Financing a ground-leased apartment property with a HUD loan

The short answer on eligibility

The insured mortgage has to sit on real estate held in one of two ways: fee simple, or a lease that meets a minimum term set by the National Housing Act (MAP 3.1.23). HUD will insure a leasehold mortgage that is a mortgageable interest under state law, but it says plainly that it prefers fee simple, and the lender’s underwriting and appraisal must describe the leasehold interest and its values in full (MAP 7.15).

Two structural rules apply to every leasehold deal:

• The landlord must own the fee and grant the lease directly to the borrower. A mortgage on a sub-leasehold is not insurable. For 223(f) and 231 that prohibition is statutory and cannot be waived (MAP 7.15.2).
• The lease must incorporate HUD’s Lease Addendum (form HUD-92070M). Substantive changes to the addendum, and waivers of the ground lease section, are approved only by HUD headquarters, except on affordable deals where a government entity is the landlord (MAP 7.15, 11.3.5).

Minimum lease term by program

The term cannot be waived because it comes from the statute (MAP 7.15.2.B.1).

A practical reading for a construction deal: a 221(d)(4) loan with a 40-year permanent term after construction needs a lease that outlasts the maturity date by 10 years, so the remaining lease term at closing has to cover the construction period, the 40 years and the 10-year tail. That is our arithmetic from the MAP rule, not a separate HUD figure.

Leases of trust lands or Native American tribal land need the term and any addendum waivers to be acceptable to both HUD headquarters and the Bureau of Indian Affairs.

What kind of leasehold qualifies

The MAP Guide recognizes four forms (MAP 7.15.2.A):

Leasehold	Addendum option	Landlord
Land only (ground lease)	Option 1, “Ground Lease”	Any fee owner
Land and buildings	Option 2, “Lease”	Public or governmental entity only
Air rights only	Option 1, “Air Rights Ground Lease”	Any fee owner
Air rights and improvements	Option 2, “Air Rights Lease”	Public or governmental entity only

So a private landlord can lease you land or air rights under a HUD loan, but not the buildings themselves.

Ground rent: what HUD accepts

Ground rent has to fit one of three forms, and the appraiser builds it into net operating income (MAP 7.15.3.1):

1. A fixed percentage of gross collections (or effective gross income), the same for the whole lease.
2. A fixed percentage of net cash flow to equity, after debt service but before the lease payment, the same for the whole lease.
3. A stated dollar amount per year that stays fixed until at least 10 years after the end of the insured mortgage’s term. It can be written as a minimum payment.

If the lease combines methods, it has to say whether the rent is the greatest, the least or the sum of them.

What HUD will not accept (MAP 7.15.3.2): variable ground rents of any kind, specifically a graduated schedule of future increases, cost-of-living or CPI escalators, and increases set by future appraisals or arbitration. This is the clause that most often has to be renegotiated with the landowner, because market ground leases commonly carry CPI or periodic fair-market resets.

Ground rent during construction

On new construction, ground rent during the build is included in the project’s estimated replacement cost and in the certified cost, for the same period used for construction interest (or the construction time plus two months). It cannot be part of the base used to calculate BSPRA on 220 or 221(d), and it cannot exceed the acceptable lease payment test. On rehabilitation under any program, ground rent during the rehab is part of replacement cost (MAP 7.15.3.3). At cost certification, ground rent paid between initial endorsement and the cut-off date is an eligible other cost, and the cost of acquiring the leasehold counts only to the extent it, the ground rent and any offsite costs do not exceed HUD’s value of the land fully improved (MAP 13.14.12). The cost certification guide covers that step.

HUD’s option to buy the fee

Section 7 of the Lease Addendum gives HUD an option to purchase good and marketable fee simple title to the land, plus the landlord’s interest in the buildings if it has one. The option price is the value of the leased fee, meaning the net present value of the ground lease, at firm commitment (MAP 7.15.2.B.3).

The Regional Center Director can waive the purchase option at firm commitment only when the landlord is a state or local government or a public entity created under state law, and the project:

• is affordable under MAP 3.1.12, or is a low-leverage, low-risk loan with significant public purpose;
• is appraised for the leased fee, the leasehold and the fee simple land; and
• has a full discussion of the lease terms in the appraisal and underwriting, with the lender concluding that the leasehold is marketable and the leased fee is worth less than the fee simple land.

For affordable projects with a ground lease and no purchase option, HUD will recognize the leasehold as security only if the landlord is a government body, housing authority or nonprofit, the property is affordable, the addendum is used without other deviations, and the loan is low-leverage and low-risk with significant public benefit. There are no regional exceptions to that (MAP 7.15.4.A.1).

How the leasehold is valued

The loan is sized on the value of the leasehold, never the fee (MAP 7.15.4, 7.15.6):

• The leasehold value goes on line 3(a) of form HUD-92264-A and drives the value-based sizing test (Criterion 3). The leased fee gets no value under Criterion 3 or 4.
• The leasehold’s value or replacement cost must in every case be less than the fee simple value.
• The appraiser values the fee simple land, the leased fee (the present value of the lease payments, by direct capitalization and discounted cash flow, with any difference explained), and the effect of the leased fee on the leasehold.
• An upfront land lease payment is treated as the present value of rent that would otherwise have been an operating expense, and the appraiser must analyze how it affects value and the loan amount.

Because ground rent is an operating expense in NOI, it also reduces the loan on the debt service coverage test. For new construction the appraiser includes ground rent in the operating deficit estimate once construction ends, since only construction-period ground rent can be in the mortgage (MAP 7.14).

Documents at closing

• Lease or memorandum of lease, recorded, naming the parties, the legal description, the term and renewal options, the Lease Addendum, and HUD’s purchase option in Section 7 unless waived (MAP 7.15.2.B.2).
• Lease Addendum (HUD-92070M), incorporated into the lease before it is signed; if that is not possible, signed separately by landlord and tenant before HUD endorses the note, with an amendment to the lease. If the lease is already recorded, the addendum is recorded too. No security instrument rider is needed for the ground lease (MAP 19.4.2.4).
• Landlord estoppel certificate, dated within 30 days of closing, identifying the lease documents and confirming the legal description, that the lease is in full force and that there are no defaults or pending defaults. It must carry the certification language of 24 CFR 200.62 and the warning language from the addendum.
• Title: the MAP Guide lists ALTA endorsement 13.1-06 for additional coverage when the project is secured by a HUD-approved ground lease (MAP 19.4.7.4).

On a 223(a)(7) refinance, a new Lease Addendum is required only if the ground lease was materially modified without HUD approval since the last HUD closing, or its term does not comply with the National Housing Act.

Fee joinders: tax abatement structures

Some states give tax abatements to rental projects whose fee is held by a state or local development agency, which then leases the property back to the developer for less than the statutory term. HUD can still insure the loan through a fee joinder: the agency joins the FHA mortgage through a Rider to the Security Instrument so the lender has a first lien on the full fee simple estate for the life of the loan (MAP 7.15.7, 19.4.2.5).

Requirements include an otherwise eligible deal, a state or locally authorized tax abatement, a public-entity landlord, counsel confirming under state law that the mortgage is a first lien on the entire fee for the term of the note, the executed rider, and title insurance satisfactory to the lender and HUD. For valuation, fee joinder deals are underwritten at full property taxes unless they meet the MAP Guide’s tax abatement rules in section 7.16.