oversight

HUD Did Not Provide Adequate Oversight and Guidance During the Technical Review of the Retreat at Santa Rita Springs

Published by the Department of Housing and Urban Development, Office of Inspector General on 2010-08-02.

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

                                                                  Issue Date
                                                                          January 21, 2011
                                                                  Audit Report Number
                                                                           2011-LA-0001




TO:         Tom Azumbrado, Director, San Francisco Multifamily Housing Hub, 9AHMLA

            Joyce Allen, Director, Office of Multifamily Housing Development, HTD



FROM:       Tanya E. Schulze, Regional Inspector General for Audit, Region IX, 9DGA

SUBJECT: HUD Did Not Provide Adequate Oversight and Guidance During the Technical
         Review of the Retreat at Santa Rita Springs

                                    HIGHLIGHTS

 What We Audited and Why

      We completed an internal audit of the Retreat at Santa Rita Springs (community), a
      Federal Housing Administration-insured multifamily property under the Section 231 of
      the National Housing Act.

      The internal audit was performed as a spinoff of a prior external audit of the community.
      We conducted the audit in response to a congressional request from Representative
      Gabrielle Giffords of the 8th Congressional District of Arizona. In November 2009, the
      owners of the community defaulted on its $29.9 million U.S. Department of Housing and
      Urban Development (HUD)-insured loan less than one month after final endorsement.
      Although the external audit disclosed that the community did not comply with applicable
      Federal rules and regulations and its regulatory agreement with HUD, those violations
      alone were not material enough to cause the owners to default on the loan. Therefore, the
      objective of the internal audit was to determine the cause(s) of the community’s failure.
      We included HUD’s technical review, Multifamily Accelerated Processing (MAP)
      lender’s underwriting practices, and the owners’ responsibilities in our internal audit to
     determine the indications of noncompliance with Section 231 program requirements that
     may have contributed to the loan default.


What We Found

     The community experienced huge operating shortfalls and eventually defaulted on the
     loan. The financial default was due to HUD’s inadequate technical review and
     monitoring, the lender’s failure to exercise due diligence in underwriting the loan, and the
     owners’ lack of financial commitment and guidance to its management agent. As a
     result, the community’s loan note was sold to an outside party for approximately $9
     million, or more than a $20 million loss to HUD.


What We Recommend

     We recommend that the Director of HUD’s Office of Multifamily Housing Development
     update the MAP Guide to include rules and requirements for processing Section 231
     loans and discontinue processing these types of loans until the MAP Guide is updated.
     We also recommend that the Director of HUD’s Region IX San Francisco Office of
     Multifamily (1) ensure that all conditions for underwriting are met in processing Section
     231 multifamily properties and that there are clear roles, responsibilities and
     communication among the HUD offices when conducting reviews to minimize potential
     problems such as those mentioned in this report and (2) improve the regional field
     office’s property management and performance monitoring of Section 231 properties by
     beginning monitoring immediately upon occupancy to minimize potential financial,
     operational, and managerial problems related to the properties under the program.

     These recommendations only address HUD’s involvement during its technical review of
     the underwriting of this loan. The owners’ and lender’s involvement in the community
     were addressed outside this report.

     For each recommendation without a management decision, please respond and provide
     status reports in accordance with HUD Handbook 2000.06, REV-3. Please furnish us
     copies of any correspondence or directives issued because of the audit.

Auditee’s Response


     We provided HUD a draft report on December 14, 2010, and held an exit conference on
     January 7, 2011. HUD provided written comments on January 13, 2011, and generally
     agreed with our report and recommendations.

     The complete text of the auditee’s response, along with our evaluation of that response,
     can be found in appendix A of this report.




                                              2
      TABLE OF CONTENTS

Background and Objective                                                     4

Results of Audit
   Finding: HUD Did Not Provide Adequate Oversight and Guidance During the   5
            Technical Review of the Retreat at Santa Rita Springs


Scope and Methodology                                                        14

Internal Controls                                                            15

Appendixes

A. Auditee Comments and OIG’s Evaluation                                     16
B. Criteria                                                                  21




                                           3
                       BACKGROUND AND OBJECTIVE

The Retreat at Santa Rita Springs (community) is a 196-unit multifamily independent living
facility located in Green Valley, AZ. Its $29.9 million Federal Housing Administration (FHA)
loan was insured under Section 231 of the National Housing Act. The community’s owners was
the Retreat IL, LLLP, an Arizona limited liability limited partnership.

Paragon Mortgage, a U.S. Department of Housing and Urban Development (HUD)-approved
Multifamily Accelerated Processing (MAP) lender, underwrote the loan. After initial
endorsement in October 2007, the loan was assigned to Capstone Realty Advisors, LLC, and
then assigned to Red Mortgage Capital, Inc., in June 2009.

