Susan S. Azad, Esq.
Latham & Watkins
633 West 5th Street, Suite 4000
Los Angeles, CA 90071-2007
213.891.8430EXITING OLD FEDERALLY FINANCED MULTIFAMILY
HOUSING DEVELOPMENTS
Prepayment Litigation
I am a litigation partner with Latham & Watkins, a California-based multi-national law firm. For the past two years, I have represented a group of 42 owners of HUD 221(d)(3) and 236 multifamily housing developments in Northern and Southern California in prepayment litigation against HUD. Our case was the first in the Country to go to trial. We did so in November of last year. I’m going to talk briefly about our case, the issues we faced and how they were resolved.
Background
As you may know, the HUD 221(d)(3) and 236 programs were developed in the early 1960’s to encourage private developers to develop and maintain low-income housing. When these property owners entered into the HUD programs, they made a contract with HUD. They agreed to develop and maintain quality low-income housing for 20 years in exchange for below-market interest rate loans and rent subsidies. After 20 years, HUD agreed to allow qualified owners to prepay their HUD-endorsed mortgages and exit the HUD programs.
When their 20 year prepayment dates were approaching, however, the Government changed the deal that HUD and the owners had agreed to nearly 20 years before. Beginning in 1987, Congress enacted a series of Acts which took away the property owners’ right to prepay their HUD mortgages and convert their properties to conventional apartment complexes after 20 years. Congress began by enacting a moratorium on prepayments, followed by the Emergency Low-lncome Housing Preservation Act of 1987-also known as Title II— and then by the Low-lncome Housing Preservation and Resident Homeownership Act of 1990 — also known as Title VI. Although Titles II and VI contained provisions purporting to allow prepayment, the prepayment conditions were impossible to meet and resulted in our owners being forced to remain in the HUD programs.
The Litigation
That’s where I come in. The owners began the Title II and Title VI preservation processes, but HUD red-tape resulted in, on average, three year delays before plans of action were approved and preservation benefits received. This meant that after their prepayment dates, the owners continued receive only the returns allowed under their original 221(d)(3) and 236 contracts with HUD, namely a 6% return on their original equity.
As you probably know, this is not very much in terms of real dollars. For our property owners, it amounted to, at most, yearly returns of between $5,000 and $20,000, depending on the size of the property. In addition, even though the rents the owners were to receive under Titles II and VI were intended to approximate existing market rents, HUD told the owners that HUD would not pay these rents retroactive to their prepayment dates. The result was a significant loss of income during the three or more years that it took HUD to process, approve and implement our property owners’ plans of action and use agreements.
Because of the significant income loss and HUD’s refusal to pay rents retroactive to the owners’ prepayment dates, the owners decided to sue HUD for breach of contract. The suit was filed in the United States Court of Federal Claims in Washington D.C. Our initial group of plaintiffs consisted of 21 property owners whose prepayment dates fell within the ambit of Title II. Later, we added an additional group of 21 plaintiffs whose prepayment dates fell within the time frames of Title VI.
Liability Adjudication
The first step in the litigation process was to obtain an adjudication of liability against HUD. Instead of going to trial on liability, we sought to obtain a summary adjudication by filing a motion with the Court known as a summary judgment motion. The motion was brought in two phases — first with respect to the Title II plaintiffs and later, the Title VI plaintiffs.
With respect to the Title II plaintiffs, the issue was fairly straight forward. These plaintiffs had all executed new use agreements under Title II and were receiving Title II benefits. Therefore, they were locked into the HUD programs for an additional 20 years. The Government argued that our plaintiffs had waived their breach of contract claims because they had accepted preservation benefits under Title II and executed new use agreements with HUD. The Court rejected the Government’s argument and found that the Title II plaintiffs had no choice but to participate in the preservation process and therefore had not waived any rights to claim damages against HUD for breach of contract. The Court found that the property owners had an unfettered right, under their original 221(d)(3) and 236 contracts with HUD, to prepay their mortgages after 20 years and free themselves of HUD regulation. The Court held that HUD had breached its contracts with these plaintiffs and that the Government was liable for any damages that resulted from that breach.
The second step was to obtain a similar liability judgment for our Title VI property owners. Their situation was more complex, because in addition to the preservation issues faced by the Title II plaintiffs, Congress, in March of last year, enacted the Housing Opportunity Extension Act of 1996. This Act granted owners with unfunded plans of action the right to prepay their HUD-endorsed mortgages if they agreed to a 60 day rent freeze following prepayment.
While the 1996 legislation only required a 60 day rent freeze, we soon learned that HUD had a different view of the post-prepayment restrictions that could be placed on owners who prepaid under the 1996 Act. HUD came out with a series of preservation letters informing owners that, in addition to the 60 day rent freeze, the owners would be required to maintain current below-market rents for all special needs tenants for a period of three years following prepayment. In addition, HUD informed the owners that in HUD-designated low vacancy areas, they would be required to maintain below-market rents for all unassisted tenants for an additional three years following prepayment. HUD also stated that owners would be liable to pay 50% of all displaced tenants’ moving expenses.
Finally, HUD forced owners who were prepaying under the 1996 Act but had Section 8 contracts expiring in 1996, to renew their Section 8 contracts— over the owners’ objection— for an additional year at the then-current below-market rents. HUD’s justification for this was the Section 8 statute, which requires that the owners provide one-year notice of their intent not to renew expiring Section 8 contracts. Significantly, however, neither the Section 8 statute nor contracts provided for such a remedy for failure to give the required notice. In addition, it was HUD who told our owners not to give their one-year notice of intent not to renew their Section 8 contracts, because Title VI preservation benefits were to be paid through the Section 8 contracts.
