Member Article

Here’s a fun conversation starter for lenders, borrowers and attorneys who regularly work on HUD-insured multifamily and health care facility loans: If HUD had a list of Ten Commandments for obtaining a HUD-insured loan, what would be Commandment No. 1?

Most professionals in the HUD-insured loan universe would likely put the “first lien” requirement at or near the top of the list of Ten Commandments. Simply put, you can’t close a HUD-insured loan unless you can demonstrate that the mortgage for that HUD-insured loan is senior to any other lien on the property. Title insurance companies provide insurance to help us demonstrate senior lien status and satisfy this commandment.  

HUD requirements, however, are not always etched in stone. One notable exception to the first lien requirement is the Section 241(a) supplemental loan, which derives from Section 241(a) of the National Housing Act. The 241(a) program is the odd man out among HUD’s loan programs because, unlike almost any other HUD-insured loan commonly offered, 241(a) loans are junior loans. To qualify as a 241(a) (i.e., supplemental) loan, there must be a senior loan, and that senior loan must be a HUD-backed or HUD-held loan.

So why would a multifamily or skilled nursing facility owner consider a 241(a) loan?  HUD’s 2021 Multifamily Accelerated Processing (MAP) Guide states that a Section 241(a) loan is “intended to keep the project competitive, extend its economic life, and to finance the replacement of obsolete equipment.” One common way for an owner to make a project more competitive with a 241(a) loan is to expand the project’s footprint. For example, a skilled nursing facility owner might use a 241(a) loan to add dedicated Alzheimer’s or dementia assistance units. Similarly, a multifamily facility owner may employ a HUD-insured 241(a) supplemental loan to add an apartment building to undeveloped.    

The underwriting considerations that go into a 241(a) loan are beyond the scope of this article.  The discussion below offers one lawyer’s perspective on a few salient features of the 241(a) program and describes certain documentation nuances, distinguishing between multifamily and healthcare 241(a) loans as appropriate.

Initial and Final Closings

As mentioned above, Section 241(a) supplemental loans are generally used to finance physical improvements to an existing HUD-insured project. Accordingly, the 241(a) loan closing process is more akin to the 221(d)(4) program (HUD’s program for multifamily new construction and substantial rehabilitation (NC/SR)) than to the 223(f) program (HUD’s refinancing loan program), complete with an initial closing for the first draw of loan proceeds and a final closing for the final draw. The typical suite of NC/SR (construction contract, building loan agreement, etc.) will apply.

Documentation in General

241(a) transactions require documents that, while largely adhering to the standard HUD templates, include certain tweaks reflecting the loan’s subordinate status.

For multifamily facility 241(a) loans, HUD has not published a dedicated set of Section 241(a) official form documents. However, the HUD closing attorney assigned to a 241(a) loan should be able to furnish certain Section 241(a) loan document templates upon request. The document revisions required for the 241(a) program are not considered “substantive changes” under the MAP Guide and are therefore not typically subject to the multi-tiered agency review that would otherwise be required.

Fortunately, HUD’s Office of Residential Care Facilities (ORCF) has published OMB-approved forms that apply specifically to health care facility supplemental loan transactions. Those forms are available here.

Davis-Bacon 

Whether Davis-Bacon wages apply to the physical work financed by the 241(a) loan depends on the nature of the senior HUD-insured or HUD-held loan. If the senior loan is a new construction/substantial rehabilitation loan, prevailing wage requirements will apply to the work funded by the supplemental loan. By contrast, if the senior loan is insured under 223(f), Davis-Bacon does not apply and the prevailing wage provisions in closing documents can be stricken per the MAP Guide.

Cross-Defaults – a One-Way Street

The 241(a) loan documents must contain cross-default provisions, such that a default under the senior loan triggers a default under the supplemental loan. Defaults under the supplemental loan, however, do not automatically create a default under the senior loan, as the standard HUD loan documents used for first mortgages do not contain cross-default provisions.

Mortgage Term

With regard to multifamily transactions, the MAP Guide specifies that a Section 241(a) loan must be coterminous with the senior loan if the senior loan has 25 or more years remaining. If the senior loan has fewer than 25 years remaining, the supplemental loan can have a term of up to 40 years, but not greater than 75% of the project’s remaining economic life.

In the health care space, ORCF’s 232 Handbook has the same general requirement that the junior loan be coterminous with the senior loan, but it does not offer exceptions to the general requirement based on how many years remain on the senior mortgage or the percentage of the facility’s remaining economic life. Instead, ORCF dictates a 10-year minimum 241(a) mortgage term minimum (10 years) and allows for junior mortgages to have terms longer than the remaining senior loan term only when “otherwise approved by HUD.”

Adding Improvements — Potential Complications

When 241(a) loan proceeds are used to add project improvements, the borrower and lender need to consider the impact of the addition on the senior loan. If the addition fits within the boundaries of the legal description of the property contained in the senior loan documents, those documents may not require modification. The improvements should be covered by the broad definition of “mortgaged property” in the senior loan documents and therefore become part of the collateral for that loan.

However, if the borrower’s addition involves acquiring property adjoining the currently-insured parcel for the senior loan, the parties will need to amend the senior loan documents to include a revised legal description encompassing the original and new property. Additionally, when the Section 241(a) transaction goes to initial closing, the parties will need to obtain an updated senior loan title policy reflecting the expanded legal description and insuring that the senior mortgage remains a first lien on the entire property.  

The Senior Lender Can Be Different From the Junior Lender

The MAP Guide contemplates transactions where the 241(a) lender and senior lender are not the same. To prevent the possibility of a default under the first mortgage, the MAP Guide requires the first lender to provide its written consent to the 241(a) transaction. Perhaps not surprisingly, this requirement applies even when the first lien and second lien lender are the same.

Refinancing a Project Encumbered by a 241(a) Mortgage

Refinancing a project subject to a 241(a) mortgage may require special care to maintain the correct lien priority of the mortgages. For example, if the owner wanted to pay off its existing first lien loan with a 223(a)(7) loan while leaving its subordinate 241(a) loan in place, the parties would need to execute and record a subordination agreement to make the 241(a) lien junior to the 223(a)(7) lien. HUD does not have a standardized form of subordination agreement for this scenario (both the Multifamily and health care forms of subordination agreement require repayment strictly from surplus cash, while 241(a) loans require regular monthly payments).  The parties would therefore need to work with HUD to create an acceptable alternative subordination document.

Conversely, if the owner wanted to refinance its 241(a) mortgage with a 223(a)(7) loan without paying off its first mortgage, no change to the first loan documents would be needed, as those documents normally do not acknowledge the existence of subordinate debt. However, if the owner later decided to pay off its senior loan with a 223(a)(7) loan, the 241(a) loan documents would need to be amended to change all references to the senior loan, such that the senior loan is identified as the 223(a)(7) loan, not the loan that is being paid off.

Suffice it to say, it makes the life of lender’s counsel much easier when the senior and junior loans are paid off with a single 223(a)(7) loan, or with two 223(a)(7) loans that close simultaneously.

Conclusion

HUD’s 241(a) program, by deviating from the first-lien requirement that applies to the rest of HUD’s programs, entails special legal and underwriting considerations that can make closing loans under the program more labor-intensive than the typical HUD-insured loan.  Lenders, borrowers and the attorneys who represent them are well-advised to develop at least a passing familiarity with 241(a), the odd man out among HUD’s loan programs that offers existing HUD projects a unique way to boost marketability.