oversight

One McKnight Place - #085-36602, St. Louis, Missouri

Published by the Department of Housing and Urban Development, Office of Inspector General on 2001-05-11.

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

                          AUDIT REPORT




                          ONE MCKNIGHT PLACE
                    REVIEW OF PROJECT DISBURSEMENTS

                           ST. LOUIS, MISSOURI

                                2001-KC-1002

                                MAY 11, 2001



                         OFFICE OF AUDIT, GREAT PLAINS
                             KANSAS CITY, KANSAS




Table of Contents                                        Exit
                                                                           Issue Date
                                                                                   May 11, 2001
                                                                          Audit Case Number
                                                                                   2001-KC-1002




          TO: Herman S. Ransom, Director, Office of Multifamily Housing, Kansas City Hub, 7AHM




          FROM: Roger E. Niesen, District Inspector General for Audit, 7AGA

          SUBJECT: One McKnight Place - #085-36602
                   St. Louis, Missouri

          We have completed an audit of One McKnight Place’s use of project funds to determine if the
          owners complied with the terms of their regulatory agreement. We conducted the audit in response
          to a request from your office.

          Our report contains four findings with recommendations requiring action by your office. The four
          findings address premature distributions of surplus cash to the owners, excessive withdrawals from
          the replacement reserve account, deficiencies relating to the management agreement, and the use of
          the project’s funds for other than reasonable and necessary project expenses.

          Within 60 days please give us, for each recommendation in this report, a status report on: (1) the
          corrective action taken; (2) the proposed corrective action and the date to be completed; or (3) why
          action is considered unnecessary. Also, please furnish us copies of any correspondence or
          directives issued because of the audit.

          Should you or you staff have any questions, please contact me at (913) 551-5871.




Table of Contents                                                                                            Exit
          Executive Summary
          We have completed an audit of One McKnight Place. The objective of our audit was to determine
          whether the owners used project funds according to their regulatory agreement. That is, were funds
          used for purposes other than reasonable operating expenses, necessary repairs, or allowable
          distributions from surplus cash. The audit was conducted in response to a HUD request.

          One McKnight Place prematurely distributed surplus cash to its owners, did not appropriately
          request funds from its reserve fund, did not execute an adequate management contract with its
          identity-of-interest management agent, and did not always spend funds only for reasonable
          operating expenses and necessary repairs.

          These actions were in violation of the Regulatory Agreement. As a result, the owners owe $31,708
          to the project’s reserve fund and must change their procedures to prevent further violations.
          Although the violations have had no determinable effect on the project at this point, future
          compliance with the Regulatory Agreement is necessary to protect the Department’s interests and
          the mortgage insurance fund.



                                               One McKnight Place prematurely distributed $908,920 in
           Distributions to Owners             surplus cash to its owners. One McKnight generated sufficient
                                               surplus cash to cover the amount of the premature distribution.
                                               However, surplus cash cannot be distributed until it has been
                                               substantiated by a surplus cash calculation. Since all cash had
                                               been distributed per the most recent surplus cash calculation, the
                                               excess distribution was in violation of the regulatory agreement.
                                               HUD only allows distributions to be made after a surplus cash
                                               calculation has been completed. This helps ensure owners and
                                               agents fulfill their responsibilities to properly maintain projects.

                                               One McKnight Place used $31,708 from its Reserve for
           Reserve FundFees
           Management   Withdrawals            Replacement account for items that were routine
                                               maintenance costs of the project, rather than capital
                                               expenses; for items that were also charged to the tenants;
                                               and for items that were not expenses of the project. HUD
                                               directives say Reserve for Replacement Funds provide cash
                                               for the replacement of capital items and are not intended to
                                               cover routine maintenance costs.          As a result, the
                                               improperly used Reserve for Replacement funds will not be
                                               available in later years to help defray the costs of required
                                               capital improvements. One McKnight Place received a
                                               management fee that exceeded the amount allowed by its
                                               management agreement.         The management agreement
                                               between the mortgagee, One McKnight Place, and the
                                               identity of interest management agent allowed for the
                                               payment of a 4 percent management fee. The actual

                                                        Page ii                                     2001-KC-1002


Table of Contents                                                                                                 Exit
                                                                          Executive Summary


                                 management fee taken by the management agent was 5
                                 percent. A letter from the mortgagee had a hand written
                                 note added that indicated the management fee was
                                 increased to 5 percent and said an additional 2 percent
                                 could be paid to the management agent for food service
                                 management. The management agreement was not updated
                                 or amended to reflect these changes, and there was no
                                 analysis to show the fees for the food service were
                                 reasonable when compared with an arms length transaction.
                                 As a result HUD lacks assurance that project funds are only
                                 being used for reasonable and necessary expenses.

