HUD construction draws and change orders: how money moves on a 221(d)(4)

Two ways HUD insures a construction loan

A 221(d)(4) deal is closed one of two ways, and the draw process depends on which.

Under insurance upon completion HUD has no risk until final endorsement, so it does not monitor the lender’s disbursements or step into construction disputes (MAP 12.16). Most of this guide is about insurance of advances, where HUD’s rules govern every dollar.

Before the first draw: the pre-construction conference

Every new construction and substantial rehabilitation project must hold a pre-construction conference before construction starts, including an early start (MAP 12.2). It is run by the HUD inspector or HUD construction analyst and attended by the borrower, its supervisory architect, the general contractor, major subcontractors (any principal trade, or any with 15% or more of the hard cost), HUD’s underwriter, the lender and HUD’s Davis-Bacon and Labor Standards staff.

The conference covers how draws, change orders, stored materials, retainage, permission to occupy and cost certification will work. Two rules from it trip up first-time HUD developers:

• Work done in anticipation of a change order is noncompliant. There are no insured advances for it, or for other work that depends on it.
• Identities of interest that appear after closing must be reported to the lender and HUD within 5 working days, identity-of-interest subcontractors need HUD’s prior approval, and shell general contractors are prohibited.

For a 223(f) the conference is optional, depending on size, repair scope and the team’s experience.

The monthly draw cycle

1. Monthly job meeting. The contractor, borrower, supervisory architect and HUD inspector meet on site each month when the draw request is prepared (MAP 12.3.5). The architect keeps the minutes. The lender must also attend when construction falls more than 10% behind the progress schedule (form HUD-5372) or other problems threaten completion.
2. Contractor’s requisition. The contractor submits form HUD-92448 for work completed and materials stored, with bills and receipts.
3. HUD inspection. The HUD inspector, usually an independent third party under contract to HUD, visits at least once a month (MAP 12.3.4.3), checks that the amounts requested are reasonable, interviews workers on form HUD-11 and records the visit on the Trip Report, form HUD-95379.
4. Lender approval. The lender’s construction loan administrator signs forms HUD-92403 and HUD-92448 for interim advances. HUD’s Regional Production Director signs the initial and final advances (MAP 12.7.1).
5. Title. The lender confirms clear title before funding and tells HUD in writing if mechanics liens stay unresolved for more than 60 days (MAP 12.7.2).

Some rules apply to every advance:

• Equity first. Escrowed funds for on-site improvements must be spent before mortgage proceeds. Government grant or loan proceeds and tax credit equity can be the exceptions (tax credit equity can go in pro rata under chapter 14); EB-5 money cannot and must be funded up front like other equity.
• Draws follow progress. Construction funds advanced must match progress as approved by the HUD inspector, and other mortgageable items need bills or receipts.
• Wages travel with the draw. Each request for advances carries a certification of compliance with Davis-Bacon wage rates. Contractor payrolls go directly to HUD’s Labor Standards and Enforcement staff at least monthly (MAP 12.12.1). The weekly certified payroll mechanics are on the Davis-Bacon page.

Retainage

The HUD construction contract holds back 10% of each monthly payment for completed work and stored materials (MAP 12.15.5). It can step down if three conditions hold: the contractor has no more than a 5% equity interest in the borrower, the surety consents in writing, and HUD has no questions about quality, contract compliance or open change orders.

• Identity-of-interest contractors (more than 5% of the ownership) generally keep the full retainage until final endorsement.
• Early partial release is possible after 90% completion with a request from the contractor, borrower and lender and surety consent, but the undisbursed holdback must stay at or above 2.5% of the contract amount.
• Projects in difficulty can get part of the holdback before 90% only to prevent a default of the construction loan, and only if that would get the project finished.

Next-to-final and final advances

The next-to-final advance can be requested once construction is acceptably complete, even with items of delayed completion. For a non-identity-of-interest contractor it releases the retainage, subject to the contractor’s cost certification having been reviewed, certificates of occupancy and HUD’s Permission to Occupy (form HUD-92485) for all units, all Davis-Bacon payroll requirements met, and the survey submitted. HUD still keeps back enough for delayed items (150% of HUD’s estimate), lien claims, liquidated damages and any negative net change orders (MAP 12.15.5.D).

The final advance releases the remaining mortgage proceeds after HUD has approved the cost certification and set the maximum insurable mortgage on form HUD-92580 (MAP 12.7.7). Items of delayed completion go into an escrow of at least 150% of the estimated cost, capped at 2% of the mortgage, and must be finished within 12 months of the final HUD inspection (MAP 12.6.2). Final closing cannot happen until HUD’s labor standards staff give written clearance on wages (MAP 12.12.2).

Change orders

Any change to the scope, price or time of the construction contract is requested on form HUD-92437, signed by the borrower, its architect, the general contractor and the lender, then reviewed by HUD (MAP 12.8.1). HUD aims to process a change request in no more than 5 workdays (MAP 12.9.1).

