oversight

Walnut Ranch Apts, Dixon, CA

Published by the Department of Housing and Urban Development, Office of Inspector General on 1995-12-19.

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

December 19, 1995
Audit Case Number
96-SF-212-1001


TO:     Janet Browder, Director, Multifamily Housing Division, 9AH


FROM:     Gary E. Albright, District Inspector General for Audit, 9AGA

SUBJECT: Walnut Ranch Apartments
      Multifamily Mortgagor Operations
      Dixon, California


       SUMMARY

We reviewed financial activities of the multifamily project known as
Walnut Ranch Apartments (project number 121-35735) located in Dixon,
California. We found that project funds were improperly used for many
years to repay loans from third parties and the general partner. Also,
the project was deprived of revenue by an unfavorable lease with the
partner. These actions were mitigated by the partner's advances to the
project until 1990. Since then, however, we estimate that project funds
were improperly reduced by $94,519.

       BACKGROUND

The National Housing Act authorizes HUD's mortgage insurance programs.
The objective of the mortgage insurance programs for multifamily housing
is to assist in the construction, rehabilitation or preservation of rental
or cooperative housing. In consideration of the mortgage insurance, the
owner agrees to various controls of certain aspects of the housing's
operations. These requirements are contained or referenced in a contract
known as a regulatory agreement. Some requirements include limits on use
of project assets to those necessary and reasonable for project operations
except for allowable distributions, proper project upkeep, and maintenance
of accounting records. The mortgage loan of Walnut Ranch Apartments was
insured under Section 221(d)(4) of the National Housing Act.

Walnut Ranch Apartments, Ltd. is a limited partnership organized to
construct, own and operate the multifamily project Walnut Ranch Apartments
that has 95 housing units. The partnership entered into a regulatory
agreement with HUD in May 1982. FPI Management, Inc., handles project
operations.
The owner defaulted on the mortgage loan in September 1993, and the
mortgagee assigned the mortgage to HUD. The principal balance of the
loan at default was $3,488,116.


       PURPOSE AND METHODOLOGY OF REVIEW

The purpose of our review was to determine whether any improper use of
project assets contributed to the default on the HUD-held (formerly
HUD-insured) mortgage loan. The review generally covered the period
July 1, 1985 to September 30, 1994.

The primary methodologies of this work included:

Analysis of audited financial statements of the project.

Consideration of the project's internal control structure
and assessment of risk exposure to determine review procedures.
We did not evaluate control effectiveness because of the limited
nature of the review.

Interviews with the owner's general partner and knowledgeable HUD
officials.

Examination of supporting documents for selected transactions.

We conducted the review in accordance with generally accepted government
auditing standards.

       RESULTS OF REVIEW

Finding - Improper Acts by the Owner's General Partner Contributed to
Loan Default.

Due to the general partner's disregard of HUD requirements governing the
operations of Walnut Ranch Apartments, project funds were improperly used
for many years to repay loans from third parties and the general partner.
Also, the project was deprived of potential revenue by an unfavorable
lease with the partner. These actions were mitigated by the partner's
advances to the project until 1990. Since then, however, we estimate
that project funds were improperly reduced by $94,519. This reduction
contributed to the owner's fiscal default on the HUD-insured loan.

Requirements of Regulatory Agreement. Paragraphs 8b and 8e of the
regulatory agreement state that the owner shall not without written
HUD approval:

"Assign, transfer, dispose of, or encumber any personal property of the
project, including rents, or pay out any funds except from surplus cash,
except for reasonable operating expenses and necessary repairs."

"Make, or receive and retain, any distribution of assets or any income of
any kind of the project except surplus cash . . ."

The regulatory agreement defines "distribution" as ". . . any withdrawal
or taking of cash or any assets of the project . . . and excluding payment
for reasonable expenses incident to the operation and maintenance of the
project."