In the summary judgment motions, HUD argued that the 1996 Act reinstated the Title VI owners’ right to prepay their mortgages and that they therefore had no claim for breach of contract. HUD also argued that the fact that our owners renewed their Section 8 contracts and executed earthquake assistance contracts, each with additional use restrictions extending beyond the owners’ prepayment dates, barred their claims for breach of contract.
We argued that the property owners not only had an unfettered contractual right to prepay their mortgages, but also to free themselves of all HUD restriction after their prepayment dates. We pointed out that the 1996 Act did not allow the owners to free themselves of HUD restrictions following prepayment, citing the 60 day rent freeze and other HUD-imposed restrictions, and thus did reinstate their contractual prepayment rights. We also argued that the additional assistance contracts the owners executed while under the belief that they would be forced to participate in the Title VI program did not bar their claims, as they had no choice but to enter into such contracts at the time they were offered.
The Court agreed with us and rejected each of HUD’s arguments. The Court held that HUD had breached its contracts with the Title Vl plaintiffs as well.
The Damages Trial
The next phase of the case was to determine what damages, if any, the property owners incurred as a result of HUD’s breach of contract. This phase would be litigated in a trial to be held in November 1996. We began this phase in mid-1995, even before we had received both of our liability judgments, by hiring one of the Country’s leading real estate economic modeling experts to develop an economic model of damages for our plaintiffs. Our goal was to create a model that was objective and could be easily applied to each of our 42 properties, without the need to adjust the model for each individual property.
The basic approach of the model was to calculate the difference in income the owners would have received had they been allowed to prepay their mortgages and convert to market on their prepayment dates, versus what they actually received operating under HUD restrictions. For the Title II properties, we decided to limit our damage period to the time between the prepayment date and execution of the Title II use agreement. For our Title VI plaintiffs, our damages period ran from the prepayment date until the date we anticipated all HUD post-prepayment restrictions would be lifted on the property.
One of the most problematic components of our damages model was determining what the market rents would have been back in the early 1990’s had our property owners been allowed to prepay and convert to the apartments to conventional units. One choice was to conduct current market appraisals to determine what the property values would have been back on the prepayment dates. We felt, however, that conducting after-the-fact appraisals would be unsatisfactory for a number of reasons.
First, it was going to be extremely difficult to reconstruct what the markets were back in the early 1990’s. Property conditions change, especially in light of the Southern California earthquake of 1994, markets change and memories fade. We thus felt that our ability today to get accurate data back to the early 1990’s was limited. Second, using after the-fact appraisals to determine property values and market rents invited the Government to submit its own appraisals on each of our 42 properties. The result would be protracted valuation hearings on each and every property. Such a process would be extremely time consuming and expensive for the parties to litigate and we felt it was not an acceptable outcome.
We solved the market rent problem by using as our market rents, the rents agreed to by the owners and HUD during the Title II and Title VI preservation process. As you may know, under the Title II and Title VI programs, HUD and/or the owners commissioned appraisals of the properties in order to determine preservation value and market rents. After the appraisals were completed, HUD and the owners agreed upon what the preservation market rents would be in the Title II or IV plan of action and use agreement. While these appraisals were performed under HUD guidelines, and varied somewhat from true market appraisals, the preservation rents were intended to reflect market rents, and in our estimation, approximated market rents within an acceptable degree of certainty. In addition, because the preservation rents had been agreed to by HUD and the owners, we felt it would be more difficult for HUD to disavow the validity of these agreed upon market rent determinations. For Title VI properties without agreed-upon rents, we took the average of the HUD and owner appraisals.
For other market estimations, such as vacancy rates, operating expenses and debt service upon refinance, we used recognized industry data in order to eliminate controversy and individualized judgments with respect to each property. Our damage model also considered such items as the cost of processing our plans of action, damages caused by HUD’s post-prepayment restrictions, and the benefits the owners received under the HUD programs from earthquake assistance loans and mortgage principal reduction.
In November of last year, we tried our damages case with respect to four "model" properties mutually selected by HUD and the property owners. Our goal at trial was to have the Court adopt our damage model, and in the process, eliminate the need to hold a damages trial on the remainder of our properties.
The damage model presented by HUD at trial was the antithesis of our model. It used individualized, after-the-fact appraisals on each property to estimate market rents and relied almost exclusively on the subjective judgments of the Government’s appraisal and economic experts. We identified for the Court a number of serious flaws with the Government’s model and argued strenuously that, given the large number of properties, not only in our case, but in similar cases, that would be facing the same damage and valuation issues, HUD’s individualized, subjective model was unworkable and would be too costly to implement on a global basis.
We are currently in post-trial briefing and are optimistic that we will receive a favorable judgment on the damages phase of our case in May or June of this year. Meanwhile, our Title II property owners continue to operate under their Title II use agreements and our Title Vl owners are in the process of prepaying under the 1996 Act.
HUD continues to modify its interpretation of post-prepayment restrictions applicable to prepayments under the 1996 Act. Most recently on December 16, following the enactment of the 1997 appropriations bill, HUD issued preservation letter no. 97-1. In this preservation letter, HUD indicates that the post-prepayment restrictions imposed on prepayments which occur in fiscal year 1997 will be reduced. Specifically, HUD has indicated its intent to provide tenant assistance to cover the cost of displaced tenant relocation expenses and has stated that, in addition to issuing tenant certificates and vouchers to very-low income tenants and low income tenants, HUD will also be issuing vouchers to moderate income special needs and tow vacancy area tenants. Theoretically, this should eliminate the need for property owners to maintain below-market rents for these special needs and low vacancy tenants for an additional three years following prepayment. We are continuing to monitor HUD’s position on prepayment issues so that we are able to take them into account as we assess our prepayment damages in the litigation.
Next: Remarks by John Meyers