What You Need To Know About HUD Loans With Aaron Krawitz

With the current inflationary environment, we are seeing a gap in seller and buyer expectations as well as a pulling back from banks in terms of lending activity. Who do you turn to then? In this episode, Jack Krupey has the guest for you! Aaron Krawitz is the CEO of Bravo Capital, a fully-approved HUD lender nationwide. Aaron shares how they assist as a direct lender for multifamily and healthcare properties. He walks us through the cycle of traditional syndication, how it goes with bridge-to-HUD, and the steps needed to be taken by a sponsor group. He then breaks down requirements, value-adds, and some of the common mistakes to avoid. What is more, Aaron gives us his outlook for 2023 and the trends to watch out for. So join this episode to learn more about HUD loans!

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What You Need To Know About HUD Loans With Aaron Krawitz

Aaron, it’s great to catch up with you. Lots have changed in the market over the few years. We’d love to get some market color. Why don’t you tell me a little bit about what you’ve seen in the multifamily market over the last couple of months and what your outlook is for 2023?

I would love to. There are a few headlines right now. First, there’s still a gap between sellers’ price expectations and what buyers are willing to pay, given what’s happened with interest rates and in the debt markets. There’s a bit of a dislocation. All the reports and data that we’re seeing are month after month, there’s a double-digit decrease in actual transaction activity while there’s a lot of sitting on the sidelines and price discovery still.

On the debt market side, besides the more recent increase in interest rates, what we’ve seen is a real pullback from banks, both in terms of lending activity, but also in terms of leverage. We’ve seen a very dislocated set of CMBS and CLO markets and a number of our peers that were very strong in terms of execution. Both of those spaces are also sitting on the sidelines more.

We are very well-positioned right now, both with our bridge lending ARM with our private debt fund that assists with acquisitions, which is balance sheet-based. We’ve been very active with that. Balance sheet bridge lenders who are active are few and far between these days. Also, with our separate business, Bravo Capital, a fully approved HUD lender nationwide, it’s become a very stable source of financing, both takeout financing on the back end of our bridge platform and for new development.

That’s great. To give you some perspective on where we sit in the market, we’re not a direct operator ourselves, but the JKAM series of funds have invested in over 40 syndication deals, and it’s a combination of 5 to 7-year fixed-rate Fannie Mae debt. There is a fair number of properties that have entered with bridge loans with an interest rate cap through most of the groups you highlighted that were some of your competitors in the market.

How does the HUD product work, and more specifically for someone who bought in March 2022 and maybe had a 3% rate cap that they hit over the last couple of months? Now, they’re at their cap, and they’ve got two years less to refinance. What do you see as a path in this market for using HUD as an option to exit a bridge loan? Fortunately, in the ones we’re in so far, our rents are up so much that we’ve renovated our way well above any interest rate risk, but for those that may have some challenges, how could HUD help?

HUD is an in-depth process. First and foremost, somebody should know it’s not a fast-closed process. In Bravo Capital, we typically advise that whoever is looking at HUD or even exploring it should send our team materials for loan sizing at the outset so that we can perform full diligence, see if it’s a fit, and want to flag it at the outset that before the HUD funding and closing, the sponsor should have at least six months ready for the HUD process given its intensive with diligence.

Assuming that all checks out, the property is eligible, and the sponsor has enough time with the 223(f) HUD-insured financing, what we’re able to provide is a higher leverage product typically than elsewhere in the market. It’s an 80% LTV product. The minimum DSCR for the market rate is 1.176%. That’s also very competitive, but the best part about HUD-insured financing is the certainty.

The fact that upon closing, you have high certainty that you are not reliant on CMBS style execution, but you know that your lender is going to be there. Also, once you have closed, having a long-term fixed-rate product means that our sponsors can sleep at night. A lot of the alternatives that are either floating rate or short duration mean that it’s hard to project long-term, especially for a long-term holder. It’s very compatible with their goals.

A lot of the market we’re in is syndicated deals where at least a few years ago, a lot of these had 3, 5, and 7-year targets where they eventually sell and pay back, return capital to passive investors and then do another one, but HUD a longer-term product. Is it a steep prepayment penalty if somebody wants to exit in 5 to 7 years?