                                 The owners of One McKnight Place paid project funds for
           Ineligible Expenses   other than reasonable and necessary operating and
                                 maintenance expenses of the project. These expenses
                                 included employee benefits, political and charitable
                                 contributions,   non-project     expenses     subsequently
                                 reimbursed to the project, and purchases for the benefit of
                                 the owner/management agent.

                                 Using funds for these expenses violated the Regulatory
                                 Agreement. The Agreement requires all project funds be
                                 used for reasonable and necessary operating and
                                 maintenance expenses of the project, with the exception
                                 that distributions for other purposes can be made from
                                 surplus cash. Using project funds for other than reasonable
                                 and necessary expenses increases the risk to HUD’s
                                 mortgage insurance fund.

                                 We recommend that the Director, Office of Multifamily
           Recommendations       Housing, Kansas City Hub ensures One McKnight Place
                                 makes future distributions only out of surplus cash,
                                 establishes and implements procedures to ensure future
                                 requests for use of reserve funds are properly prepared,
                                 repays the reserve funds for excessive withdrawals, executes
                                 a management agreement stating the duties to be performed
                                 and the appropriate fees to be paid, and accounts for its funds
                                 in such a way that it can be shown all non-project expenses
                                 are paid from surplus cash.




                                      Page   iii                                  2001-KC-1002


Table of Contents                                                                              Exit
Table of Contents
Management Memorandum                                                         i



Executive Summary                                                            ii



Introduction                                                                 1



Findings

1. Surplus Cash Was Prematurely Distributed                                  2

2. Reserve Funds Were Not Properly Used                                      5

3. Management Fees Were Not Paid According To The Management
   Agreement And May Not Be Reasonable                                       9

4. One McKnight Place Made Purchases That Were Not Reasonable Or
   Necessary                                                                12



Management Controls                                                         16



Follow Up On Prior Audits                                                   17



Appendices
   A Schedule of Questioned Costs                                           18


   B Auditee Comments                                                       19


   C Distribution                                                           22

                                    Page iv                        2001-KC-1002


                                                                              Exit
          Introduction
          The Department of Housing and Urban Development coinsured, under the 221(d)(4) program, a
          $21,621,300 mortgage to construct One McKnight Place. The owner of One McKnight Place is
          McKnight Place Partnership I, L.P. The general partners of the ownership are One McKnight Place
          Management Company (48.75 percent), and D.A. Smith Family Partnership (48.75 percent). The
          limited partners are Charles Deutsch (1.25 percent) and David and Elana Smith (1.25 percent). On
          September 21, 1987, the owners signed their Regulatory Agreement with the coinsuring mortgagee,
          and on August 31, 1995, the Regulatory Agreement was modified as a result of a loan modification
          that lowered the interest rate.

          One McKnight Place’s mortgage was originated by a coinsuring lender. HUD delegated to
          coinsuring lenders certain responsibilities that HUD Field Offices generally perform for projects
          with fully insured and HUD-held mortgages. The responsibilities included reviewing monthly and
          annual financial statements; reviewing management agents and fees; authorizing withdrawals from
          the replacement reserve; conducting on-site reviews of project operations; and negotiating workout
          agreements and mortgage relief.

          Subsequent to constructing the coinsured portion of the property, the owners, under a different
          corporate identity, constructed phases II and III of the property without HUD assistance. Phases II
          and III are known as McKnight Place Extended Care. Phase IV was recently constructed through
          use of HUD’s 241 supplemental loan program in the amount of $14,076,400. The Regulatory
          Agreement for this phase was dated July 14, 1999. One McKnight Place (phase I) generated gross
          revenue of $9.8 million in 2000. It has 221 units and is located in St. Louis County, Missouri.



                                                The overall audit objective was to determine whether project
           Audit Objective                      officials used project funds for purposes other than
                                                reasonable operating expenses, necessary repairs, or
                                                allowable distributions from surplus cash.

                                                To achieve our objective, we reviewed the project’s bank
           Audit Scope and                      statements, canceled checks, general ledgers, invoices, and
           Methodology                          management agreement. We also interviewed project
                                                management and owners.

                                                We performed audit work from February 2001 through
                                                March 2001. The audit covered the period January 1, 1998
                                                through December 31, 2000. We extended the review, where
                                                necessary, to include other periods. The Audit was
                                                conducted in accordance with generally accepted government
                                                auditing standards. We provided draft findings to One
                                                McKnight on April 3, 2001 and received the owners’
                                                responses to our findings on April 20, 2001. We provided a
                                                copy of this report to the owners of One McKnight Place.


                                                        Page 1                                  2001-KC-1002


Table of Contents                                                                                           Exit
                                                                                                         Finding 1


                Surplus Cash Was Prematurely Distributed
          One McKnight Place prematurely distributed $908,920 in surplus cash to its owners. The project
          generated sufficient surplus cash to cover the amount of the premature distribution. However, surplus
          cash cannot be distributed until after it has been substantiated by a periodic surplus cash calculation.
          Since all cash had been distributed per the most recent surplus cash calculation, the excess distribution
          was in violation of the regulatory agreement. HUD only allows distributions to be made after a surplus
          cash calculation has been completed to ensure owners and agents fulfill their responsibilities to properly
          maintain projects.