The project has been delinquent periodically on the insured mortgage and
has never had surplus cash. As of the end of fiscal year 1994, the
project had a surplus-cash deficiency of $117,763. Also, the owner
defaulted on a HUD-insured mortgage loan in September 1993, and the
loan note has been assigned to HUD. Thus, any distribution would violate
the regulatory agreement and be a misuse of project assets.

Further, the HUD management certification form requires reasonable efforts
to be made to maximize project income.

Repayments of Partner Advances. Until recent years, the general partner
advanced significant funds to the project to help meet its financial needs.
Through June 1994, we identified advances totaling over $325,000. Contrary
to HUD requirements, however, the general partner was repaid for part of
the advances. We identified repayments totaling $29,690. Appendix B lists
the advance and repayment amounts by year.

Prior to the January 17, 1991 change to HUD handbook Financial Operations
and Accounting Procedures for Insured Multifamily Projects, owners could
repay advances if prudent judgment was used, but were prohibited if the
repayments would jeopardize the project's financial condition. In our
opinion, the repayment of owner advances before the 1991 change violated
the previous requirement because it contributed to the weak cash position
of the project and under funding of the tenant security deposit obligation.
The regulatory agreement requires that the liability for tenant security
deposits be fully and separately funded but, except for the 1987 fiscal
year, the security deposit account has been underfunded. The underfunded
amount was usually in the range of $20,000 to $27,000. Through fiscal
year 1992, the underfunded amount exceeded the cash in the operating
account.
After the January 1991 change, advances were only to be repaid from
surplus cash unless specific HUD approval was given. The project had
no surplus cash, and the owner did not obtain HUD approval for the
repayments. Thus, repayments after the change also violated the
regulatory agreement.

Nevertheless, subsequent advances by the general partner exceeded the
repayments, thus mitigating the negative financial effects on the
project. Further, the advances mitigated the effects of repayments
on third-party loans and the unfavorable lease agreement discussed
below, but only through June 1990.

Repayments on Third-party Loans. Payments on loans not authorized
by HUD have been made since the mid-1980's. The general partner
executed a loan for $100,000 with the First Northern Bank of Dixon
to refinance an earlier loan from the bank. The refinanced loan
called for 13 percent annual interest, with monthly payments of $1,493
and a balloon payment due November 1990. This note was secured by
other (non-project) real property owned by the general partner. When
the balloon payment was due, a promissory note was executed with a
relative of the partner. This note was for $66,000 with annual interest
of 12 percent and monthly payments of $1,468.

We identified payments from project funds totaling $88,101 (excluding
a $65,262 balloon payment financed with the subsequent loan) for the
bank loan and $49,916 for the relative's loan. Payments after June
1990 (when partner advances stopped mitigating the effects) totaled
$55,889: $5,974 to First Northern and $49,916 on the relative's loan.
We noted no payments on these loans after February 1994.

The owner did not obtain HUD approval of loans from third parties.
Further, HUD told the owner in August 1987 that the payments violated
the regulatory agreement. Also, in response to a finding in the 1987
financial statements, the general partner acknowledged that HUD had
not authorized the payments, and the partner stated that such payments
would no longer be made from project funds. Nevertheless, the general
partner continued to use project funds for loan payments in disregard
of her promise and the regulatory agreement.

Unfavorable Lease Agreement with General Partner. The general partner
executed a lease between herself and the project for use and operation
of the project's laundry facilities. The lease has been in effect since
September 1982. The lease provides for the project to furnish the space
and utilities in exchange for $750 a year (The partner usually reduced
the advance balance by $750 a year instead of making the payment to the
project). The partner provided no documentation to support the
reasonableness of the lease with the project.

The lease agreement between the project and owner was not fair to the
project. The agreement deprived the project of revenues and enriched
the partner. We contacted a laundry-equipment company to determine if
there was a more equitable lease available. (The general partner had
leased 8 washers and 8 dryers from the company.) According to the
company sales representative, 99 percent of their contracts involve a
lease where the company provides and maintains laundry equipment and
their receipts are split, usually on the basis of 50 percent to the
company and 50 percent to the party providing the space and utilities.

