oversight

Portfolio Reengineering: Properties Unable to Cover Operating Expenses at Market Rents

Published by the Government Accountability Office on 1997-07-14.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

(A)
 )
United
   A States
General Accounting Office
Washington, D.C. 20548

Resources, Community, and
Economic Development Division

B-277410


July 14, 1997


The Honorable Connie Mack
Chairman, Subcommittee on Housing
  Opportunity and Community
 Development
Committee on Banking, Housing
 and Urban Affairs
United States Senate

Subject: Portfolio Reengineering: Properties Unable to Cover Operating
         Expenses at Market Rents

Dear Mr. Chairman:

The Department of Housing and Urban Development's (HUD) insured Section 8
portfolio (properties that both receive project-based Section 8 rental assistance
and have mortgages insured by HUD's Federal Housing Administration [FHAI)
suffers from long-standing problems, including high subsidy costs. To address
these high costs, your C )mmittee recently approved the Multifamily Assisted
Housing Reform and Affordability Act of 1.997, which, among other things,
proposes a reduction in existing subsidized rents to market levels at a large
number of properties. Although many properties will continue to be financially
viable with the reduced subsidy levels, some properties will likely be unable to
cover their operating expenses, even if the existing debt on the mortgages is
totally forgiven.

In a June 26, 1997, letter, you asked us to provide you with information
concerning properties that would be unable to cover operating expenses with
market-level rents, on the basis of our analysis of Ernst & Young LLP's 1996
study on the effects of a proposal by HUD for restructuring the insured Section
8 portfolio.' In May 1996, Ernst & Young reported on the results of a study


'We evaluated the results and reasonableness of Ernst & Young's study in
our report entitled Multifamily Housing: Effects of HUD's Portfolio
Reengineering Proposal (GAO/RCED-97-7, Nov. 1, 1996).
                                   GAO/RCED-97-202R HUD's Portfolio Reengineering
B-277410
analyzing the effects of HLUD's proposal, called "mark-to-market" (later revised
and renamed "portfolio reengineering"), that was aimed at restructuring the
insured Section 8 portfolio.2 HUD's restructuring proposal was desigred to
lower subsidy costs, reduce HUD's risk of insurance losses, and improve the
physical condition of many properties through a process that included resetting
rents to market levels and reducing mortgage debt if necessary to permit a
positive cash flow.

In response to your request, this product describes (1) the basic methodology
used in Ernst & Young's study. (2) the data that the study developed on
properties that would not be able to cover operating expenses (i.e., that would
have a negative cash flow) after restructuring, and (3) the increase in rents
above market-level rents that would be needed for these properties to achieve a
positive cash flow and a comparison between the rent levels and the fair market
rents (FMR) for the areas in which properties are located.

SUMMARY
Ernst & Yolng's study assessed how properties in the insured Section 8
portfolio would be affected by HUD's proposal by analyzing a stratified random
sample of 558 out of 8,363 insured Section 8 properties. In assessing the effects
of restructuring, Ernst & Young assumed, among other things, that project-based
Section 8 assistance would be replaced with tenant-based assistance; vacancy
rates would adjust to market-level rates; operating expenses for some properties
would decrease by up to 15 percent of the difference between their historical
levels and industry averages for properties in their area; funding would be
provided for covering a property's immediate deferred maintenance and short-
term capital needs when the property was subject to reengineering; and
required deposits to replacement reserves would cover the estimated annual
replacement costs for all of a property's major systems, regardless of the length
of their remaining useful lives.

Our analysis of Ernst & Young's data shows that 60 of the 558 insured Section 8
properties in its sample would have a negative cash flow after restructuring
even if their existing mortgage debt were written down to $0. By negative cash
flow, we mean that the properties' adjusted net operating income (net operating




2More  specifically, Ernst & Young determined the amount of mortgage write-
down needed for each property on the basis of the mortgage that the
property could support after it was marked to market. This computation
was based on the financing terms that Ernst & Young anticipated that
lenders would provide for new mortgages on the properties.
2                                  GAO/RCED-97-202R HUD's Portfolio Reengineering
    B-277410

income after deposits to replacement reserves) after restructuring would be
negative?