                                                  One McKnight Place is governed by a Regulatory Agreement
            Program Requirements                  that says distributions can only be paid out of surplus cash
                                                  that existed as of the end of a semi-annual or annual fiscal
                                                  period. It also says that distributions may be paid only after
                                                  the end of the fiscal period in which the surplus cash is
                                                  generated.

                                                  One McKnight made distributions to its owners that
            Premature Distributions               exceeded the amount of surplus cash that was calculated to
                                                  be available as of the end of the fiscal period prior to the
                                                  distribution.

                                                  The December 31, 1998 surplus cash calculation showed the
                                                  project had surplus cash in the amount of $565,850. One
                                                  McKnight distributed the $565,850 to its owners between
                                                  January 1 and February 4, 1999. However, One McKnight
                                                  distributed another $400,000 on March 18, 1999 and
                                                  $306,920 on May 7, 1999 to its owners. At these times no
                                                  surplus cash was available. The June 30, 1999 surplus cash
                                                  computation showed One McKnight had surplus cash
                                                  totaling $659,485. The project distributed the $659,485 to its
                                                  owners between July 1 and July 15, 1999. On December 21,
                                                  1999, One McKnight made payments totaling $202,000 to its
                                                  owners. Again, at this time no surplus cash was available.
                                                  The next surplus cash computation date was not until
                                                  December 31, 1999.

                                                  Since the Regulatory Agreement only allows distributions to
                                                  be made to the extent of surplus cash available as of the end
                                                  of the prior period, and the project had already fully
                                                  disbursed its surplus cash before making these distributions,
                                                  the payments violate the Regulatory Agreement. One

                                                       Page 2                                       00-KC-103-0002


Table of Contents                                                                                                  Exit
                                                                                     Finding 1


                              McKnight should have kept the funds in the project until the
                              next surplus cash date, at which time they would have been
                              eligible to distribute the funds as part of surplus cash. For
                              example, if the project had not made the extra distributions in
                              March and May, the project would have had that $706,920 in
                              cash when the June 30, 1999 surplus cash computation was
                              done, making the total surplus cash available for distribution
                              $1,366,405 rather than $659,485.

                              The project’s improper distribution of funds was a timing
                              issue that self-corrected when new surplus cash calculations
                              were made. Therefore, we are not making recommendations
                              for repayment of funds. However, since the future financial
                              position of a project can vary, HUD only allows distributions
                              to be made after a surplus cash calculation has been completed.
                              This helps ensure owners and agents fulfill their responsibilities
                              to properly maintain projects.



          Auditee Comments    Excerpts from One McKnight’s comments on our draft
                              finding follow. Appendix B, page 25, contains the complete
                              text of the comments.

                              In 1999, One McKnight made distributions from replacement
                              reserve funds to reimburse the owners for project expenses
                              paid between 1992 and June 30, 1999. These distributions
                              were in addition to regular surplus cash distributions as a
                              result of the owners’ understanding of how the regulations
                              applied and the nature of the circumstances. If these funds
                              had been applied for in the surplus cash period in which the
                              work was done, then a corresponding amount of cash equal
                              to these distributions would have been available as surplus
                              cash. The owners assumed that these refunds from the
                              replacement reserve account did not have to be part of a new
                              surplus cash calculation. In the future, any refund from the
                              replacement reserve account will be part of a surplus cash
                              calculation for a prescribed period.



          OIG Evaluation of   All distributions may only be paid out of surplus cash
          Auditee Comments    calculated as of the end of the prior fiscal period. The
                              regulatory agreement defines a distribution as the outlay of
                              any cash or asset of the project excluding outlays for

                                   Page 3                                       00-KC-103-0002


Table of Contents                                                                              Exit
                                                                                Finding 1


                            mortgage payments, reasonable expenses necessary for the
                            proper operation and maintenance of the project, and
                            repayment of owner advances authorized by HUD’s
                            administrative procedures. The payments described above
                            meet the definition of distributions.

                            One McKnight's promise to distribute any future replacement
                            reserve account releases only after the surplus cash
                            calculation for a prescribed period should prevent recurrence
                            of this issue, if followed.



          Recommendations   We recommend the Director, Office Multifamily Housing,
                            Kansas City Hub, ensure the owners of One McKnight Place:

                            1A.     Pay future distributions for other than reasonable and
                                    necessary operating expenses only to the extent of
                                    surplus cash that was calculated to be available per
                                    the last surplus cash calculation.