The partner did not provide information on the amount of gross revenues
generated by the laundry equipment. Therefore, to evaluate the
reasonableness of the partner's arrangement and to estimate the amount
of lost revenues to the project, we compared the annual lease payments
of $750, equal to $7.89 per unit, to three sources:

 average laundry income of 14 HUD-insured projects with 90-100 units
 located in the San Francisco HUD office's jurisdiction. This equated
 to $4,939 in annual revenues, or $51.99 per unit.

 the laundry-equipment company representative. The representative
 estimated revenues of $10 per unit a month. This would be equivalent
 to annual revenues of $5,700 to the project ($10 times 50 percent,
 times 12 months, times 95 units).

 the staff of the project's management agent. The staff estimated at
 least $132 a year per unit, equal to annual revenues of $12,540.

Based on the above, the unfavorable lease deprived the project of $7,726
a year (an average of the above estimates) in annual revenues. This
totals $38,630 for the five years from July 1990 to June 1995.

In our opinion the third-party loan payments ($55,889)and the unfavorable
lease ($38,630) totaling $94,519 represented unauthorized distributions.
They reduced assets available to the project and thus contributed to the
owner's fiscal default on the HUD-insured loan.

Auditee Comments. We considered written comments to our conclusions from
Wilson, McCall & Daora, CPAs, submitted on behalf of the project's general
partner. The entire comments are displayed in Appendix A. We also
considered the remarks of the general partner and her accountant (from
the same CPA firm) at a conference with us on December 5, 1995.
The CPAs contended that only loan repayments made after May 1992 should
be returned because that was the date of the handbook revision that
required HUD approval for loan repayments. We note, however, that the
requirements concerning repayments of owner advances changed in January
1991 (CHG 2 of Handbook 4370.2) which were repeated in the May 1992 version. Further, as
previously discussed, earlier payments jeopardized the project's financial condition, thus violating
the earlier handbook requirements.

The general partner told us she presumed she could continue making
payments on the loan because of the extent of the advances made previously.
As discussed earlier, however, the regulatory agreement allows such
payments only under certain circumstances, which were not met.

The CPAs contended that our estimate of lost income due to the partner's
lease is invalid because it does not consider such factors as the profit
gained by the partner and the partner's costs operating the laundry
facility. In our opinion, these factors are irrelevant because the
issue is the loss of revenues due to the non-arm's-length contract.

The general partner stated that the HUD Sacramento Area Office had
approved similar laundry lease arrangements for other projects. We
found no evidence that the HUD California State Office, responsible for
Walnut Ranch, had approved the lease. Our position is that even if
the lease was reasonable in the early 1980's, the owner's responsibility
was to maximize project revenues (especially considering the project's
poor financial condition) and subsequently obtain a fair lease. The
general partner stated that a plan would be submitted to HUD covering
future laundry arrangements.

Recommendations. We recommend that you:

A. Coordinate with our efforts to obtain compensation from the general
partner for the improper distributions.

B. Require the project's management agent to obtain an equitable lease
for the laundry facilities.

Within 60 days, please furnish us a status report on the corrective
action taken, the proposed corrective action and the date to be
completed, or why action is not considered necessary for the
recommendations.

If you or your staff have any questions, please contact Mark Pierce,
Senior Auditor, on 436-8101.
Appendix B

Schedule of Loan Payments and Partner Advances and Repayments

Fiscal Year  Third Party Advance   General Partner
Ended June 30 Loan Payments Repayments    Advances

    1986         $10,543      $ 2,675      $ 58,373 (Note 1)
    1987          17,919         -       77,410
    1988          17,919      22,060        37,886
    1989          17,919         750      122,830
    1990          17,919         750       24,237
    1991          16,250       1,955          110
    1992          17,618         750        3,022
    1993         17,618          750         500
    1994           4,404        -        1,667

    Note 1: This amount includes partner advances for years through 1986.
.