Coppersands Incorporated (Coppersands) was the management agent approved at the firm
application stage. In October 2008, the owners replaced Coppersands with another management
agent, Watermark Retirement Corporation (Watermark). Watermark managed the community
until it ceased operations in November 2009.

The community experienced huge operating shortfalls due to the owners’ inability to lease up the
property. The owners were able to maintain the property until October 2009 to ensure HUD’s
firm commitment approval for final endorsement of the community. Days after final
endorsement, the owners stopped making loan payments and were unwilling to invest additional
capital into the community. These actions led to the community’s financial problems and the
owners’ loan default. On December 28, 2009, Red Mortgage assigned the loan to HUD. HUD
recently sold the loan at a note sale for $9.8 million, a loss of more than $20 million. The sale of
the loan to an outside party resulted in the community no longer being HUD insured.

HUD’s Lender Qualification and Monitoring Division (LQMD) performed a quality assurance
project default review of the community to evaluate the MAP lender’s loan underwriting
practice. On July 8, 2010, LQMD issued a report to the lender that covered the results of the
review. HUD’s Office of Inspector General (OIG) issued a separate external report reviewing
the community’s operations.

Our objective was to determine the cause(s) of the community’s failure.




                                                 4
                                RESULTS OF AUDIT

Finding: HUD Did Not Provide Adequate Oversight and Guidance
         During the Technical Review of the Retreat at Santa Rita
         Springs
The community experienced operating financial shortfalls and eventually defaulted on the loan.
Our review determined that HUD, the approved MAP lender, and the owners had contributed to
the financial problems that hampered the community. HUD’s inadequate technical review and
property monitoring, the MAP lender’s failure to exercise due diligence in its underwriting, and
the owners’ lack of financial commitment and guidance to its management agent contributed to
the community’s financial problems that led to the loan default. As a result, HUD incurred more
than $20 million in losses from the sale of the loan to an outside party.



 HUD Provided Inadequate
 Oversight and Guidance

       Underwriting Guidance Was Incomplete

       On March 27, 2007, HUD issued Mortgagee Letter 2007-05, which authorized the use of
       the MAP Guide to process Section 231 loans. According to the mortgagee letter,
       chapters 3, 5, 6, 7 and 8 of the MAP Guide would be modified to reflect guidance on
       processing Section 231 loan applications. However, changes had not been made as of
       December 2010. Initially, the MAP Guide was used by the MAP lender in processing a
       Section 221(d)(4) loan application for the community in May 2007. When the program
       was changed to a Section 231 program upon HUD’s recommendation, HUD and the
       MAP underwriter used the MAP Guide to process the Section 231 loan according to the
       mortgagee letter. Because no changes were made to the guide, there were no explicit
       instructions in the MAP Guide for processing Section 231 loans and HUD technical
       reviewers used the 221(d)(4) instructions in the MAP Guide without regard to the
       underwriting differences between the two programs. According to HUD, the significant
       underwriting differences between Section 221(d)(4) and Section 231 are the appraisal and
       market study because the studies for Section 231 would focus on the target market of
       potential residents who were 62 years of age and older and/or handicapped. Under
       Section 221(d)(4), the studies would not be age restrictive.

       Underwriting Conditions Before Firm Commitment Approval Were Not Met

       HUD approved the loan firm commitment for initial endorsement without verifying that
       the underwriting conditions it required had been met. However, HUD Handbook 4430.1
       states that HUD’s regional field office manager was responsible for ensuring that



                                               5
underwriting conditions to the firm commitment were met before initial closing. The
underwriting conditions for the community included the downsizing of the common area
kitchen, revisions of the appraisal and market analysis, and submission of the required
form HUD-92013-E for analysis of optional services that were to be provided to
residents. This deficiency occurred because the HUD San Francisco and Phoenix
multifamily offices did not understand their responsibilities for processing this loan.

