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COLORADO REAL ESTATE JOURNAL
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Finance
L
enders and investors
alike have an inter-
est in “asset-based”
underwriting of proposed
multifamily development proj-
ects. Asset-based underwriting
involves the disciplined evalu-
ation of a proposed develop-
ment project on its own merits.
As such, it differs from “cred-
it” underwriting, which is the
evaluation of a borrower’s or
sponsor’s ability to make debt
service payments or to repay
a loan from sources other than
the underwritten asset; in the
case of equity, credit under-
writing assesses the ability to
guarantee a specified return
on investment. Asset-based
underwriting also differs from
“creditworthiness” underwrit-
ing of the borrower’s or spon-
sor’s adherence to standards
of responsibility in managing
debt and the underlying real
estate assets securing that debt.
The underwriting required
for FHA 221(d)(4) construc-
tion and permanent financing
of new apartments provides
an illustrative example of
how asset-based underwriting
works in practice. As a non-
recourse loan program, FHA
221(d)(4) financing involves
asset-based loan underwriting,
and to a lesser extent, cred-
itworthiness underwriting, in
contrast to credit underwrit-
ing associated with recourse
lending, such as from a bank.
Investors in properties subject
to FHA-insured financings who
are reliant on sponsors’ projec-
tions also can take advantage
of the rigorous scrutiny applied
by the FHA-insured lender in
the loan underwriting process
in their evaluation of whether
to invest equity in the project.
Underwriting of a proposed
new apartment development
starts with a review of the
sponsor’s proposed develop-
ment budget and pro forma net
operating income. These projec-
tions are evaluated for reason-
ableness compared to similar
projects that have been evalu-
ated by the lender. If the bud-
get assumptions or pro forma
NOI projections are in line with
those of similar successful proj-
ects, the project passes to the
next step in underwriting.
A market study is then com-
missioned by the lender to eval-
uate growth drivers such as job
creation, household formation
and other factors that influence
demand for new apartments.
The existing supply of complet-
ed projects is considered, as are
projects under construction and
proposed, in order to reconcile
supply and demand. The mar-
ket study is specific to the pro-
posed project, meaning that the
proposed new supply is further
refined to match demand in
regard to product size, type and
amenities, as well as by income
qualification of proposed resi-
dent renters.
An appraisal is commis-
sioned to determine the achiev-
able rents, other income and
c a t e g o r i e s
of expenses
used in deriv-
ing NOI pro-
jections. This
is perhaps
the
most
i m p o r t a n t
single under-
writing test
used in deter-
mining a loan
amount, as
a failure to
generate suf-
ficient cash flow from opera-
tions would result in insuffi-
cient funds to meet debt-ser-
vice obligations. A debt-service
coverage cushion is employed
to hedge against shortfalls in
actual performance from pro-
jections.
Environmental
consider-
ations come next. When under-
writing a proposed multifam-
ily loan, these considerations
include evaluations of soil and
water contamination, radon
and vapor intrusion, toxic sub-
stances, flood risk and wet-
lands disturbance. Additional
considerations relate to high-
way and railway noise, airport
flight patterns, and proximity
to potential hazards such as
above-ground storage tanks
and discharges from industry.
Environmental events pose cat-
astrophic risk to the value of
the asset, as well as significant
costs of remediation, and may
be cause for a proposed financ-
ing to be rejected.
The FHA 221(d)(4) program
requires that the lender obtain
a comprehensive architectural
and cost review of the proposed
development. The architectural
review is a peer review of the
completeness of the permit-
ready construction drawings,
and its scope also includes con-
firming compliance with local
building codes. The cost review
is a line-item cost benchmark-
ing by trade to other similar
projects and sometimes results
in refinement of construction
cost estimates. The construc-
tion contract is further evalu-
ated by a surety, who provides
a payment and performance
bond guaranteeing completion
of construction on time and for
a guaranteed maximum price.
Since the FHA 221(d)(4)
financing is nonrecourse to the
project sponsor or borrower,
various credit support escrows
are required during develop-
ment to cover unforeseen con-
tingencies. Two percent of the
loan is set aside in escrow as an
owner’s hard-cost contingency,
and an additional 2 percent
is set aside as a soft-cost con-
tingency for working capital
needs during construction and
initial marketing. If not needed,
the funds that were set aside in
escrow are released to the bor-
rower after project completion
and stabilization.
Funds also are escrowed to
cover the projected operating
deficit as the project under-
goes initial lease-up. As with
the working capital escrows for
contingencies, unused funds
are released to the borrower
upon achievement of stabilized
occupancy and when the proj-
ect has demonstrated the abil-
ity to meet debt service require-
ments.
Finally, FHA221(d)(4) lenders
evaluate the creditworthiness
of proposed sponsors and bor-
rowers. This includes an evalu-
ation of owned real estate and
debt schedules to determine
patterns of behavior and com-
petence in managing other real
estate holdings. It also involves
evaluating a sponsor’s expe-
rience with the development,
management and initial lease-
up of other apartment projects
or other forms of real estate to
determine whether the spon-
sor is qualified to take on the
challenge of developing a new
apartment project.
The asset-based underwrit-
ing required for FHA 221(d)
(4) financing of new apartment
projects is time-tested and prov-
en. The program has remained
solvent and viable for many
years due to the rigorous appli-
cation of underwriting guide-
lines. Sponsors of proposed
new apartment projects should
choose an approved FHA mul-
tifamily lender with the requi-
site experience to guide them
through this process and to bet-
ter assure a successful financ-
ing and completed project.
s
Peter Wessel
Senior director, Love
Funding, Denver
