WASHINGTON -- New rules proposed for HUD's low-income housing preservation program may hinder 501(c)(3) bond deals being planned to finance purchases of multifamily units under the program, market participants said last week.

A draft of a Department of Housing and Urban Development notice obtained by The Bond Buyer states that deals under HUD's program financed with tax-exempt bonds would be subject to the same stringent rules already in force for non-bond deals, which are financed instead through federally insured loans under Section 241 of the housing code.

Earlier, housing lawyers had said that bond deals would be more attractive than federally insured loans because there would be less red tape and fewer restrictions on things like the size of the financing or the amount of issuance costs permitted for the deal.

By applying the rules for insured loans to the bond-financed loans, HUD will be making it harder to bring those deals to market, said one housing lawyer, who said his firm is urging HUD to ease the bond restrictions.

"We are adamantly opposed to any arbitrary application" of the so-called Section 241 rules to bond transactions under the preservation program," said Stephen Wallace, a lawyer with the firm of Peabody & Brown.

"Unfortunately, HUD has decided to crimp the market," said Robin Salomon, a principal with DFC Group, a real estate consulting firm.

The preservation program was created by Congress in 1990, when lawmakers became concerned about the upcoming prepayment of thousands of housing units built in the 1960s and 1970s by private developers that received HUD-subsidized 40-year mortgage loans. In return for the subsidies, the developers were required to keep low-income tenants in the units for at least 20 years.

Many of those mortgages have reached their 20th year, prompting developers to prepay their loans so that, released from low-income requirements, they could then turn the units into more expensive rental or condominium properties. The 1990 legislation permits HUD to offer incentives to owners either to keep the properties occupied by low-income tenants or to sell to entities -- mainly 501(c)(3) organizations -- that are willing to do so.

Housing industry officials have predicted that nonprofit agencies seeking to acquire properties under the program would finance their purchases using acquisition loans financed with tax-exempt bonds. Earlier this year, officials said they expected the first bond-financed deals to come to market by the end of this year.

Paving the way for those tax-exempt deals was a $6.3 million taxable bond issue closed June 27 by the Molpus Co., a real estate development company in Mississippi. Molpus already owned the seven apartment buildings involved in the deal, and was persuaded not to prepay its old HUD-insured loan because the department agreed to give the company enough subsidies under the Section 8 rental program to ensure payment of debt service on the bonds and an 8% return on the equity in the property.

At the time, the underwriter for the deal said an uninsured bond-financed loan was more attractive than an insured Section 241 loan partly because of the lengthy turnaround time involved in obtaining the federal insurance.

In addition, the Section 241 loan would have had restrictions that did not apply to the Molpus bond financing. For example, the size of a Section 241 loan is limited to 70% of the equity in the project, and transaction costs are limited to 5.5%.

But last month's draft HUD notice states that those restrictions and all others that apply to Section 241 loans would be extended to uninsured loans financed by bonds.

The rules are needed to protect HUD's interests as the insurer of the original mortgage and "to ensure that the non-insured financing will not be more costly to the government than Section 241 financing would have been," the draft notice states.

But Salomon said HUD's decision to extend the rules appears to be "predicated on its concern about losing market share." HUD wants to see insured loans originated because they would generate fees for the department that would be lost with an uninsured loan financed by bonds, Salomon said. Attempts to reach HUD officials for comment were unsuccessful.

Meanwhile, an organization representing housing project owners wrote to HUD last week urging the department to soften the proposed rules.

In an Oct. 25 letter to the department, the Institute for Responsible Housing said HUD need not worry that its interests as the original insurer would not be protected by any lack of oversight on an uninsured financing.

"In a bond transaction, project oversight would be required by multiple parties," including the first mortgagee, the trustee, and a national rating agency, said the institute, which is represented by Peabody & Brown.

The institute said it was concemed about the effect on bond financings of several of the proposed restrictions. For example, the institute said, limiting issuance costs to 5.5% is a problem for small issuers, "in which the fixed costs...would exceed the applicable ceiling."

For small deals, the institute suggested that "on a case-by-case basis the owner or purchaser be able to receive a waiver of the maximum fee cap."

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