As of August 2007, the HUD Region IX Office of Multifamily had issued a directive
requiring that loan applications for more than $15 million be reviewed by the San
Francisco office for the preapplication and firm commitment stages of the loan process.
Both the Phoenix and San Francisco offices performed technical reviews of the
underwriting of the community’s loan. Since the San Francisco office conducted a
limited technical review of the underwriting, it did not use the required checklist for
verifying whether underwriting requirements had been met. However, the Phoenix HUD
office believed that both offices were conducting full technical reviews of the
underwriting of the loan. As a result, neither HUD office understood its responsibilities
in performing the technical review of the underwriting of this loan. HUD issued the firm
commitment without the underwriting conditions having been met, and the community
encountered the following issues:

                            The Kitchen Was Not Downsized

Section 231 allows projects to install modest or nonluxury equipment in a common area
kitchen for use by the residents or outside and unrelated catering entities. However,
HUD’s review of the community’s design found that the common area kitchen located in
the 11,000-square-foot community/club house was more than a warming kitchen and
recommended that it be downsized according to program requirements. The MAP lender
responded and agreed that the specifications of the kitchen would be changed to conform
to the requirements of Section 231. According to HUD, the kitchen was supposed to
have only one stove, microwave, and refrigerator instead of two of each appliance. The
purpose of the request was to reduce unnecessary construction costs and minimize
potential financial issues at the community. However, the MAP lender did not conduct a
follow-up inspection to verify whether the kitchen plans and specifications had been
modified as requested by HUD. As a result, community house construction costs of at
least $1.5 million were not reduced.

                  The Appraisal and Market Study Were Not Updated

The owners’ proposal stated that the community was an independent living facility with
services such as optional meals, housekeeping, and transportation. It was originally
underwritten under the Section 221(d)(4) program but was changed to Section 231 at
HUD’s recommendation. According to HUD’s LQMD, both programs had similarities in
the restrictions of mandatory meals and services. However, each program had different
underwriting requirements. HUD program technical reviewers recommended an updated
appraisal to revise the rent comparables and market study to meet Section 231
requirements. The HUD technical reviewers believed that the underwritten rents



                                        6
provided in the exhibits for the Section 221(d)(4) loan application were higher than the
intended market for residents seeking optional meals and services. However, HUD
approved the firm commitment without an updated appraisal and market study under the
Section 231 program.

                           Requirements Were Not Submitted

The MAP lender did not submit the required form HUD-92013-E, Supplemental
Application and Processing Form - Housing for the Elderly/Disabled. This supplemental
form should accompany the loan application for the processing of loans for multifamily
properties that house elderly/disabled residents. HUD Mortgagee Letter 2007-05
required the MAP lender to use this form and submit it with the Section 231 loan
application due to the proposed optional services such as meals and transportation. The
MAP lender acknowledged that this omission was an oversight on its part. However,
HUD did not request this document to determine the validity of the proposal. As a result,
the community incurred unapproved expenses related to optional services that HUD
failed to review.

HUD Monitoring Was Inadequate

HUD was responsible for monitoring, as well as coordinating with owners, managing
agents, lenders, subsidy contract administrators, and other clients, to ensure compliance
with program rules and requirements. HUD was required to perform ongoing monitoring
of the community during occupancy. In January 2009, the community began operations
with initial occupancy occurring in February 2009. Throughout its entire operations, the
community’s occupancy rate did not exceed six percent. However, HUD did not perform
property management and performance monitoring until September 2009, which was
before the firm commitment on final endorsement in October 2009. During our review,
we found that HUD did not provide adequate property management and performance
monitoring of the community to ensure compliance with HUD requirements and
regulations. The lack of adequate HUD monitoring resulted in various violations. The
following violations contributed to the default of the community:

              An Unapproved Management Was Operating the Community

Watermark was not HUD approved until September 2009. It replaced Coppersands in
October 2008 and had been managing the community without HUD approval.
Watermark’s management of the community resulted in violations relating to the
conversion of security deposits to community fees, the incurring of ineligible
management costs, and duplicative billings being charged to the community. These
issues occurred because the management agent had insufficient knowledge of HUD
requirements for Section 231 program and disregarded the owners’ regulatory agreement
with HUD. During the external review of the community performed by the OIG, it was
determined that these violations contributed to the community’s financial instability.




                                        7
          The Community Was Not Marketed as Proposed in the Underwriting

HUD was not aware that the community was not marketed as proposed in the
underwriting. The community was supposed to be an independent living facility that was
viable without mandatory or optional services such as meals, housekeeping, and
transportation. However, the community was marketed as a congregate care facility with
the services listed above. The expectations of prospective residents for the community as
a congregate care facility were not fulfilled because the promised amenities such as a
bistro and beauty salon were not completed and operational during occupancy. There
were many prospective residents who applied for residency at the community but decided
not to move in due to the lack of the promised amenities. During its operation, the
community had a total of 13 residents. As a result, the community’s lack of these
marketed amenities factored into the owners’ inability to attract potential residents and
lease up the property.

