3.2 Commercial and Ground

Table of Contents Page 3.2.1 Purpose...... 1 3.2.2 Applicability...... 1 3.2.3 Definitions...... 1 3.2.4 Ground Leases...... 2 A. Term of ...... 3 B. Valuation of Mortgage...... 3 C. Acceptable Lease Payments...... 3 D. Option to Purchase Lease...... 4 3.2.5 Commercial Leases...... 4 3.2.6 Sources of Authority...... 5 3.2.1 Purpose

HUD The purpose of this chapter is to describe HUD’s requirements for commercial and ground leases for projects insured or assisted by the FHA.

3.2.2 Applicability

This chapter applies to owners and lenders of projects insured or subsidized by the Federal Housing Administration (FHA). Where particular programs have special requirements, these requirements will be described.

3.2.3 Definitions

The following terms and definitions are associated with commercial and ground leases:

1. Commercial. Any space within a multifamily property that is reserved for nonresidential use from which income is derived or anticipated.

2. Community Facilities. Project amenities, such as a pool, resident parking/parking garage, business center or fitness center that are predominantly used by residential tenants, with or without charging additional fees.

3. Estate. This represents the entire ownership, from beneath the soil to the air above, enduring by and indefinitely into the future.

4. Lease. A lease is a written contract between an owner (the lessor) and a resident (the lessee) with the conditions under which the lessor will transfer the use of real property to the lessee in return for lease payments or rent.

5. Ground Lease. A long term agreement by which an owner of land (lessor) leases an unimproved site to a resident (lessee) for a term of years that is long enough to enable the lessee to construct a building on the leased site and obtain a permanent mortgage.

6. Ground Rent. Payments on a ground lease are called ground rent and must bear a reasonable relationship to the value of the site "As Is" (before construction of on- site or off-site improvements) unless the ground lease is from a governmental agency which has made the ground lease available for limited ground rent to support the development of affordable housing.

7. . The interest of the lessee under a ground lease for a term of years is called a leasehold estate. When the term of the lease expires, all rights to possession and use revert back to the lessor/fee simple owner and the leasehold estate terminates.

3.2 Commercial and Ground Leases 1 February 11, 2014 8. The Leased Fee. The interest of the lessor/fee simple owner during the period when the property is under lease.

9. In computing payments due under the lease, the terms “gross collections,” “operating expenses and taxes,” “net income before debt service payments,” and “net cash flow” shall be defined as follows:

a. Gross collections (or effective gross income) shall mean the annual amount collected from all sources, less refunds.

b. Operating expenses (residential and commercial) and taxes shall be composed of items in accord with generally accepted accounting principles (GAAP). However, for lease payment computations, taxes shall not include income taxes, and operating expenses shall not include interest charges, or charges or allowances for depreciation of real or personal property, or amortization of financing expense, or payments to any officer or director of the corporation, unless such payments are for services at the project which are necessary to the operation of the project. Operating expenses must include the annual amounts deposited to the Reserve for Replacement.

c. Net income before debt service payments shall mean the annual amount which remains after operating expenses and taxes are subtracted from effective gross income.

d. Debt service payments shall be the annual amounts paid to mortgage principal, interest, and MIP.

e. Net cash flow shall be the annual amount remaining after debt service payments are subtracted from net income.

3.2.4 Ground Leases

A ground lease is a long-term agreement for an owner to lease unimproved land to a tenant/developer who agrees to construct new improvements to the land. At the end of the lease, the land and all improvements are typically turned over to the property owner. Ground leases allow an owner to retain an interest in the improved property without having to finance or manage the construction or operations of the project. For a developer, a ground lease may increase project cash flow and the return on equity, and may enhance project marketability.

A housing project subject to a ground lease will not be approved for an FHA insured mortgage unless it meets HUD’s requirements for underwriting and valuation found in the Multifamily Accelerated Processing (MAP) Guide, Chapter 7.15. HUD’s Lease Addendum (HUD-92070M (00/06)) must be appended to the ground lease and the parties must comply with its terms.

3.2 Commercial and Ground Leases 2 February 11, 2014 A. Term of Lease

1. Generally, the term of the ground lease may vary to conform to applicable state and local law.

2. Certain programs have additional restrictions:

a. Section 207/223(f) and Section 231 Substantial Rehabilitation. The lease term must satisfy one of the following requirements:

1) Term must be 99 years and be renewable, or

2) Term must be at least 50 years from the date the mortgage is executed.

b. Section 220, 221(d), and 231 (new construction only). The lease term must satisfy one of the following requirements:

1) Term must be 99 years and be renewable, or

2) Term must have at least 10 years remaining after the maturity date of the insured mortgage.

3. Any proposed change to the lease term must be approved by the HUD closing attorney. To be approved, the change must be consistent with applicable program restrictions and state and local law, and must be legally necessary.1

B. Valuation of Mortgage

A mortgage secured by a project subject to a ground lease is based on a valuation that is less than it would be for the same project held in fee simple.

C. Acceptable Lease Payments

HUD reviews the lease payments required under the ground lease for acceptability. The review is made by the appraiser at firm commitment. The purpose of the review is to determine that the annual ground rent payments, even if they increase over time, do not put the borrower in a weaker position than if the insured mortgage was secured by a property that was held in fee.

1 MAP Guide, Chapter 7.15(C), November 2011

3.2 Commercial and Ground Leases 3 February 11, 2014 D. Option to Purchase Lease

The ground lease must contain an option for HUD to buy out the lease. The price of the option must be included in the lease addendum Form HUD-92264, Multifamily Summary Appraisal Report.

3.2.5 Commercial Leases

HUD regulations at 24 CFR Section 200.7 permit a FHA-insured project to include commercial and community facilities only with HUD approval. HUD has established uniform documentation requirements for the review of leases and rent charges for space established and designated as commercial.

HUD’s involvement in the adequacy of rents charged for the commercial portion of the properties is focused on the following:

1. Financial feasibility of the property,

2. Protection of HUD’s interests in the property due to the encumbrance of a commercial lease on the property, and

3. Ensuring that any housing subsidy for the residents of the property is not being used for the benefit of the commercial tenants.

Commercial space is limited to 20-percent of total net rentable area and commercial income to 30-percent of effective gross project income. The Deputy Assistant Secretary for Multifamily Housing has limited waiver authority to permit more commercial activity, but only where the commercial component will contribute to meeting the Department’s Strategic Plan goals.

Owners must provide a new form HUD-92458, Rent Schedule for Low Rent Housing, and supporting documentation with each change in commercial lease terms. Documentation used to approve commercial rents are as follows:

1. Analysis of commercial rents relative to project debt service and operating costs,

2. Analysis and approval of commercial rents set below market,

3. Certification that commercial lease complies with requirements of the Regulatory Agreement, and

4. Certification that the commercial leases contain all the standard HUD rider provisions.

3.2 Commercial and Ground Leases 4 February 11, 2014 3.2.6 Sources of Authority

1. MAP Guide Section 3.2

2. Mortgagee Letter 2011-32

3.2 Commercial and Ground Leases 5 February 11, 2014