforming use under local zoning requirements. This is necessary to ensure that no impediments exist that prevent the Third Party Borrower’s project moving forward as proposed.

Staff from the jurisdiction in which the proposed project is located must provide this information. The staff must certify that the local government in which they work has vested in them the authority to verify consistency with local land use regulations and the zoning designation.

The local jurisdiction staff must provide the zoning designation and certify that the building(s) as proposed and the intended use(s) are consistent with the referenced zoning designation and current land use regulations. If the proposed project includes rehabilitation, the staff must certify that the proposed project is a legal non-conforming use, if applicable.

How successfully can this project be completed, accounting for various environmental, legal, and market factors that will affect it? Is it shovel-ready? Is there a market?

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines12

The staff should also certify that, to the best of their knowledge, there are no additional land use regulation hearings or approvals required to obtain the zoning classification, building size or density for the proposed project. The staff should also certify that there are no known conditions that would preclude construction or rehabilitation (as the case may be) of the referenced project on the proposed site.

The required Environmental Review will determine whether the development triggers compliance with the requirements of 24 CFR § 58.6, which include the Flood Disaster Protection Act; the Coastal Barriers Resources Act; and HUD’s requirement for disclosure of properties located in airport runway clear zones. If the property does trigger any of these requirements, the Underwriter must ensure that any additional costs are included in the total development costs as well as on-going operations.

Evidence of Site Control The Third Party Borrower must provide evidence of site control to the Underwriter to demonstrate project readiness. If the Borrower does not have site control or a clear path to site control, there could be unexpected, and often costly, delays or unexpected impediments to project implementation. Evidence of site control include the following:

��Sales or Purchase Agreement with assignments and addendums �Recorded Deed or Certificate of Title ��Lease or Ground Lease, including all attachments and addendums

Title Insurance An American Land Title Association (ALTA) lender’s title insurance policy must be required by the Recipient’s Underwriter and based on the latest Minimum Standard Detail Requirements for ALTA/American Congress on Surveying and Mapping (ACSM) land title surveys including the following endorsements or their equivalent if available in the applicable jurisdiction:

��ALTA 8.2 commercial environmental ��CLTA 100 comprehensive endorsement ��CLTA 116 designation of improvements (in addition to any zoning endorsements that may be required, as discussed in the “zoning” section above)

If the project property is being pledged as collateral on the Section 108 guaranteed loan, the Recipient shall provide HUD with a standard title policy, naming the Recipient as the insured party. The policy must either include in the definition of the “insured” each successor in ownership of the indebtedness secured by a lien or be accompanied by an endorsement of the policy to the U.S. Department of Housing and Urban Development (HUD) Secretary.

Survey and Legal Description A professional ALTA/ASCM Survey is required for verification of physical boundaries and any encumbrances on the property submitted as collateral. It is essential to use an experienced and reputable land surveying company that holds a valid license within the state in which the

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines13 property is located. The survey must also be accompanied by legal description that defines the property boundaries and means of access.

Environmental Site Assessment A Phase I Environmental Site Assessment is required and must be prepared by a qualified environmental engineer according to the current Phase I Environmental Standard E1527 established by ASTM International.

It is a general industry practice that the assessment must be completed not more than six (6) months prior to loan closing and must provide definitive conclusions as to the overall acceptability of the property.

Special note: A Phase II environmental investigation will be required if recommended by the Phase I environmental consultant.

Property Condition Assessment If Section 108 guaranteed loan proceeds will be used to acquire an existing building, a physical property inspection known as a Property Condition Assessment (PCA), also known as a Property Condition Report (PCR), of the subject premises is required. The PCA should be conducted by a registered architect or licensed engineer and submitted in conjunction with a Phase I Environmental Assessment.

The objective of the PCA is to identify any physical deficiencies of the property, estimate the remaining useful life of its various physical components, such as building systems, assess the adequacy of its condition, and identify items of deferred maintenance and the estimated cost of any needed repairs or improvements. A PCA will also provide cost estimates for long term maintenance.

The most important sections within the PCA are the “Immediate Repairs/Deferred Maintenance” and “Replacement Reserves” schedules. A Deferred Maintenance Holdback in the amount of 125% of the architect’s or engineer’s estimated cost to correct the deferred maintenance items should be established at loan closing by the Recipient.