              Community Rents Marketed More Than Underwritten Rents

The management agent charged rents at approximately 50 percent more than the
underwritten rents. HUD could have acted and declared the community in technical
default because of this lapse in following HUD rules and regulations. However, HUD
did not know that the increased rents were more than the proposed underwritten rents
until other problems with the community were discovered. Had HUD conducted
adequate and timely monitoring of the community, it could have prevented the
management agent from increasing the rents. These advertised rents at the community,
which were higher than the underwritten rents, hindered the owners’ ability to lease up
the community and factored into its low occupancy.

                Required Monthly Reports Were Not Submitted to HUD

The community owners were required to submit monthly reports to HUD. These
monthly reports provided information such as lease ups, rent revenue, operating
expenses, cash availability, security deposits, and other information needed to evaluate
the property’s operation. The community started operations in January 2009, and tenant
occupancy began in February 2009. However, HUD did not receive the first required
monthly report until May 2009. There was no apparent follow-up on the part of HUD to
request outstanding monthly reports from the owners. HUD’s failure to request required
monthly reports from the owners left it unaware of the community’s escalating financial
problems.

                The Owners Violated Section 231 Program Requirements

Section 231 properties have restrictions on mandatory or optional meals and services.
The owners were allowed to have a warming kitchen in the community’s congregate area
for catered food provided by an outside entity unrelated to the owners. The owners
violated these requirements due to HUD’s lack of monitoring at the community. The
owners also hired a chef that prepared meals for the residents. To meet Pima County



                                        8
Health Department requirements for a food establishment, the community’s executive
director started to convert the kitchen into a commercial grade kitchen by purchasing a
commercial grade refrigerator and two commercial grade microwaves. In addition, the
executive director had applied for a food establishment license to operate the commercial
kitchen. The establishment of a commercial grade kitchen at the community was in
direct violation of Section 231 program rules. However, HUD’s lack of adequate
monitoring at the community allowed these violations to occur during the process.

                 Escrowed Funds Were Depleted Faster Than Projected

The lender required the owners to provide at least $597,600 toward a working capital
fund and $768,763 toward an initial operating deficit fund. These funds were supposed
to last at least 12 months from the community’s initial occupancy to cover potential
financial shortfalls. The lender controlled all disbursements of these funds, while HUD
approved the disbursement requests. However, the owners exhausted both funds months
after the initial occupancy. One of the reasons for the immediate expenditure of funds
was the increased expenses incurred for unapproved meals and services. An outside
entity was supposed to provide these optional meals and services without the community
incurring any of the related expenses. HUD’s inadequate monitoring allowed the
community to incur food expenses such as groceries and payroll expenses that should not
have been allowed.

 Final Endorsement Was Approved Without a Financial Commitment From the Owners

The owners began to default on the community’s first loan payment in July 2009. The
owners also did not make a loan payment in August and September. However, HUD did
not become aware of the owners’ loan default until September 2009. When the problem
became evident, HUD intervened and met with the owners to determine whether the
community would be able to proceed to final endorsement in October 2009. The owners
stated that they would be able to fund the loan payments to make the loan current through
September 2009. The owners stated that the October 2009 payment would be deducted
from the loan proceeds from the final closing. The owners had planned to seek additional
partners for more available capital to assist the community financially or sell the
community to an interested investor, which would have required HUD’s consent to a
transfer of assets. If the community were sold to an investor, the transfer of assets would
have required the owners to provide additional funds to the property until it broke even
financially. However, HUD did not wait for this plan to materialize and immediately
proceeded with final endorsement without a financial commitment from the owners.

The regional director stated that HUD’s Phoenix office should have monitored the
property more closely and identified the potential red flags during the final endorsement
process. The director went on to state that HUD could have delayed the final
endorsement process if it had known of the community’s situation. Unfortunately, HUD,
the owners, and the MAP lender focused on closing the loan to minimize risk. As soon
as the owners achieved the minimum requirement for closing, which is having the loan




                                         9
    payments current, HUD proceeded immediately for firm commitment on final
    endorsement.

    HUD eventually knew of these violations but did not act to correct them. According to
    HUD, these should have been considered technical violations. However, HUD’s, the
    MAP lender’s, and the owners’ goal during that time was to proceed to final
    endorsement.