HUD approves a change only if it fits one of three classes (MAP 12.8.2):

How each kind is funded:

• Additive changes. Except for necessary changes, the borrower escrows the cost of an additive change order once HUD estimates the aggregate increase reaches $5,000, and of every additive change after that (MAP 12.8.3). A letter from the contractor confirming the borrower has paid can stand in for the escrow. Nonprofit borrowers can use the developer fee. After 75% completion, on schedule and with no noncompliance findings, HUD may let approved additive changes come from the 2% construction contingency.
• Price disagreements. If the contractor’s estimate exceeds HUD’s, the difference is escrowed; if HUD’s estimate is higher, HUD’s excess is held until final endorsement (MAP 12.11.2).
• Deductive changes. While the aggregate decrease stays under 2.5% of the contract price, the lender cuts the contractor’s final requisition. At 2.5% or more, the decrease shows on every requisition and the mortgage is reduced at cost certification where required (MAP 12.8.4).
• Changes that cut income. These are grounds for rejection unless the change is necessary and unavoidable; if HUD’s re-underwriting produces a smaller loan, later requisitions are reduced (MAP 12.8.5, 12.11.2).
• Changes caused by error or negligence of the architect, owner or contractor are recorded as such and their cost stays out of the mortgage (MAP 12.8.11).
• Unapproved changes. The inspector reduces the requisition for the noncompliant work and for any removal it may require (MAP 12.9.3).

The only change that can be made before approval is an emergency that endangers life or property or halts construction (MAP 12.8.8). Change orders submitted after the final HUD Trip Report are not approved unless they concern items of delayed completion or the Regional Production Director agrees in writing. Any physical change must also leave the environmental review and its mitigation conditions intact.

Time extensions and keeping the loan in balance

The lender can approve a time extension only when the delay is beyond the contractor’s control (strikes, unknown site conditions, weather worse than the seasonal average), it is requested on time under the contract, and the surety consents in writing (no surety consent is needed where completion is assured by cash or a letter of credit) (MAP 12.8.6).

HUD prices an extension mechanically: 65% of the contractor’s monthly general requirements cost per month, a quarter of that per week, and nothing for extensions under a week. Carrying costs are pro-rated daily from the underwriting, and an extra year of MIP is due if the extension pushes the construction term past 12, 24 or 36 months (MAP 12.10.2, 12.11.2).

If the delay is the contractor’s fault, extra interest, taxes, insurance and MIP are paid through the liquidated damages clause. HUD treats the interest budget as overspent when the share used runs 10% or more ahead of the share of construction completed (MAP 12.7.8). The liquidated damages amount is then moved from the construction line to carrying charges, with notice to the borrower, contractor and surety.

Escrows that sit beside the draws

Sources: MAP 12.8.1.A.5, 12.15.3, 12.15.4, 12.15.6, 12.6.2. Working capital cannot pay hard construction costs. Insurance upon completion deals need the working capital and operating deficit escrows too, but not the extra 2% contingency (MAP 12.16.M).

Occupancy before completion

Units can be leased before the whole project is done. The borrower, supervisory architect, contractor, lender and HUD sign a Permission to Occupy, form HUD-92485, backed by a certificate of occupancy and evidence of property and liability insurance (MAP 12.14). HUD favors partial occupancy building by building or floor by floor where it brings in needed income and earlier rent-up. Dwelling units with open punch-list items are not accepted for occupancy; punch-list items in common areas and outside do not block it (MAP 12.6.1).

Repairs on a 223(f) or 223(a)(7)

A purchase or refinance with repairs follows a lighter version of the same rules (MAP 12.17):

• Critical repairs are finished and confirmed by a HUD site visit before closing. Only critical accessibility repairs HUD approves for deferral can wait.
• Non-critical repairs can be deferred, normally finished within 12 months, and paid from a repair escrow holding the full cost plus a 10% or 20% assurance of completion. Releases are against a schedule of values, for completed hard costs; soft costs follow pro rata.
• Inspection depends on scope. 223(a)(7) work and 223(f) work limited to repairs and Level 1 alterations can be self-certified. Level 2 alterations get periodic inspections unless waived. Work needing a project architect (over $15,000 per unit, or Level 2 and 3 alterations) is inspected at 35%, 65% and 100%.
• Change orders after closing that add cost are funded by the borrower when approved, and the repair escrow is never reduced for changes that save money. Total repairs must stay under the substantial rehabilitation threshold.
• Leftover escrow goes back to the borrower once HUD confirms the repairs and title; where repairs exceed $400,000, a latent defects assurance of 2.5% of the repair cost is held for 15 months first.
• If repairs are not finished by the deadline, the lender completes them with the escrow funds and returns what is left, less its costs.

Davis-Bacon does not apply to 223(f) repairs; see 223(f) and the Davis-Bacon page.