Seismic Risk Assessment (if applicable) If the Engineering Property Condition Assessment identifies the project property as being within a Seismic Zone of 3 or 4, i.e. zones with the highest probability of damaging ground motion, a Seismic Risk Assessment/Probable Maximum Loss (PML) Study should be conducted by a reputable engineering firm that is current with the latest ASTM E2026-99 standards regarding seismic risk assessment. The PML is a traditional measure of earthquake loss popularized by the insurance and seismic engineering industry in the 1980s. The Recipient and the Recipient’s Underwriter should determine if additional property insurance is necessary based on the PML.

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines14

BORROWER EXPERIENCE AND

MANAGEMENT CAPACITY

In addition to evaluating the project specifics noted above, the Recipient’s Underwriter must also review the experience and financial soundness of the Third Party Borrower.

The primary objective of this step in the process is for the Underwriter to be able to identify what entity or person is ultimately responsible during all project stages and whether this responsible entity has the experience and capacity to ensure the project will be successful.

Ownership Type

The Third Party Borrower must provide the Underwriter with the identity of all parties/counterparties and entities or individuals involved in the organizational structure in order for the Underwriter to be able to determine ownership, financial strength and creditworthiness. A Key Principal is defined as an individual(s) or entity owning or controlling twenty-five percent (25%) or greater interest in the project.

They must:

�Be legally authorized to do business in the United States and;

�Not appear on the HUD list of debarred contractors on the System for Award

Management (SAM).3

The following table illustrates various ownership structures that may participate in a 108-funded project:

Borrower(s) Key Principal(s) 4

General or Limited Partnership General Partner(s) Limited Liability Company- LLC Managing Member(s) Corporation (for profit and non-profit) Controlling Shareholder(s) Trust Controlling Party(ies) Individual(s) Individual(s)

Who is accountable? Do they have the experience and capacity to successfully implement the project?

BORROWER EXPERIENCE AND

MANAGEMENT CAPACITY

3 http://portal.hud.gov/hudportal/HUD?src=/program_offices/enforcement/debarments.

4 �This assumes a “Key Principal” is a “natural person,” as opposed to a “legal person,” which may be a private (i.e., business entity or non-governmental organization) or public (i.e., government) organization.

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines15

BORROWER EXPERIENCE AND MANAGEMENT CAPACITY

Third Party Borrower Experience - “Management Capacity”

The Underwriter shall also complete a sufficient due diligence review of the Third Party Borrower’s ownership history, as well as management capacity, if the Third Party Borrower will also be managing the project. The underwriting report must detail the following components:

Borrower Information Information for Credit Review Report

Borrower Legal Identity Date and place of formation/incorporation

List of Principals Name, role and contact information

Principals and Key Staff Qualifications Resumes, Qualifications

Experience with Development & Property Management Description of projects, dates completed, locations, sources of financing

Organization Chart Key principals and staff roles and responsibilities

Development Team (e.g. architect, engineers, general contractor, lawyer, property manager)

Name, role, contact information resumes and qualifications of firms and their key principals

Organization Financial Statements Balance sheet, income and expense, statement of cash flows, other real estate owned

Organization Tax Returns From two most recent years

Personal Financial Statements from Key Principals and Guarantors

From two most recent years

Tax Returns from Key Principals and Guarantors From two most recent years

Pending Litigation, Foreclosures or Mechanics Lien Claims If applicable

Contingent Liabilities If applicable

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines16

The Third Party Borrower and members of the development team should have recently completed at least one like-project of similar size and scope. If not, then Borrower must show how they will bring the experience and skills needed to bring the project to successful fruition, including additional staff or contractors.

Management Capacity

The Third Party Borrower must submit a narrative that details its organization and management capacity that includes the following:

�What is the history and background of the borrower as an entity and its principals?

�What factors of management experience and capacity will position the project for success?

��Who does what functions in the organization and related to the project that will be funded with Section 108 loan proceeds?

�What is the development experience of the borrower for income generating real estate development projects (e.g. types of projects, number of units/square footage, total cost of projects and financing sources)?

�What is the property management experience of the borrower?

�What has been the financial performance of the borrower over time that is an indication of acceptable management capacity?

�What, if any, is the pending litigation and foreclosures, mechanic’s lien claims, or contingent liabilities of the borrower?