The MAP Lender Failed To
Exercise Due Diligence in
Underwriting This Loan


    In July 2010, HUD LQMD issued a report related to its December 2009 onsite default
    project review of the community. Its objective was to determine whether the HUD-
    approved MAP lender performed it’s underwriting of the loan in accordance with
    applicable HUD rules and requirements. Based on the review, LQMD identified various
    causes, findings, and observations in the underwriting of the loan that led to the owners’
    loan default and noncompliance with applicable HUD rules and requirements. Among
    the causes, LQMD’s findings and observations regarding the MAP lender’s underwriting
    of the community included

                                The Owners Were Inexperienced

    The owners acknowledged that they had no substantial experience in elderly multifamily
    housing under the Section 231 program. An experienced owner is critical in ensuring
    that a property with elderly residents is financially sustainable to operate with minimal
    problems. For example, the owners should have known that advertising the community
    as a congregate care facility and asking for rents at 50 percent more than the underwritten
    rents would factor into their ability to lease up the property. According to the
    management agent, the community was neither an independent living facility nor an
    assisted living facility. Without a clear understanding of the type of elderly housing that
    was intended for the community, the owners hindered their ability to attract prospective
    residents to occupy the community. The MAP lender stated that they agreed with HUD’s
    LQMD comment that they failed to provide an experienced owner in elderly housing
    particularly during the economic period in which the project came on line. In response to
    LQMD’s comment, the lender stated it would implement corrective actions in future
    loans to ensure owners have adequate experience in managing properties such as the
    community.

                             Financial Capacity Was Not Established

    The owners formed a limited liability limited partnership to operate the community.
    They contributed land that was appraised at $2.5 million as equity toward the loan. Since
    the land was used as collateral toward the loan, the MAP lender did not require the



                                            10
owners to provide cash toward the loan. Although the MAP lender appeared to have
provided assurance that the community was fully capitalized by requiring working capital
and initial operating deficit escrows, it should have performed a more extensive analysis
of the financial capacity of the owners beyond the minimum requirements. Elderly
properties such as the community are long-term investments that need continued financial
support from owners to ensure financial stability. Therefore, the capital needed for
properties such as the community should be beyond the established requirements needed
to operate the community and minimize potential problems.

                   The Appraisal and Market Study Were Not Updated

In March 2007, a contracted third-party firm performed an appraisal and market study as
part of the application for the community under the Section 221(d)(4) program. After the
application package with the appraisal and market study were completed, the owners
decided to apply for Section 231 loan financing instead of the Section 221(d)(4) loan
financing using their original application package. In August 2007, the MAP lender
believed that this appraisal and market study used for the Section 221(d)(4) loan
application was applicable for use under the Section 231 loan program. It stated that the
market study analyzed the same target, competition, and demand under the Section 231
as under the Section 221(d)(4). However, our review of the market study showed that the
demand for independent living housing consisted of individuals 75 years of age and
older. However, the study stated that this target group mostly had disabilities and needed
meals and other supportive services. The study further stated that there was no market
for an independent facility with optional meals and other supportive services for residents
75 years of age and younger.

The study also found that the Green Valley area had a population, of which only six
percent of residents were under the age of 75. These residents were considered to be
healthy, mobile, and active individuals who may have wanted but did not need optional
meals and services. This was the target group intended to reside at the community.
Further, the market study provided as an exhibit with the Section 221(d)(4) application
submission stated that in 2006, Tucson home sales and prices fell and that the data
indicated a continued slowdown in the housing market with an indirect impact on the
community. Based on the data and analysis, the community would have enjoyed a strong
prelease and initial rent up as a result of potential residents’ selling their homes at a
profit. The market study projected a 93 percent occupancy rate at the community. The
study also estimated that the annual demands for units at the community in 2007, 2008, and
2009 were to be 107, 111, and 114, respectively. However, our review found that the
community had only 13 units occupied during its entire operation.

The appraisal for the community included incorrect information related to the occupancy
rates among comparable properties. Specifically, the appraiser reported that one of the
comparable properties had an occupancy rate of 95 percent. However, discussions with a
HUD appraiser found that the comparable property had an occupancy rate of 77 percent
since June 2007. HUD had considered this is a serious discrepancy. Since the MAP
lender did not request a revised appraisal report, HUD technical reviewers believed that
the underwritten rents were higher than the market rents in the area.


                                        11
                         There Was an Economic Downturn in the Area

    When the loan application was submitted in May 2007, there appeared to be indications
    of a decline in the economy. However, the MAP lender’s appraisal and market study
    projections showed a high demand for occupancy of independent living facilities with
    meals and other supportive services. According to the MAP lender, it had underwritten
    the loan conservatively but did not update the appraisal and market study to reflect the
    present economic conditions. As a result, the MAP lender used outdated market data to
    underwrite the loan.

    According to the LQMD report, the underwriter’s failure to exercise prudent
    underwriting practices during the collapsing economy contributed to the owners’
    defaulting on the loan and the community’s financial instability. The lender could no
    longer do anything about this loan but said that they would implement tighter
    underwriting procedures for the new loans they would make. LQMD stated that it would
    close all report comments except for the issue of identity of interest, which was being
    recommended for further review.