The typical HUD prepayment penalty is a ten-year typical step-down, so 10%, decreasing by 1% each year until burn off. What’s a little-known fact about HUD is that the prepayment is customizable. We have worked with sponsors on five-year prepays, for instance, if they believe that there will be a shorter hold, it’s a more detailed discussion as to how that works, so that’s one way.

If there’s a shorter-term hold, you don’t have to hold for the whole 35-year loan term. Customizing and shortening the prepay is one earlier exit option. Another option is the TPA process. Assigning your HUD loan if you have a purchaser who is an experienced sponsor is a common process, and you’re not hit with the prepay fee. There’s a separate nominal TPA fee, but transferring is a commonly executed strategy for those with shorter hold windows.

We had an exit on one of the deals we invested in in October at the height of interest rate rises. It was sold to a local family office, and they went in with a ten-year fixed-rate debt. Fortunately, the ten-year has not moved as these 2 and 3-year. If you’re entering at close to LTV and a few years later, you’re still at 70 LTV, there are a lot of family office type of buyers who don’t want the highest leverage and would take on a long-term fixed-rate product, assuming rates don’t plummet down again. If that’s the case, it’s probably worth eating a prepayment penalty, and if rates end up at 2% again, then somebody will want to take a new loan, and the value is probably up significantly at that point.

For those with a historical perspective, we see that we’re clearly in an inflationary environment. There’s no clear end in sight to when inflation will reigned-in, and we’re still at the lower end of the historical spectrum in terms of where the US ten-year treasury is. Fixed-rate long-term debt is the place to be. There’s no question. Not just for new HUD loan execution, but we’re even seeing that recently closed and executed HUD loans turn a property into an acquisition target because the HUD loan is seen almost as an asset on the property. It is assignable.

HUD Loans: Fixed-rate long-term debt is the place to be.

For instance, we’ve seen loans in recent months close with a four-handle. We saw a 4.84% closing a number of weeks ago for a market-rate property that we worked on. Right now, that sponsor is shielding calls because not only is it a great property, but purchasers want to assume a 4% fixed rate loan on a beautiful new construction property. That factors into the analysis, the assignable piece of the HUD loan.

You mentioned that it is a longer closing cycle than traditional. Realistically, for a majority of the deals that I see, it’s not very realistic to use HUD for the initial purchase, and that’s the reason you guys have a proprietary bridge product. Walk me through the cycle of the type of traditional syndication we’re involved in, whether it’s off-market or market, where you realistically have to close it in roughly 90 days, and you’re not going to start with a HUD loan. Can you walk me through how it goes with bridge to HUD and the steps that would need to be taken by a sponsor group?

The beauty of bridge to HUD is a sponsor is able to get the best of both worlds, especially given that we have both platforms in-house. A sponsor is able to execute on that faster close that you mentioned and can close in 30 to 60 days with our bridge product. A unique feature of our bridge product is there’s no lockout period or minimum term. As soon as the property is ready for HUD and the sponsor wants to go to HUD, there’s no exit fee with us, and they can go directly to HUD.

In terms of the HUD execution itself, we have a separate entity. We have a wall between our two teams, but with the borrower’s permission, we could very easily share borrower information, loan form information, and third-party reports and leverage that so that there’s real efficiency. From a user interface perspective, there are two very separate loan teams working on two loans. From the borrower’s experience, it feels like one seamless process both to enjoy the quick acquisition with a bridge product but also to get the benefit of the low fixed rate HUD product a number of months later.

Let’s say someone who’s already been a key principal on a Fannie or Freddie deal or any of the other bridge lenders but hasn’t done a specific HUD loan. Are there any differences in net worth requirements or experience requirements? Have you had to have signed on a HUD loan before, where you may need to add a different key principal to the GP team to execute this?

There’s a lot packed in there. Anybody who has significant multifamily experience and hasn’t had a negative track record of defaults, criminal issues, or bankruptcy would be eligible for a HUD loan, particularly for a 223(f), which is an already built and stabilized product. As you can imagine, for a ground-up product, which is a 221(d)(4), both for us as HUD’s fiduciary and for HUD itself, there’s a lot more scrutiny to make sure that somebody has the capability to do a 221(d)(4). If somebody’s doing ground-up construction, I differentiate that and say it’s very helpful to have prior HUD (d)(4) experience if you’re doing a (d)(4), given that the risk and capability required, it is less if you’re executing a 223(f) already built and stabilized acquisition.