                                  Page 4                                   00-KC-103-0002


Table of Contents                                                                        Exit
                                                                                                  Finding 2


                    Reserve Funds Were Not Properly Used
          One McKnight Place used $31,708 from its Reserve for Replacement account for items that were
          routine maintenance costs of the project, rather than capital expenses; for items that were also
          charged to the tenants; and for items that were not expenses of the project. This amount was
          included in the premature surplus cash distribution to the owners outlined in Finding 1. HUD
          directives say Reserve for Replacement Funds provide cash for the replacement of capital items
          and are not intended to cover routine maintenance costs. As a result, the Reserve for
          Replacement funds will not be available in later years to help defray the cost of needed capital
          improvements.



                                              One McKnight Place is governed by a Regulatory Agreement
           Program Requirements               that says the project should apply for withdrawals from the
                                              reserve fund in accordance with chapter 5 of HUD Handbook
                                              4566.2. Handbook 4566.2 says the reserve provides cash for
                                              the replacement of capital items and is not intended to cover
                                              routine maintenance costs. The Handbook lists items that are
                                              specifically eligible for reimbursement from the reserve.
                                              Exterior painting is on the list, but interior painting is not.

                                              HUD Handbook 4350.1, applicable to multifamily housing
                                              projects but not specifically referenced in One McKnight’s
                                              Regulatory Agreement, was used as a guideline by the
                                              mortgagee when reviewing the project’s request for release
                                              of reserve funds. The Handbook says a reserve fund is
                                              established to help ensure that the physical life of buildings
                                              and structures extend to the assumed 55-year economic lives.

                                              It was not the original purpose of a reserve fund to provide
                                              for a complete, dollar for dollar, capability of replacing all
                                              the building structural components and equipment as they
                                              wear out but rather to provide a readily available source of
                                              capital that will help defray replacement costs in the latter
                                              years of amortization of a mortgage note. Owners should
                                              make reimbursement requests during the same fiscal year in
                                              which the expenditure occurs, preferably at least sixty days
                                              prior to the close of the project's fiscal year. Some of the
                                              items traditionally contemplated as ineligible for draws from
                                              a Replacement Reserves Fund are repainting of interior areas,
                                              minor repairs to gutters and downspouts, caulking and
                                              sealing.


                                                    Page 5                                     2001-KC-1002


Table of Contents                                                                                           Exit
                                                                                Finding 2


                             One McKnight applied for and was granted releases from the
                             reserve fund for claims totaling $31,708 that were
                             inappropriate to charge to the reserve fund. The claims were
                             not eligible for reimbursement from the reserve fund because
                             the improvements were: not for the project, claimed more
                             than once or in an amount greater than the project paid, also
                             billed to the resident, or routine maintenance including
                             service, repairs, cleaning, caulking, and interior painting.

                             The $31,708 was part of One McKnight’s withdrawals from
                             its reserve fund of $75,000 in 1998 and $709,379 in 1999.
                             The amount of the releases was large because the project
                             requested reimbursement from the reserve fund for capital
                             improvements that were not claimed dating back to 1992.
                             The project should have made timely applications for release
                             of the reserve funds, rather than saving six years of project
                             improvements for one request. One McKnight’s Chief
                             Financial Officer said the former Chief Financial Officer
                             neglected to request draws from the reserve for replacement
                             account for all the capital improvements that were made.

                             One McKnight should not have made application to the
                             mortgagee for the release of the $31,708 of reserve for
                             replacement funds. One McKnight’s Chief Financial Officer
                             said a temporary employee helped prepare the request and
                             may have made some mistakes. He also said he was
                             unaware that interior painting was not normally paid from
                             reserve for replacement funds.

                             Since the $31,708 was inappropriately withdrawn from the
                             reserve for replacement account, and since funds that
                             exceeded the surplus cash calculation were distributed to the
                             owners during the same period (see Finding 1), the owners
                             need to repay the reserve for replacement account $31,708.
                             A properly funded reserve for replacement account helps
                             ensure the future health of a project.



          Auditee Comments   Excerpts from One McKnight’s comments on our draft
                             finding follow. Appendix B, page 25, contains the complete
                             text of the comments.

                             The $31,708 that the OIG identified as inappropriate to
                             charge to the reserve fund consisted of certain amounts due

                                  Page 6                                     2001-KC-1002


Table of Contents                                                                        Exit
                                                                                   Finding 2


                              to clerical error and certain amounts due to interior painting
                              of common areas within the building which One McKnight
                              does not classify as routine maintenance. This is an
                              extensive common area unique in character to a senior
                              housing community and, therefore, this work would be
                              classified as a capital expenditure. One McKnight certainly
                              agrees to refund any amounts mistakenly taken from the
                              Replacement Reserves due to clerical errors. If your
                              conclusion, after getting input from our co-insured lender
                              and fund administrator, results in a final determination that
                              the items you refer to as "routine maintenance", including
                              interior painting, were not eligible for reimbursement, then
                              we will refund that portion as well.