The Owners Failed To Provide
the Necessary Financial
Commitment and Guidance to
Their Management Agent

    The owners’ financial commitment to the property ended when they exhausted their
    capital contributions. A property such as the community needed the owners’ continued
    financial support to ensure its financial stability. Although the owners’ other partners had
    also signed statements of financial commitment to provide additional funds as necessary
    until the community was financially sustainable, HUD could not enforce the
    commitments. This condition existed because the loan was a nonrecourse loan and the
    partners’ involvement in the community was only as limited liability partners. Although
    these partners had liquid assets of more than $48.3 million, they were unwilling to
    commit additional funds to the property. Although it was not required by HUD or the
    lender, committed owners should know that the capital needed to operate properties such
    as the community should be beyond the required amount needed to minimize financial
    uncertainties.

    Our prior external audit of the management agent’s practice found instances in which
    they did not operate the community in accordance with Federal rules and regulation and
    its regulatory agreement with HUD related to the Section 231 program. According to the
    review, the owners’ lack of knowledge related to HUD-insured elderly properties, such as
    those financed under the Section 231 program, played a role in the property’s financial
    problems. This lack was evident among the problems found that included conversion of
    security deposits to community fees, ineligible management cost, and unsupported
    duplicative billings charged to the property. These practices resulted in fewer funds
    being available to pay for eligible expenses. An owner experienced in elderly properties



                                            12
    such as the community would have the capability to address critical issues that could
    affect daily operations. An experienced owner would not have allowed the management
    agent to advertise the community’s unit rents at more than the underwritten rents, which
    hampered efforts to lease up units.

Conclusion


    HUD’s inadequate oversight and guidance, the MAP lender’s failed due diligence in
    underwriting, and the owners’ lack of financial commitment and management expertise
    caused the community’s financial problems that led to the owners’ loan default. These
    problems also led to HUD’s selling the loan to an outside party for approximately $9
    million, or more than $20 million less than the original $29.9 million loan initially
    insured by HUD.

Recommendations

    We recommend that the Director of HUD’s Office of Multifamily Housing Development

    1A. Update the MAP Guide with rules and requirements for processing Section 231
        program loans and discontinue processing these types of loans until the MAP Guide
        is updated.

    We recommend that the Director of HUD’s Region IX San Francisco Office of
    Multifamily

    1B. Ensure that all conditions for underwriting are met in processing Section 231
        multifamily properties and that there are clear roles, responsibilities and
        communication among the HUD offices when conducting reviews to minimize
        potential problems such as those mentioned in this report.

    1C. Improve the regional field office’s property management and performance
        monitoring of Section 231 properties by beginning monitoring immediately upon
        occupancy to minimize potential financial, operational, and managerial problems
        related to the properties under the program.




                                           13
                        SCOPE AND METHODOLOGY

We performed onsite work at the HUD field offices in San Francisco, CA, and Phoenix, AZ,
from September to November 2010. The internal review covered the period May 2007 through
November 2009, which included submission of the loan application to the loan default.

To accomplish our objective, we

       Reviewed applicable laws, regulations, and guidance issued by HUD (see criteria in
       appendix B).
       Reviewed pertinent documents maintained by multifamily staff at the HUD Phoenix
       program center and San Francisco hub.
       Interviewed HUD technical reviewers and supervisors from the HUD Phoenix program
       center and San Francisco hub.
       Interviewed the HUD-approved MAP lender and underwriter.
       Reviewed the loan application and narrative summary including exhibits submitted by the
       MAP lender.
       Reviewed LQMD reports.
       Interviewed the LQMD director and staff.
       Reviewed OIG’s external report performed on the community’s operations.
       Reviewed HUD’s technical review reports on the HUD-approved MAP lender’s
       underwriting practice and HUD’s oversight and monitoring.
We conducted the audit in accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain sufficient, appropriate
evidence to provide a reasonable basis for our findings and conclusions based on our audit
objective. We believe that the evidence obtained provides a reasonable basis for our findings
and conclusions based on our audit objective.




                                              14
                              INTERNAL CONTROLS

Internal control is a process adopted by those charged with governance and management,
designed to provide reasonable assurance about the achievement of the organization’s mission,
goals, and objectives with regard to

       Effectiveness and efficiency of operations,
       Reliability of financial reporting, and
       Compliance with applicable laws and regulations.

Internal controls comprise the plans, policies, methods, and procedures used to meet the
organization’s mission, goals, and objectives. Internal controls include the processes and
procedures for planning, organizing, directing, and controlling program operations, as well as the
systems for measuring, reporting, and monitoring program performance.




 Relevant Internal Controls


       We determined that the following internal controls were relevant to our audit objective:

           Monitoring the property’s operations in compliance with applicable laws and
           regulations and
           Maintaining complete and accurate records.