BORROWER EXPERIENCE AND MANAGEMENT CAPACITY

Historic Hotel, Cary, North Carolina

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Property management is critical to the successful operation of the property and must be thoroughly considered by the Underwriter. The property manager must have at least a three (3) year record of managing similar type properties. If an external management company is used, the Third Party Borrower must have a written contract with the management company. The agreement must outline the plan for managing the property as well as include all contractual obligations of the Third Party Borrower and the management company. All management agreements must be subordinate to the mortgage.

The Underwriter will consider the size and complexity of the project when determining the adequacy of existing management (i.e., smaller properties may require different levels of management expertise than larger properties). The Underwriter will consider the following factors in determining the acceptability of external management companies:

�Record and reputation �Types of properties managed �Total number of units/square feet/facilities managed �Location of the management company’s main office with respect to the property �Marketing and leasing plan �Borrowers must disclose any and all judgments and contingent liabilities.

BORROWER EXPERIENCE AND MANAGEMENT CAPACITY

Housing Development, High Point, North Carolina

Property management is critical to the successful operation of the property and must be thoroughly considered by the Underwriter.

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines18

BORROWER’S FINANCIAL CAPACITY AND

CREDITWORTHINES

Financial Statements

The Third Party Borrower must provide an overview of its financial position as well as that of any person or entity that will be providing a financial guarantee that the loan will be repaid in order to confirm that the guarantor has the financial capacity to guarantee 100% of the loan’s principal balance, either individually and/or jointly (See “Evaluation of Guarantees” below.)

In cases where the Third Party Borrower may be a special purpose entity that is created solely for the assisted project, the Underwriter would require financial statements from the key principals of the special purpose entity and guarantors of the Section 108 loan since the Third Party Borrower itself would have no financial statements available nor would it be able to provide a guarantee.

The Underwriter will review three years of audited financial statements and current interim statements for the borrowing entity, general partners, and guarantors. The Recipient should require that the Third Party Borrower submit the following financial documents:

�Balance sheet for the past three years identifying contingent liabilities

�Income and expense statement for the past three years

�Statement of cash flows

�Contingent liabilities and a statement concerning their amount, nature and path towards resolution

�Detailed schedule of other real estate holdings

�Tax returns for the past three years

�Bank statements for the past 6 months

�Authorization to pull credit reports, as specified by the Recipient and

�Any notes from Third Party Borrower that can provide explanation and/or rationale for any information that Underwriter may perceive as a credit and/or capacity issue.

The financial statements must also include any other factors that might affect the financial condition of the Third Party Borrower or Key Principal(s).

The Underwriter must consider the Third Party Borrower’s financial condition and resources.

This includes the financial capacity of any key principal(s), the value of any underlying collateral, and the Third Party Borrower’s character and credit history to repay as agreed. Third

BORROWER’S FINANCIAL CAPACITY

AND CREDITWORTHINESS

How likely is it that the Third Party will repay the loan? Does it or its principals have the financial position to provide some level of assurance?

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines19

Party Borrowers must demonstrate the capacity to meet a realistic repayment plan from available cash flow and liquidity. Liquidity measures ability to convert assets to cash. Cash is the most liquid asset for paying off debt.

The Recipient and its Underwriter should establish project evaluation criteria that addresses the following questions for the following components of the financial statements:

Balance Sheet

�What is the ratio of current assets to total assets? How has this changed over time?

�How much debt does the Borrower currently have on its books?

�What is the ratio of debt to equity?

The balance sheet presents a “snapshot” of a Third Party Borrower’s financial position at a specified date or point in time. For example, the amounts reported on a balance sheet dated December 31, 2015 reflect that instant when all the transactions through December 31 have been recorded. The balance sheet informs the reader of the entity’s or individual’s financial position as of one moment in time. It helps the lender see what an entity or individual owns as well as what it owes to other parties.5 The following are commonly used (but not an exhaustive list) ratios to evaluate the condition of a borrower’s balance sheet.