          OIG Evaluation of   The regulatory agreement requires that withdrawals from the
          Auditee Comments    replacement reserve be applied for in accordance with HUD
                              Handbook 4566.2. This Handbook says that the replacement
                              reserve funds may generally only be used to pay for
                              replacement of those items listed in Appendix 16. HUD
                              expects that lenders will rarely approve withdrawal for other
                              than the uses listed in Appendix 16. Reserve funds may be
                              used for purposes other than those itemized in Appendix 16
                              only if the lender determines that the project's cash flow is
                              not sufficient to cover the outlay and such uses would be the
                              best use of reserve funds. One McKnight Place did not meet
                              this condition of insufficient cash flow. The list contained in
                              Appendix 16 does not include painting under the Interior
                              Decorating heading. Painting only appears under the
                              Exterior heading. Therefore, use of replacement reserve
                              funds for interior painting would have had to fall under the
                              acceptable exceptions outlined in the Handbook, which it did
                              not.

                              Further, the Handbook states that if the owner is requesting a
                              withdrawal for other than the uses listed in Appendix 16, the
                              owner must explain why other project funds cannot be used
                              as well as prepare an analysis of the reserve's ability to cover
                              future replacement costs. The owners of One McKnight
                              Place did neither of the above. Therefore, we conclude the
                              owners should reimburse the $31,708 that was
                              inappropriately withdrawn from the reserve fund.




                                   Page 7                                       2001-KC-1002


Table of Contents                                                                            Exit
                                                                             Finding 2




          Recommendations   We recommend the Director, Office of Multifamily Housing,
                            Kansas City Hub, ensure the owners of One McKnight Place:

                            2A.     Establish and implement procedures that ensure
                                    future reserve for replacement fund withdrawal
                                    requests comply with HUD’s guidelines and are
                                    completed timely (during the fiscal year when the
                                    improvements are made).

                            2B.     Repay the reserve for replacement fund $31,708 from
                                    non-project funds.




                                  Page 8                                  2001-KC-1002


Table of Contents                                                                     Exit
                                                                                                  Finding 3


          Management Fees Were Not Paid According To
          The Management Agreement And May Not Be
                         Reasonable
          One McKnight Place received a management fee that exceeded the amount allowed by the management
          agreement. The management agreement between the mortgagee, One McKnight Place, and the
          identity of interest management agent allowed for the payment of a 4 percent management fee.
          The actual management fee taken by the management agent was 5 percent. A letter from the
          mortgagee said an additional 2 percent could be paid to the management agent for food service
          management. Additionally, the letter had a hand written note on it initialed by one owner that
          indicated the management fee was increased to 5 percent. The management agreement was not
          updated or amended to reflect these changes, and there was no analysis to show the fees for the
          food service were reasonable when compared with an arms length transaction. As a result, HUD
          lacks assurance that project funds were only used for reasonable and necessary expenses.



                                              Chapter 4 of HUD Handbook 4566.2 states that after the
           Program Requirements
                                              lender approves a management agent, the project owner and
                                              any identity-of-interest or independent fee manager must
                                              execute a management agreement.            The agreement
                                              establishes the management fee and the conditions in which
                                              that fee is to be paid. The regulatory agreement requires
                                              that the management fees be reasonable in amount.

                                              Chapter 4 further says the owner has a responsibility to
                                              shop and compare. The regulatory agreement requires
                                              owners to obtain contracts and services on terms most
                                              advantageous to the project and at costs not in excess of
                                              amounts normally paid for such contracts and services in
                                              the area in which the services are rendered. Project owners,
                                              therefore, are required to shop and compare management
                                              fees, as necessary, to determine that the fee proposed by the
                                              owner does not exceed the amount normally paid on similar
                                              projects, except as justified by special conditions existing at
                                              that project.

                                              The owners/management agent of One McKnight Place
            A Letter Established Fees         believed that a letter, dated July 25, 1995, from the
                                              mortgagee to One McKnight Place was sufficient to
                                              establish the 5 percent management fee and the additional 2
                                              percent for the management of food services. The letter

                                                   Page 9                                      2001-KC-1002


Table of Contents                                                                                           Exit
                                                                                       Finding 3


                                    from the mortgagee said an additional 2 percent could be
                                    paid to the management agent for food service
                                    management. Additionally, the letter had a hand written
                                    note on it initialed by one owner that indicated the
                                    management fee was increased to 5 percent.

                                    The owner said the 2 percent special distribution/food
                                    service management fee was for running the daily
                                    operations and oversight of the food service department.
                                    This included hiring and oversight of the menus.