       We assessed the relevant controls identified above.

       A deficiency in internal control exists when the design or operation of a control does not
       allow management or employees, in the normal course of performing their assigned
       functions, the reasonable opportunity to prevent, detect, or correct (1) impairments to
       effectiveness or efficiency of operations, (2) misstatements in financial or performance
       information, or (3) violations of laws and regulations on a timely basis.

  Significant Deficiency



       Based on our review, we believe that the following item is a significant deficiency:

           HUD did not have adequate controls in place for oversight and guidance during its
           monitoring and technical review of the community (see finding).




                                                15
                        APPENDIXES

Appendix A

        AUDITEE COMMENTS AND OIG’S EVALUATION


Ref to OIG Evaluation    Auditee Comments




                          16
Comment 1




            17
18
19
                        OIG Evaluation of Auditee Comments

Comment 1   The report stated that HUD’s technical reviewers recommended that the appraisal
            and market study should have been updated by the approved MAP lender since it
            was created to support the Retreat at Santa Rita Springs’ application under
            Section 221(d)(4). When the application was changed to a Section 231 property,
            the underwriting differences between Section 221(d)(4) and Section 231 programs
            were not taken into consideration. We agree that HUD performed an appraisal
            and market study of the property under the Section 231 program. However, HUD
            based its conclusions on the MAP lender’s original appraisal and market study
            that was submitted under the Section 221(d)(4).




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Appendix B

                                        CRITERIA
HUD Handbook 4350.1, REV-1, Section 1-1. Goals, Responsibilities, and Relationships

1-3. Monitoring. In carrying out this mission, HUD monitors and works with mortgagors,
     managing agents, mortgagees, subsidy contract administrators, and other clients to assure
     compliance with the requirements of HUD’s programs.

1-13. HUD Asset Management Functions. To a varying degree, HUD Field Office Loan
      Management (Asset Management) Branch staff are involved in the following asset
      management functions:

      A. Development of Projects: Management input into the approval or disapproval of
         ownership structure and management and the proposed practices during the
         development stage of the project.

      B. Transfers of Physical Assets (TPAs): Review proposed changes in ownership when
         under management.

      C. Property Management:
         1. Review proposed added capital improvements or refinancing proposals, including
            projections of performance, when under management.
         2. Conduct property management reviews and assist owners and managing agents to
            achieve effective property management.
         3. Conduct physical inspections of projects.
         4. For most projects, establish rental rates.
         5. Analyze insurance coverage for adequacy.
         6. Where applicable, assure that the model form of lease is used.
         7. Monitor rental market conditions.
         8. Monitor Management Improvement and Operating (MIO) plans.
         9. Approve additional forms of subsidy, such as Flexible Subsidy Operating
            Assistance, Capital Improvement Loans, and Loan Management Set Aside Section
            8 assistance.

      D. Performance Monitoring of All Projects:
         1. Analyze annual and monthly financial statements.
         2. Analyze the project’s overall performance and potential.
         3. Analyze subsidy requirements, types, usages, reserves, and availability.
         4. Analyze long term capital needs.
         5. Assure the owners analyze property tax assessments.
         6. Consider mortgage relief when appropriate.
         7. Ensure owners provide adequate housing at the lowest possible cost.




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      E. Additional Performance Monitoring of Projects With HUD-Held Mortgages, including
         direct loans:
         1. Assist in escrow analyses.
         2. Analyze causes of default and/or delinquency.
         3. Combine the results of analyses and work with owners/managing agents in
            developing reinstatement plans, including modification or restructuring of
            indebtedness.
         4. Collect all debt, particularly delinquent debt.
         5. Initiate foreclosure when necessary.

HUD Handbook 4430.1, REV-1, Section 1-3. Authority and Responsibility for Closing

A. Field Office Manager (Regional Director of Housing performs all Field Office Manager
   initial closing functions for Regional Offices) is responsible for:

   1. Assuring that conditions of the commitment are met.

HUD Handbook 4470.1, REV-2, Mortgage Credit Analysis for Project Mortgage Insurance,
Chapter 3. Financial Statements

3-5. OBJECTIVE OF FINANCIAL STATEMENT ANALYSIS. Financial statements provide
     historical information for measuring and evaluating financial performance and provide
     advance warning of financial problems.

3-6. HOW TO ANALYZE FINANCIAL STATEMENTS

     F. If funds are being provided by a parent company or affiliate of the sponsor:

        1. Require a certification from the Board of Directors or authorized agent that specifies
           the funds the parent company/affiliate is willing to commit.