According to our analysis, rents for the units in these 60 properties would, on
average, need to increase above market-level rents by about $113 per unit per
month in order for the properties to achieve a positive cash flow. 4 If the
restructured rents at these 60 properties were increased to the area's FMR, 25
properties (42 percent) would be able to achieve a positive cash flow, including
deposits to replacement reserves. An additional 24 properties (40 percent)
would be able to achieve a positive cash flow if their rents were increased to
 120 percent of FMR. Of the 11 that would need rents higher than 120 percent
of FMR, 4 could cover operating expenses with rents from greater than 120 to
 130 percent of FMR; 5 would need rents from greater than 130 to 140 percent of
FMR; and 2 would need rents greater than 140 percent of FMR. (Enc. I shows
the rent levels that each property would need in order to achieve a positive
cash flow.) It is important to note that although these higher rents would allow
the 60 properties to cover operating expenses, many of the properties also have
deferred maintenance and short-term capital needs that would probably need to
be funded from a source other than mortgage write-downs or the properties'
revenues after restructuring. According to Ernst & Young's data, deferred




3 Ernst & Young's study placed each sample property into one of four
 categories on the basis of the extent to which the property's net income
would cover its expenses after restructuring. The study classified properties
that would be unable to cover operating costs after restructuring as
 "nonperforming." However, the number of properties in the nonperforming
category is somewhat larger than the 60 properties that would have a
negative cash flow. This occurs because Ernst & Young classified properties
as nonperforming on the basis of two tests that compared properties'
adjusted net operating incomes with the amount of their existing mortgage
payments and capital needs. As a result of these tests, Ernst & Young
classified an additional 13 properties with slightly positive adjusted net
operating incomes as nonperforming, whereas our analysis includes only
those properties with negative adjusted net operating incomes.
4The  $113 per unit per month average rent increase is a weighted average
taking into account the number of units in each property. Also, it is
important to note that in an analysis of a probability sample such as the one
that Ernst & Young drew, it is normal practice for us to compute margins of
error for all estimates. However, because of time constraints, we did not
compute the margins of error for this report.
3                                  GAO/RCED-97-202R HUD's Portfolio Reengineering
B-277410
maintenance and capital needs at these properties range from $1,304 to $22,017
per unit.5

Equally important-to the extent that the actual effects of restructuring differ
from the assumptions used by Ernst & Young-properties may perform
differently than projected. For example, the adjusted net operating incomes for
these properties could improve if operating expenses decrease by more than the
15-percent adjustment used by Ernst & Young and/or if deposits to replacement
reserves are required only for properties' capital items whose lives expire within
a set period of time rather than for all major systems regardless of the length of
their remaining useful lives. 6 Furthermore, to the extent that project-based
assistance is continued rather than converted to tenant-based assistance,
vacancy rates at the properties may be lower, potentially resulting in higher
adjusted net operating incomes. However, the continued use of project-based
assistance also has policy implications, including restricting recipients' choice of
housing.7

AGENCY COMMENTS

We provided the Department of Housing and Urban Development with copies of
a draft of this report for review and comment. On July 10, 1997, the General
Deputy Assistant Secretary, Office of the Assistant Secretary for Housing -
Federal Housing Commissioner, informed us that the Department concurred
with the information presented in the draft.




5 OurNovember 1996 report noted. however, that for most of the 10
properties that we reviewed in detail, Ernst & Young's study estimated
substantially higher deferred maintenance needs than did the properties'
owners and managers and the contract appraisers that we hired to review
the properties.
6For example, as noted in our November 1996 report, if a property's hot
water systems were evaluated to have a remaining useful life of 25 years, the
annual replacement reserve would include prorated amounts for the full cost
of replacing hot water systems. Lenders that we contacted noted that if
restructured loans were for 15 years, funding for replacing the hot water
systems would typically not be required.
7Our November 1996 report provides additional information on the policy
implications associated with using tenant-based versus project-based Section
8 assistance.
4                                   GAO/RCED-97-202R HUD's PortfolUo Reengineering
    B-277410

    SCOPE AND METHODOLOGY

    The information provided is based on our prior review of Ernst & Young's study
    and on our analysis of the data developed as a part of that study.8 We
    discussed the results of our analysis with cognizant Ernst & Young officials and
    with officials in HUD's Office of Multifamily Housing. We performed this
    review from June through July 1997 in accordance with generally accepted
    government auditing standards.



    Please call me on (202) 512-7631 if you or your staff have any questions. Major
    contributors to this report include Rick Hale, Christine Fishkin, Austin Xelly,
    Mark Egger, and Leigh Ward.