Financial Ratio

Current Assets: $100,000 less Current Liabilities: $75,000 equals Working Capital: $25,000

Current Assets: $100,000 divided by Current Liabilities: $75,000 equals Current Ratio: 1.33 current liabilities $75,000 long term liabilities $300,000 equals Total Liabilities: $375,000

Total Liabilities $375,000 divided by Owners' Equity $250,000 equals Debt to Equity Ratio: 1.50

Debt to Equity

Total Liabilities ÷ Owners' Equity = Debt to Equity Ratio

Definition

Working Capital

Current Assets - Current Liabilities = Working Capital

Current Ratio

Current Assets ÷ Current Liabilities = Current Ratio

BORROWER’S FINANCIAL CAPACITY AND CREDITWORTHINESS

5 http://www.accountingcoach.com/balance-sheet/explanation 6 http://www.investopedia.com and www.accountingcoach.com for basic financial analysis terms http://www.accountingcoach.com/balance-sheet/explanation http://www.investopedia.com http://www.accountingcoach.com

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines20

Income and Expense Statement

�Does the Third Party Borrower generate sufficient and steady income to meet its financial obligations? How has this changed over time?

�Is this individual or this entity profitable?

The income statement is also referred to as the profit and loss statement, P&L, statement of income, and the statement of operations. It reports the revenues, gains, expenses, losses, net income and other totals for the period of time shown in the heading of the statement.7

While reviewing the income and expense statement it is important that the borrower clearly states whether or not they present this report on a “Cash” or “Accrual” accounting basis.

The cash basis of accounting recognizes revenues when cash is received and expenses when they are paid; however, this method does not recognize accounts receivable or accounts payable.

Many smaller businesses opt to use the cash basis of accounting because it is simple to maintain.

The cash accounting method does not track receivables or payables. The cash method is beneficial in terms of tracking how much cash the business actually has at any given time.

Transactions are not recorded until the cash is received or paid.

Under the accrual basis, revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid. This method is more commonly used than the cash method, especially for larger corporations. The accrual basis of accounting gives a more realistic idea of income and expenses during a period of time, therefore providing a long-term picture of the business that cash accounting cannot provide. The downside is that accrual accounting does not provide any awareness of cash flow; a business can appear to be very profitable while in reality it has empty bank accounts. Accrual based accounting without careful monitoring of cash flow can have potentially negative consequences.8

If a Third Party Borrower submits financial statements on a ‘cash basis’, the Underwriter should request recent accounts receivable and accounts payable reports. Most small business computerized accounting systems can switch between cash and accrual accounting for reporting purposes.

How well do the key principals manage cash to meet financial obligations?

7 http://www.accountingcoach.com/financial-statements/explanation/3 8 https://bench.co/syllabus/accounting/cash-accounting-vs-accrual-accounting/

BORROWER’S FINANCIAL CAPACITY AND CREDITWORTHINESS

http://www.accountingcoach.com/terms/C/cash-basis-of-accounting http://www.accountingcoach.com/financial-statements/explanation https://bench.co/syllabus/accounting/cash

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines21

Statement of Cash Flows The cash flow statement reports the cash generated and used during the time interval specified in its heading. The period of time that the statement covers is chosen by the Third Party Borrower. For example, the heading may state “For the Three Months Ended December 31, 2015” or “The Fiscal Year Ended September 30, 2015.”

Cash flow statement reports cash generated and used in the following categories:

�Operating activities within the income statement �Investing activities such as purchase or sale of assets such as real estate and equipment �Financing activities such as incurring and/or paying off debt as a borrower or providing debt as a lender9

Contingent Liabilities statement concerning their amount, nature and path towards resolution A contingent liability is a potential liability that may occur, depending on the outcome of an uncertain future event. A contingent liability is recorded in the accounting records if the contingency is probable and the amount of the liability can be reasonably estimated. If the contingent liability is probable, but the amount cannot be reasonably estimated, the contingency should be reported in the footnotes that accompany the financial statements.

Contingent liabilities can include:

�Outstanding lawsuits �Claims against the company not acknowledged as debts �Legal liability �Liquidated damages �Tort �Unliquidated damages �Destruction by disaster such as storm or flood �Product warranty �Disputed Taxes �Financial guarantees given

Schedule of Real Estate Holdings The Underwriter will examine the Schedule of Other Real Estate Holdings to determine the Third Party Borrower’s and Key Principal(s) financial exposure to other properties and clearly note any assumptions regarding capitalization rates and/or gross income multipliers utilized in determining the value for other real estate owned.