HUD Handbook 4570.1, REV, CHG-2, Section 1-1. Nature and Purpose of Section 231

   b. There is no substitute for a strong and capable sponsorship primarily concerned with the
      continuing operation of a project for the elderly and/or handicapped rather than just its
      initiation. Sponsors of profit-motivated projects should be interested in long-term
      investment, with profits from construction as a secondary consideration. Both profit-
      motivated and non-profit sponsorships must be financially capable and willing to provide
      funds as may be necessary in the completion and operation of a project.

HUD Handbook 4570.1, REV, CHG-2, Chapter 2, Section 4

  d. Congregate Living: Congregate living facilities may be considered by any eligible
     mortgagor. He may propose to supply tenants with food, furniture, maid service, health
     insurance, infirmary, limited nursing care, or other personal services. Regardless of the
     nature and extent of the congregate facilities provided, each dwelling unit shall contain at



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  a   minimum; a kitchen sink, a minimum size standard refrigerator, a “cook top,” adequate
      electrical capacity and outlets for small appliances, storage space for food and utensil
      storage and complete bathroom facilities. Where a mortgagor proposes to furnish food or
      other services, the sponsor shall clearly separate such charges from the total charges for
      shelter, rent and utilities which are entered on FHA Form 2013. Also, the sponsor's FHA
      Form 2013 should contain only those expenses estimated to be required to supply living
      quarters including utilities. FHA Form 2013-E will be used to show estimated expenses
      and income relating to meals and other services.

HUD Handbook 4570.1, REV, CHG 2, Chapter 2, Section 4

   g. Firm Commitment Stage: At this stage, final plans and specifications are reviewed. With
      a Design Representative assigned to the project, there should be conformity with previous
      concepts and decisions agreed upon by HUD-FHA and the sponsor, and there should be
      no changes in plans which are not approved by HUD-FHA as design progresses. Again,
      reanalysis is limited to changes necessitated by sponsor actions. Otherwise, all HUD-
      FHA decisions previously made must stand.

Mortgagee Letter 2007-05

The following are basic policies which apply to all loans (MAP or Traditional Application
Processing (TAP)):

   (1) Mortgagee Letter restates outstanding Departmental policy regarding Section 231 and
       authorizes the use of the MAP to process Section 231 mortgages. Section 231 project
       mortgages shall comprise eight or more new or rehabilitated units designed for use and
       occupancy by elderly persons.

   (2) For new construction cases, Section 231 is a replacement cost program like Sections
       221(d)(3) and 221(d)(4).

   (3) Section 231 mortgages have the same restrictions on mandatory meals and services,
       central kitchens and dining areas, and non-shelter spaces as Section 221(d)(3) and
       221(d)(4) mortgages. Non-shelter services may not be made a mandatory condition of
       occupancy. Charges for any optional services must be reviewed by the MAP Lender and
       approved by HUD for reasonableness. Institutional central kitchens are not permitted,
       nor may the project provide meal services on either a mandatory or optional basis. The
       prohibition does not preclude the installation of modest (non-luxury) equipment in a
       common use kitchen (for example, sink, stove, or refrigerator) in a non-shelter space for
       use of tenants or by outside entities providing catered meals.

   (4) Where optional services are proposed, i.e., a Form HUD 92013-E must be submitted with
       the insurance application. The HUB/Program Center must make a determination that any
       service program is self-supporting. No optional service income can be used in the net
       income calculation to support mortgage debt service.




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   (5) The provisions of this letter cannot be waived by HUD directors. Chapters 3, 5, 6, 7 and
       8 of the current MAP Guide will be modified to reflect this guidance on processing
       Section 231 applications.

MAP Guide, Section 8.4, Firm Commitment Processing Financial Statements, C. Processing for
Financial Statements

9. Sponsor’s Continuing Commitments

   a. A written statement must be submitted from principals who are sponsors indicating the
      parameters of their financial commitment to and contractual relationship(s) with the
      mortgagor:

      (1) If the relationship is not intended to continue until the project reaches sustaining
          occupancy, the financial requirements have not been met.

      (2) Any sponsor not having an ownership interest in the mortgagor entity must also certify
          in writing the amount it is willing to commit.

MAP Guide, Section 8.4, Firm Commitment Processing Financial Statements, C. Processing for
Financial Statements

10. Individuals are prohibited from submitting financial statements as a sponsor and then
    abandoning the project and the mortgagor after the Firm Commitment is issued.

MAP Guide, Chapter 12, Insurance Closings, Section 12.1.2, Authority and Responsibility for
Closing

A. The Hub Director is responsible for:

   1. Assuring that conditions of the HUD Firm Commitment are met.




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