                                    When One McKnight Place opened in 1988, they
          Competitive Bids and      contracted with Marriott in St. Louis for food service
          Comparable Studies Were   manangement. Marriott was paid approximately $40,000
          Not Performed.            per year, which equated to about 0.8 percent of gross
                                    receipts. Because One McKnight Place wanted to serve a
                                    quality and style of food that Marriott was not able to
                                    provide, the owners did not renew Marriott’s contract and
                                    took over the food service responsibilites. In 1995, the
                                    owners began paying themselves 2 percent of gross
                                    revenues for their services. From 1998 through 2000, this 2
                                    percent fee ranged from $181,683 to $196,411 per year.
                                    Since the current payment is substantially greater than the
                                    amount the project previously paid for food service
                                    management, we believe it may be excessive. There were
                                    no bids let or studies completed to determine what was a
                                    reasonable fee for the services rendered.

                                    As a result, HUD lacks assurance the fees paid for project
                                    management and food service were reasonable and
                                    necessary.



          Auditee Comments          Excerpts from One McKnight’s comments on our draft
                                    finding follow. Appendix B, page 25, contains the complete
                                    text of the comments.

                                    One McKnight believes that a 5 percent general management
                                    fee and a 2 percent food management fee is extremely
                                    reasonable. Management fees at standard garden apartment
                                    projects begin at 5 percent and do not include the varied and
                                    extensive number of service components that One McKnight
                                    oversees. However, One McKnight owners believe that it
                                    would not be easy to find meaningful competitive prices for

                                         Page 10                                    2001-KC-1002


Table of Contents                                                                               Exit
                                                                                   Finding 3


                              the management services that they provide due to the
                              uniqueness of their project. Therefore, they propose to enter
                              into a standard 5 percent management contract with a related
                              identity of interest and submit it to their lender for approval.
                              Under these circumstances, they are willing to fund the 2
                              percent food service management fee out of their regular
                              semi-annual Surplus Cash distributions since they already
                              self-manage these operations.



          OIG Evaluation of   One McKnight's planned actions should correct the problem
          Auditee Comments    we identified with the management contract if the actions are
                              approved by the lender and properly implemented.


          Recommendations     We recommend the Director, Office of    Multifamily
                              Housing, Kansas City Hub, ensure the owners of One
                              McKnight Place:

                              3A.     Execute a current management agreement with the
                                      management agent and the mortgagee, and

                              3B.     Either pay food service management fees out of
                                      regular semi-annual surplus cash distributions; or
                                      solicit bids for the food service management fees and
                                      execute a contract for food management with the
                                      most competitive bidder, or limit the amount paid to
                                      the amount of the lowest competitive bid.




                                    Page 11                                     2001-KC-1002


Table of Contents                                                                            Exit
                                                                                                    Finding 4


               One McKnight Place Made Purchases That
                  Were Not Reasonable or Necessary
          The owners of One McKnight Place paid project funds for other than reasonable and necessary
          operating and maintenance expenses of the project. These expenses included employee incentives,
          political and charitable contributions, non-project expenses subsequently reimbursed to the project,
          and purchases for the benefit of the owners/management agent. Using funds for these expenses
          violated the Regulatory Agreement. The Agreement requires all project funds be used for
          reasonable and necessary operating and maintenance expenses of the project, with the exception
          that distributions for other purposes can be made from surplus cash. Using project funds for other
          than reasonable and necessary expenses increases the risk to HUD’s mortgage insurance fund.



                                                The Regulatory Agreement says that project funds must be
           Regulatory
           UnallowableAgreement
                       Purchases                used to pay amounts required by the mortgage, make
                                                required reserve deposits, pay reasonable expenses necessary
                                                to the operation and maintenance of the project, and repay
                                                owner advances authorized by the Secretary’s administrative
                                                procedures and approved by the mortgagee. Any other
                                                distributions can only be paid out of surplus cash that existed
                                                as of the end of a semi-annual or annual fiscal period. The
                                                owners of One McKnight Place used project funds for
                                                employee incentives, political and charitable contributions,
                                                non-project expenses subsequently reimbursed to the
                                                project and purchases for the benefit of the
                                                owners/management agent.

                                                One McKnight made expensive purchases for the benefit of
                                                its employees. During the 3 years we reviewed, the project
                                                paid approximately $15,000 for tickets to the St. Louis
                                                Cardinals baseball games. Additionally, the project paid
                                                thousands of dollars for gift certificates at the Galleria
                                                shopping mall, for personal trainers for its top staff, holiday
                                                parties, and employee bonuses. For example, during the 3
                                                years we reviewed, holiday parties at the Ritz Carlton hotel
                                                cost $23,635 and bonuses for 21 employees totaled
                                                $401,405.