For the deals I have in mind and the stuff we’ve been involved with, almost all of it is value add. We’ve not been very involved in the ground-up space. You mentioned stabilized. Can you give a range? A lot of these value adds when we’re entering them, they’re 90% occupied. They maintain the high 80s to low 90s occupancy. There’s a combination of moving rents to market but maybe renovating 5 to 10 units a month, or maybe some months you don’t want to have more renovations, just do more adjusting rents to closer to market without driving down occupancy. Where’s the line for stabilization on the typical value add? I’m sure you’re pretty familiar with the standard playbook of the ’70s and ’80 vintage value add.

We welcome transitional property with our bridge fund. If something is a lease up and is not anywhere close to 90% stabilized, and if there is a heavy value add involved or bridge fund is meant for a transitional product. In contrast, when somebody is going to HUD, both for HUD’s purposes and also for the sponsor’s purposes, it makes sense for the property to be as polished and as stable as possible. Usually, we are looking above 90% stabilized.

Also, thinking from the sponsor’s perspective, if you’re locking in proceeds and a 35-year loan term with a prepay, whether it’s for 5 years or 10 years prepay, you want to make sure that you’re maximizing the value of the property and loan proceeds before you go to HUD. That’s another reason why we are typically seeing 90% plus stabilized and much of the work and upgrading done before opting into that HUD financing.

That makes a lot of sense. I want to change gears a little bit. This has come up a lot. With interest rates going up, cap rates have seemed to expand a bit, but it’s certainly not been linear. It’s very market and value add dependent, but what trends have you seen high level on how much cap rates have moved compared to interest rates?

We’ve seen cap rates not move enough to reflect interest rates, and there are a number of deals that don’t meet the DSCR requirement. Thankfully for HUD, it’s a very competitive DSCR requirement. The minimum is 1.176% for a market rate project, but even with that, we’re seeing a lot of projects that don’t pencil. That led to sponsors getting more creative in terms of how they’re going to achieve their goals and their yields, whether it’s working harder to find off-market transactions with a story or it means sponsors that haven’t done development before forming a JV and getting into development. The tactics are changing.

We’ve seen many similarities. The one thing, at least, I see on the heavier value add, the entry cap is often not reflective to some extent. You’re backing into somewhat closer to a stabilized cap because at $500 or $600 a month to increase in rent, you’re pricing in some of the upsides to a slightly lower entry cap, at least maybe on trailing 3 or 6 because you want the deals that have so much upside that you can stabilize it at a higher cap. Sometimes it almost looks like a construction project of what cap rate you’re building, too, because there’s so much rent and upside in both raising rents and renovating units. We have a few projects where rents are up 91% after renovation, which is pretty amazing.

That’s a great result. Also, another trend we’re seeing and related is that in 2023, the data is showing that there’s a tremendous wave of maturities coming, and it’s a unique set of maturities given that interest rates have gone up higher than some sponsors planned for. They’re entering a market where they need a new loan, and they’re not quite sure if it even makes sense to take on the type of financing they’ve taken on previously in terms of floating bridge rate. It’s leading to a lot of traditional non-sellers becoming sellers thinking they can’t necessarily handle new financing.

We’re seeing requests for bridge-to-bridge or taking out existing bridge loans because somebody wasn’t necessarily able to execute their plan in time for a permanent loan takeout. It’s a different type of environment to navigate. The HUD product is a great product, with the combination of a competitive fixed interest rate. It makes a loan pencil that might not otherwise with the debt fund execution.

You said the biggest anxiety I hear from our investor base and potential investor base is, “What happens when balloon payments? What happens when people have to refi?” Fortunately, most of our deals have another, at least plus one-year extension, but it is a big anxiety driver for probably everyone. It’s probably the biggest risk for everyone in the market. It’s having actual balloon payments, which is something very different than anyone who’s been a residential investor who’s generally refi-ing into 30-year fixed and having to make these decisions every 3 to 5 years. It’s nerve-wracking, and this is the first time in a generation that we’ve had rates move the way they have.