    Sincerely yours,




    Judy A. England-Joseph
    Director, Housing and Community
      Development Issues

    Enclosure




    8See   footnote 1.
5                                     GAO/RCED-97-202R HUD's Portfolio Reengineering
ENCLOSURE I                                                                         ENCLOSURE I

                   MONTHLY RENTS NEEDED PER UNIT FOR PROJECTS WITH
                      NEGATIVE ADJUSTED 1NET OPERATING INCOMES


                                                           Rent
    Count of                                       needed for
    properties          Monthly                        positive
    with             shortfall in                   cash flow                     Percentage
    negative           adjusted                        (sum of                       of area's
    adjusted net             net     Estimated    shortfall and         Area's   FMR needed
    operating         operating       average       estimated         average     for positive
    income              income      market rent   market rent)           FMR        cash flc v
    1                     ($64)          $411           $475            $757               63
    2                       (34)          363             397            570               70
    3                       (12)          369            381             518               74
    4                       (86)          559            645             856               75
    5                        (4)          646            650             847               77
    6                      (28)           621            649             822               79
    7                        (9)          394            403             500               81
    8                      (37)           365            402             487               82
    9                        (9)          468            477             576               83
    10                       (6)          308            314             379               83
    11                     (70)           556            626             749               84
    12                       (2)          336            338             386               88
    13                     (24)           432            456             511               89
    14                     {42)           553            595             666               89
    15                     (<1)           348            348             388               90
    16                    (112)           614            726             808               90
    17                     (65)           688            753             827               91
    18                     (41)           270            311             329               95
    19                    (197)           480            677             713               95
    20                     (40)           401            441             463               95
    21                    (187)           281            468             488               96
    22                     (<1)           311            311             323               96
    23                    (170)           607            777             802               97


6                                                 GAO/RCED-97-202R HUD's Portfolio Reengineering
ENCLOSURE I                                                                       ENCLOSURE I


    Count of
                                                1|       Rent
                                                  needed for
    properties        Monthly                         positive
    with           shortfall in                    cash flow                    Percentage
    negative         adjusted                         (sum of                      of area's
    adjusted net           net     Estimated     shortfall and        Area's   FMR needed
    operating       operating       average        estimated        average     for positive
    income            income      market rent    market rent)          FMR        cash flow
    24                    (17)          397             414             425               97
    25                    (29)          260             289             294               98
    26                    (65)          489             554             550             101
    27                    (41)          299             340             335             102
    28                    (96)          321             417             409             102
    29                   (49)           519             568             556             102
    30                   (16)           496             512             498             103
    31                   (16)           590             606             587             103
    32                   (25)           296             32"             310             104
    33                  (218)           574             792            756              105
    34                  (418)           564             982             937             105
    35                     (7)          283             290            277              105
    3i6                 (258)           674             932            886              105
    37                   (32)           579             611            579              105
    38                   (95)           863             958            905              106
    39                   (19)           403             422            387              109
    40                   (65)           295             360            329              109
    41                  (282)           692             974            890              109
    42                  (228)           639             867            792              109
    43                   (13)           411             424            383              111
    44                   (88)           343             431            388              111
    45                   (30)           450             480            414              116
    46                   (92)           310             402            341              118
    47                 (104)            682             786            665              118
    48                   (82)           344             426            359              119


7                                               GAO/RCED-97-202R HUD's Portfolio Reengineering
ENCLOSURE I                                                                        ENCLOSURE I

                                                        Rent
    Count of                                     needed for
    properties        Monthl,                        positive
    with           shortfall in                   cash flow                     Percentage
    negative         adjusted                        (sum of                       of area's
    adjusted net           net     Estimated    shortfall and         Area's   FMR needed
    operating       operating        average      estimated          "verage    for positive
    income            income      market rent   market rent)            FMR       cash flow
    49                    (85)           302            387             324              120
    50                    (27)           305            332             274              121
    51                    (55)           305            360             288              125
    52                    (40)           335            375             295              127
    53                   (187)           376            563             435              129
    54                   (155)           510            665             510              131
    55                   (165)           551            716             548              131
    56                   (127)          453             580             428              135
    57                   (190)           344            534             389              137
    58                    (47)           395            442             322              138
    59                   (314)          431             745             467              159
    60                   (535)           399            934             374             250

Legend:

FMR = fair market rent

Notes: Amounts shown are on a per unit, per month ba, is. The large increase in rents needed
for property number 60 is due primarily to Ernst & Young's determination that substantial annual
deposits to replacement reserves would be required for the prC perty.

Source: GAO's analysis of data from Ernst & Young.




(385691)

8                                                GAO/RCED-97-202R IUD's Portfolio Reengineering
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