                                                The owners also used project funds for an assortment of
                                                political and charitable contributions. In 1999, the owners
                                                contributed $3,333 to Harmon for Mayor and $1,667 to the
                                                Senate Majority Fund. The owners also contributed to the

                                                      Page 12                                    2001-KC-1002


Table of Contents                                                                                             Exit
                                                                       Finding 4


                    Children’s Miracle Network, Yes to Schools school bond
                    donation, the Vaad Hoeir of St. Louis, The Symphony Fund
                    and many other causes. Although some of the project’s
                    charitable contributions also provided One McKnight Place
                    with advertising, the payment still included a donation. For
                    example, One McKnight paid $900 to Sha'arei Chesed
                    Shul. This payment was toward a $1,800 platinum
                    membership, the cost of which was split with another
                    McKnight organization. Although the payment provided an
                    advertisement and 2 dinner tickets, an advertisement could
                    have been purchased for a lesser amount.              For a
                    contribution of $360, the project could have purchased a
                    full-page advertisement, which included dinner tickets
                    valued at $160, making the value of the advertisement
                    $200.

                    Further, One McKnight Place funds were used to pay for
                    non-project expenses that were subsequently reimbursed to
                    the project. Even though the funds were reimbursed, project
                    funds should not be used for non-project expenses or to make
                    loans for non-project expenses. The project had house
                    accounts for its employees where tabs that were deducted
                    from paychecks were kept. Often when an employee would
                    submit a personal credit card statement, the balance was paid
                    in full and then the total of the purchases that were deemed
                    personal was charged back to the employee. Also, certain
                    employees and owners had extra cell phones or pagers for
                    family members or used their official phones for personal
                    reasons. The project paid for these bills upfront and then
                    billed the personal portions to the house account.

                    Finally, in some instances the owners used project funds to
                    pay expenses that were for the owners’ benefit or used
                    project resources in a way that did not benefit the project.
                    For example, the Project paid $1,031 to purchase airfare for
                    one of the owners to travel to the project to attend an award
                    ceremony, used the Chief Financial Officer to perform the
                    accounting for the partnership, and used another employee to
                    provide services for another business of one owner.
                    Additionally, one of the owners’ secretary and another
                    owners’ assistant were paid employees of the project. These
                    expenses would have more appropriately been paid out of the
                    partnership account or the management agent account.

                    The owners believe that since the project was very profitable

                         Page 13                                    2001-KC-1002


Table of Contents                                                               Exit
                                                                                 Finding 4


                             and always generated surplus cash, there was no problem in
                             offering great employee benefits.        Offering employee
                             benefits and making contributions to the community allowed
                             the property to be of high caliper. The Chief Financial
                             Officer believes these payments just reduced the amount of
                             the next surplus cash computation and caused no harm.

                             We agree with the Financial Officer that no harm has
                             occurred to date due to the profitability of the project. The
                             payments only reduced the next period’s surplus cash amount
                             available for distribution to the owners. The project is in
                             excellent physical condition and is current on its mortgage
                             payments. However, the project could be less profitable in
                             future periods. The Regulatory Agreement’s requirements
                             related to spending are in place to protect the Department’s
                             interest and reduce risk to HUD’s Mortgage Insurance fund.
                             The surplus cash computation requirement and procedures
                             allow owners of profitable projects to withdraw an
                             appropriate amount of funds from the project while still
                             protecting the insurance fund.




          Auditee Comments   Excerpts from One McKnight’s comments on our draft
                             finding follow. Appendix B, page 25, contains the complete
                             text of the comments.

                             ”Based on our project being somewhat unique and its
                             successful operating history, we respectfully disagree with
                             your interpretation of the Regulatory Agreement on this
                             point. The expenses you identified represent a very small
                             portion of our overall operating expenses (perhaps with the
                             exception of employee bonuses), were reasonable and were
                             necessary for the operation and maintenance of the project at
                             the superior level at which it operates. We believe each item
                             you identified can be substantiated as beneficial to our
                             project's ongoing success….. Most of these expenses would
                             still be necessary for employee retention, even if the project
                             was not in a surplus cash position. However, if our overall
                             profitability and available Surplus Cash were to change in the
                             future, we would review these practices at that time and we
                             would further assume that the mortgagee would do the same.
                             A less desirable, more cumbersome and costly alternative
                             would be to pay for such reasonable employee incentives,
                             political and charitable contributions from a partnership

                                  Page 14                                    2001-KC-1002


Table of Contents                                                                         Exit
                                                                                  Finding 4


                              account funded from Surplus Cash. We do not believe this
                              to be either reasonable or in the best interest of the project
                              and sincerely hope that you will reevaluate your position on
                              this issue.”



          OIG Evaluation of   We commend One McKnight on its successful operating
          Auditee Comments    history, but emphasize that past performance is not a
                              guarantee of continued future success. This successful
                              operating history does not relieve the project of
                              accountability to HUD through compliance with the
                              Regulatory Agreement. HUD cannot allow One McKnight a
                              different standard than other projects. The Regulatory
                              Agreement must be enforced regardless of the project's
                              current wealth. The best solution is to fund the expenditures
                              described in our finding from a separate partnership account,
                              funded from surplus cash. This would allow the owners a
                              means to make these expenditures while still holding them to
                              the same standard for direct use of operating funds as other
                              projects.


