This is the text for a presentation I made in
October 1997 at a Council for Affordable and Rural Housing Seminar.
______________CAPITAL IMPROVEMENT PLANS
In the 1970’s Congress adopted new ways of defining program costs so that it could make better budget decisions. Thus, HUD Section 8 project costs were arrived at by saying each unit will cost $5,000 per year in subsidies, times 20 years, equals $100,000 in budget authority per unit. This was the budgeted cost or Budget Authority. It was revolutionary in its day.
The housing industry said that was unfair when a navy destroyer was put in the budget at the purchase cost, with no regard to the lifetime costs of operation. Congress didn’t buy the argument. Since no good deed goes unpunished, housing has continued to be budgeted in this way. And we’re now at the point that the two approaches join when we actually need to contemplate the lifetime costs of 515 projects.
The program emphasized cost containment, which was achieved. Units were built for as little as possible. The Agency has kept a strict leash on rent increases so that Reserve contributions were minimized and excess cash was not permitted to accumulate.
The program is now at the point that we can seriously raise as the question of what to do with an aging portfolio? A little perspective. As of October 1, 1997, there were very roughly:
500 projects that were 8 years old
1,500 projects that were 9-10 years old
5,900 projects that were 11-15 years old
7,400 projects that were 16-20 years old
6,700 projects that were 21 years old or older.
Aging is a code word for saying the project is ready for major capital infusions above the current level maintenance — or may be slipping from a B property to a C property. Roofs — 20 years, sure. Appliances — 15 years maybe, give or take. Parking lots. Kitchen cabinets. We can make a whole list.
The Agency is beginning to be aware of the issue of the aging portfolio, as shown by the number of loans being made for rehabilitation in conjunction with transfers. However, not every project is being transferred and not every owner wants to apply for a subsequent loan for rehabilitation.
Why wouldn’t an owner want to transfer the project? There are as many reasons as there are owners. I’ll leave it up to you to decide for yourself.
Why wouldn’t an owner not want to apply for a subsequent loan?
— the loan carries a 20 year restrictive use clause which could affect an equity loan or prepayment
— if the subsequent loan term is 30 years or even 50 years, a subsequent loan may extend beyond the life of the Limited Partnership
— without a transfer (for the Acquisition Low Income Housing Tax Credits), there is no particular financial incentive
— with a loan, the possibility of a sale or transfer is made remote because there may be no way then to get LIHTC if there is no need for rehabilitation.
The concept of a Capital Improvement Plan, then, is to replace the capital items which are at the end of their useful lives, and to fund the capital replacements from project income. The Plan, and its funding, can be an alternative to a subsequent loan. (Of course, keep in mind that the Agency may want you to reamortize the initial loan to make room for a rent increase — however, reamortization imposes a 20-year restrictive use clause.)
A Capital Improvement Plan sounds like a good idea — until you get into it. There’s nothing like it in terms of playing with fire. It raises issues of the original adequacy of the Reserve amount, and particularly the capability of present ownership and management.
The Agency can say: “Why isn’t there enough money in the Reserve? Why didn’t you take better care of the project? How can this 20-year-old project need any work?”
But this is disingenuous on the part of the Agency because Exhibit B of 1930-C addresses long term improvements in pages 94 and 95:
X MAINTENANCE: Maintenance is the process by which a project is kept up in all respects and includes land, buildings, and equipment. Maintenance responsibilities will be included in the management plan. Proper maintenance will help to keep a good image for the project, help to minimize vacancies, and help to preserve the project. Plans and policies for inspections, effective maintenance and repair are to be established at the outset and modified periodically as needed. The following types of maintenance are necessary:
A Routine maintenance.
B Responsive maintenance.
C Preventive maintenance.
D Long-term maintenance and replacement (curable depreciation). These are major expense items which normally do not occur on an annual basis and cannot be afforded from an annual budget income. These expenses include items such as repaving the parking lot or repainting an entire building or project; replacement of furnishings and equipment, including such items as stoves, refrigerators, carpets, water heaters, furnaces, etc., whenever such replacements are beyond the capacity of the project to pay out of the normal operating budget. The borrower may request permission to use reserve funds to pay for these expenses when they occur. However, use of funds out of the reserve account must be preapproved by FmHA.
E Inspection maintenance.
Thus, let’s say you brave the criticism and decide to prepare a Capital Improvement Plan. Keep in mind that a Capital Improvement Plan has major implications for rents and the rate of usage of RA.
A recent heartbreaker (but the judge is still out) is a project in the Northeast that is over 20 years old. It is a 52 unit Family project. The Loan Agreement provides for a $7,225 Annual Reserve Deposit, but the Agency had informally approved an increase to $18,000 annually. The most recent Physical Inspection of the project by the Agency had indicated no particular concern over the condition of the project.