Please see Exhibit C for a sample template of a Schedule of Real Estate Owned that reflects what the Recipient should require from its Third Party Borrowers.

9 http://www.accountingcoach.com/cash-flow-statement/explanation

BORROWER’S FINANCIAL CAPACITY AND CREDITWORTHINESS

http://www.accountingcoach.com/cash-flow-statement/explanation

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines22

A key question that the Recipient needs to address when analyzing the schedule of other real estate owned by a Third Party Borrower is:

�How well are current real estate properties owned by the Third Party Borrower performing?

�How may the performance of other real estate owned by the borrower provide insight to the Third Party Borrower’s development and management capacity?

Tax Returns If applicable, Federal income tax returns for the previous two (2) years are required from the Third Party Borrower and/or identified Key Principal(s).

�Does information in the financial statements tie to the information stated in the tax returns? If not then the Borrower needs to provide an explanation to satisfy discrepancies.

Bank Statements The Underwriter must review the Third Party Borrower’s bank statements for the most recent three (3) months. The bank statements must verify the collection of monthly rental and other income (if applicable) attributable to leases in place at the time of underwriting.

�How well do bank statements provide a window to verify cash on hand as stated in most recent financial statements?

Creditworthiness

In addition to financial statements and verification of bank accounts, the underwriter determines a recommendation of “Creditworthiness” based on an evaluation of credit reports and credit scores, verification of employment, and past bankruptcies.

Personal Credit Reports Personal credit reports are required for the Third Party Borrower, Key Principal(s) or others owning or controlling a twenty-five percent (25%) or greater interest in the borrowing entity.

Experian, Transunion, and Equifax are the three primary reporting agencies that keep track of and evaluate the personal credit histories for most individuals. Credit reports must be dated within sixty (60) days prior to the issuance of the Section 108 Loan Guarantee Commitment.

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines23

Business Credit Reports A report from an established business credit-reporting agency (such as the Dun & Bradstreet “Business Information Report”) or other acceptable commercial credit report for business entities is required. If not using D&B, an acceptable commercial credit report must include the following:

�Public filings that includes suits, liens, judgments, bankruptcies and federal debt;

�Uniform Commercial Code (UCC) filings;

�Credit payment history;

�Industry standards showing how the facility compares in the areas of financial stress and payment trends; and �A credit payment delinquency risk score over a 12-month period.

A general industry practice requires acceptable credit reports to be no more than 60 days old at the time of application for funding and no older than 120- days at the closing of the loan.

The Recipient should order all credit reports directly after the Third Party Borrower signs an authorization and release.

Credit Scores The Underwriter is responsible for obtaining credit scores for each individual Third Party Borrower(s) and Key Principal(s) (those owning or controlling a twenty-five percent (25%) or greater interest in the borrowing entity). The credit score primarily referred to in this document is FICO® Score developed by the Fair Isaac Corporation (FICO).

If the underwriter identifies issues related to credit scores and/or credit reports, the underwriter may consider requesting from the Third Party Borrower a Credit Explanation Statement that addresses each issue identified in the credit report. A satisfactory Credit Explanation Statement should include:

1. � Clarity that the borrower understands and takes responsibility for each negative event and

2. � The steps the borrower took and/or is taking to remedy the negative credit event and resolve the issue.

The Recipient and the Underwriter are looking specifically for a pattern of pro-active responsibility and accountability for meeting all financial obligations. Mistakes can happen.

�How well did or does the borrower take responsibility and action to remedy a credit related issue?

Minimum Credit Score Requirement All credit-scoring models rank individual consumers by their relative credit risk. That is, a score represents a borrower’s likelihood of becoming delinquent on a loan. In most cases, for Section 108 loans HUD recommends that individual Third Party Borrowers and Key Principal(s) have a

Income Producing Projects Secured by Real Estate HUD Section 108 Underwriting Guidelines24 minimum qualifying credit score of 700. For those individual Third Party Borrowers and/or Key Principal(s) with credit scores below 700, exceptions can be considered on a case-by-case basis with compensating factors.

Past Bankruptcies The Underwriter must evaluate such applications on a case-by-case basis. The Third Party Borrower and any Key Principal(s) in a limited partnership must sign a detailed Credit Explanation Letter, Certified Ownership, and Loan History…