          Recommendations     We recommend the Director, Office Multifamily Housing,
                              Kansas City Hub, require the owners of the One McKnight
                              Place to:

                              4A.     Stop paying non-project type expenses from project
                                      funds.

                              4B.     Take administrative action against the owners if
                                      they continue to pay non-project expenses using
                                      non-surplus cash project funds.




                                    Page 15                                   2001-KC-1002


Table of Contents                                                                          Exit
          Management Controls
          In planning and performing our audit, we considered the management controls of One McKnight
          Place to determine our auditing procedures, not to provide assurance on the controls. Management
          controls include the plan of organization, methods and procedures adopted by management to
          ensure that its goals are met. Management controls include the processes for planning, organizing,
          directing, and controlling program operations. They include the systems for measuring, reporting,
          and monitoring program performance.



                                               We determined the following management controls were
           Relevant Management                 relevant to our audit objectives:
           Controls
                                               •= Assuring appropriate expenditure of project funds.

                                               •= Assuring compliance with laws and regulations.

                                               We assessed the relevant controls identified above.

                                               It is a significant weakness if management controls do not
                                               provide reasonable assurance that the process for planning,
                                               organizing, directing, and controlling program operations
                                               will meet an organization’s objectives.

                                               Based on our review, we believe the following items are
           Significant Weaknesses              significant weaknesses:

                                               •= One McKnight Place prematurely distributed surplus
                                                  cash (see Finding 1).

                                               •= One McKnight Place did not appropriately use its reserve
                                                  for replacement funds (see Finding 2).

                                               •= One McKnight Place did not have an adequate
                                                  management agreement in place (see Finding 3).

                                               •= One McKnight Place spent project funds for other than
                                                  reasonable and necessary expenses (see Finding 4).




                                                     Page 16                                   2001-KC-1002


Table of Contents                                                                                          Exit
          Follow Up On Prior Audits
          This is the first audit of One McKnight Place performed by the Office of Inspector General.




                                                    Page 17                                   2001-KC-1002


Table of Contents                                                                                        Exit
                                                                                             Appendix A

          Schedule of Questioned Costs
                Recommendation                                       Type of Questioned costs
                   Number                                    Ineligible 1/         Unsupported 2/


                       2B                                     $31,708




          1/    Ineligible costs are costs charged to a HUD-financed or HUD-insured program or activity
                that the auditor believes are not allowable by law, contract or Federal, State or local
                policies or regulations.

          2/    Unsupported costs are costs charged to a HUD-financed or HUD-insured program or
                activity and eligibility cannot be determined at the time of audit. The costs are not
                supported by adequate documentation or there is a need for a legal or administrative
                determination on the eligibility of the costs. Unsupported costs require a future decision
                by HUD program officials. This decision, in addition to obtaining supporting
                documentation, might involve a legal interpretation or clarification of Departmental
                policies and procedures.




                                                   Page 18                                   2001-KC-1002


Table of Contents                                                                                        Exit
                                       Appendix B

          Auditee Comments




                             Page 19   2001-KC-1002


Table of Contents                                 Exit
                                       Appendix B

          Auditee Comments




                             Page 20   2001-KC-1002


Table of Contents                                 Exit
                                       Appendix B

          Auditee Comments




                             Page 21   2001-KC-1002


Table of Contents                                 Exit
                                                                                          Appendix C

          Distribution Outside of HUD
          Chairman, Committee on Governmental Affairs, 340 Dirksen Senate Office Building,
            United States, Senate, Washington, DC 20510
          Ranking Member, Committee on Governmental Affairs, 706 Hart Senate Office Building,
            United States, Senate, Washington, DC 20510
          Chairman, Committee on Government Reform, 2185 Rayburn Building, House of
            Representatives, Washington, DC 20515
          Ranking Member, Committee on Government Reform, 2204 Rayburn Building
            House of Representatives, Washington DC 20515
          Subcommittee on Oversight and Investigations, Room 212 O’Neil House Office Building
            Washington, DC 20515
          Director, Housing and Community Development Issue Area, United States General Accounting
            Office, 441 G Street NW, Room 2474, Washington DC 20548
          Deputy Staff Director, Counsel, Subcommittee on Criminal Justice, Drug Policy & Human
            Resources, B373 Rayburn House Office Building, Washington, DC 20515
          Chief, Housing Branch, Office of Management & Budget, 725 17th Street, NW, Room 9226,
            New Executive Office Building, Washington, DC 20503




                                                  Page 22                                 2001-KC-1002


Table of Contents                                                                                    Exit