We did a Capital Improvement Plan which projected the major capital improvements for the next 6 years. A general contractor inspected the project and prepared the list of capital improvements at current costs. There were the usual items in a project of this age: roofs, water lines, refrigerators and ranges, kitchen counters, bathroom vanities, windows, etc.
We submitted a rent increase to increase the Reserve deposit; the rent increase was $61 per unit per month. We included the Capital Improvement Plan with the rent increase. The items ranged from appliances to roofs to siding to heating systems.
There is no FmHA format for such Plans and no Agency guidance on them. HUD issued HUD NOTICE H 97-2, dated 1/28/97, entitled “COMPREHENSIVE NEEDS ASSESSMENTS (CNAs).” Compare what we submitted with what HUD would have required — we went out 6 years, specifying items by years. HUD wants specifications for year one, and then lumped for subsequent years. HUD wants full blown plans going to 10 years after the loan is paid off. Frankly, if we’d used the HUD approach, the Agency would have been more than speechless at the costs.
Let’s think about this situation for a moment — you own the project. It was built to an adequate standard, but it was and is and will remain a B property. You’ve maintained it adequately. But 20 years is 20 years and things do reach the end of their lives. You buy a 20,000 mile tire and you get 20,000 miles; whether you get 24,000 or 19,000, you know you won’t get 50,000. That was a more expensive tire. Or, as the ad has it, YOU PAY NOW, or YOU PAY LATER. Well, this is LATER.
So we put in a rent increase. The Servicing Office denied the rent increase:
After careful consideration, we were unable to take favorable action on your request for a rent increase at the above referenced complex.
Your rent change request is based on the fact that because many repairs are required at the complex you want to increase the annual transfer to the reserve account from the required $7,225 to $40,000 for this fiscal year. In addition you plan to increase the reserve account to $70,000 after this year. Currently, we have agreed to allow $18,000 to be deposited annually into the reserve account.
Your proposal to complete the repairs you have outlined is not realistic and subsequent increases would put a burden on the tenants not receiving rental assistance. The rental rates proposed for the two-bedroom units would exceed the economic rent for the area and could lead to occupancy problems.
We would like to advise you that you may apply for a loan to make all necessary repairs which would require a much smaller rent change and all repairs would be completed at one time.
Another alternative would be to continue to fund the reserve account at the current level of $18,000 plus contribute your annual return which would result in a total of $30,427 from which repairs could be made.
In addition to the above, we feel that the capital needs assessment may require revisions which would impact the need for immediate funding from the reserve account.
As I said, the appeal decision is not final. We were most amused that the rent increase would put a burden on tenants not receiving RA; we were more amused with the ideas of getting a rehab loan or contributing the Return. The serious intent of capital improvements was lost upon the Agency. (I should point out that once we win, we plan to have the Agency pay for the costs of the appeal).
There are some thoughts in the Agency about the need for addressing the needs of aging projects. Recently, the Agency wrote to require that in conjunction with closing an equity loan obligated last month, the borrower was to submit “an acceptable Capital Improvement Plan.” Not only is there no format and approach to Capital Improvement Plans, but there are no standards for what constitutes an acceptable Plan.
Part of the background for any Capital Improvement Plan is that the Agency requires under a SECURITY AGREEMENT that provides in Section III, paragraph C:
Debtor will . . . (3) care for and maintain the collateral in a reasonable manner. . . .
Both the Security Agreement and the Loan Agreement provide that the Owner will comply with the Agency regulations and requirements. And, the Loan Agreement provides in Section 5, Regulatory Covenants that:
. . . the Borrower shall . . . :
a. Impose and collect such fees, assessments, rents, and charges that the income of the housing will be sufficient at all times for operation and maintenance of the housing . . .
The owner is thus obligated to maintain the housing in order to provide decent, safe, and sanitary housing. And it is clear the project is to be self-supporting.
So, what is the likelihood that you will ever deal with a Capital Improvement Plan? If you have to submit a Workout Plan to address servicing issues in a project, it is likely that you will be asked to submit a Capital Improvement Plan. If you want to address the needs of your aging project, you may want to submit a Plan.
Absent any Agency policy, you’re on your own. Of course, there’s the issue of who prepares and who pays for a Capital Improvement Plan? Should it be prepared by a professional such as a general contractor or can management prepare the Plan, with or without compensation?
For the moment there are no answers from the Agency.
I mentioned playing with fire? The rent increase denial could be used by the Agency to find that there’s now a ton of deferred maintenance at the project. Deferred maintenance can get you a D classification from the Agency. The fastest way to upgrade from a D is a Workout Plan, which just happens to require a Capital Improvement Plan. Notice how no good deed goes unpunished?
Capital Improvement Plans make me think of Ross Perot’s references to the budget deficit as being like the crazy aunt in the attic — we all know she’s there, but we don’t want to talk about her, much less deal with her, and God forbid that we would acknowledge her.
Well, the dear aging relative is in the attic — Do we want to deal with her NOW, LATER, or MUCH LATER?