An average deal with that DSCR might be hard to do without sticking an Excel sheet up, but let’s keep it high-level here. For a typical sponsor who’s doing a value add and is able to execute, and maybe they’ve not renovated enough of the units yet for a deal that’s generally going well but was on a three-year interest-only bridge and is going to move either directly to HUD, or it makes sense to maybe go to another bridge with the long-term plan of HUD. Where’s the line of a deal that’s not going to work because the business plan is failing, and they’re only renovating 5% of the units that have been driven by NOI to meet these new debt service coverages?

That latter example sounds like a need for a bridge to a bridge. A lot of what we tell both our friends and clients is to be honest with ourselves, especially in terms of proformas. When looking at the HUD process, it is an elongated process, and as a result, you can start the process at least with us relatively early on, and we could start building an application and a narrative while somebody is showing us their proformas and need to be actualized over the course of our application.

Where people get into trouble is if they’re overly optimistic in terms of their own timelines, whether it’s rent growth, occupancy, executing their value-add plan, the personal integrity of being honest with oneself, do they need an additional bridge to bridge or are there hurdles in any of those categories above? That’s very helpful so that sponsors don’t spin their wheels with a process where they’re ready for that execution or meet those hurdles in terms of occupancy, completing repairs, or DSCR coverage.

You’ve given a lot of great tips to the majority of sponsors. Unless they’ve locked in with ten-year Fannie debt, almost every sponsor I’ve spoken to over the past few years is going to have some big decisions to make over the next year or two. I haven’t seen as much HUD in recent years in our deal flow. My gut says there are going to be a lot more HUD takeouts over the next few years.

I would think so. Looking historically that some of the peak years for HUD have been during the great financial crisis, peak COVID, and at times when the market is scared. Part of the public policy behind HUD is to make sure that there is consistent and certain transactional activity and that having a fixed rate at the terms that are being offered is very competitive. That has been the track record for HUD, so I would expect to do the same, and even in early 2023, we’re starting to see significantly more demand, a real uptick versus what we saw in the prior year.

This is probably a stupid question that I should know, but what are the HUD rates more closely tied to? Is it off the ten years or somewhere off the prime? If someone’s on loan right now and they want to do a quick math on what their rate might be in today’s dollars, what can they compare it to?

We’re always available. Bravo Capital has a desk, and we could always provide a real-time HUD quote. If somebody’s trying to monitor on their own, it’s hard to do for the multifamily rate, but it is loosely tied to the US ten-year treasury. If you already have a HUD quote and you’re trying to see, what’s happening in the intervening months, it’s a similar type of instrument ultimately. If the US ten-year is widening or tightening, it’s a good indication as to what’s happening with your HUD rate in the interim.

It sounds like it wasn’t as silly of a question as I thought, so thank you for that. You mentioned that there are two different divisions, and they’re separate, but with borrower consent, you can speak to each other, is everything centralized under the Bravo brand?

For lender compliance and liability purposes, we have different walled-off entities, but at the same time communicate with a sponsor. Authorization is very fluid. There are no hurdles once we have that authorization to speak with some of our colleagues and affiliate companies. You mentioned the two main companies. We have Bravo Capital and Bravo Bridge Fund. We also have an affiliated sister company, Bravo Mez Fund, that provides mezzanine capital. It’s almost a replacement for LP capital, especially these days, as we’re seeing other financing sources pull back on leverage. It’s been a very helpful tool whether it coincides with our bridge fund or side by side with somebody else’s financing.

That’s interesting. You say mezzanine. Is it true mezzanine where it’s an actual second lien, which some other senior lenders won’t allow, or is it in some cases structured as a pref equity that might be compliant with other first lien lenders?

It is structured as a true mezzanine. The collateral typically is not a second mortgage but instead is a mezzanine pledge. It sees the collateral pledge in the entity that owns the property, and we’ve worked with many major lenders to have an inter-creditor so that our mezzanine product could slot in seamlessly, side by side as a senior loan and get the sponsor the leverage that they need.

That’s great. There is a lot of interesting stuff here, and you’ve given a ton of information to the readers. Do you have any other closing thoughts?

First, I want to hear what your vision is for 2023 and what you see as the biggest opportunity.

I appreciate that. I echo a lot of what you’ve said. We are seeing that buying opportunities are getting better. To some extent, the cap rates are expanding, and some of the increase in capital cost is priced in. However, there’s still a premium for the heavy value add, even at a 5% cap rate when you have a property that you can spend $7,000 renovating an apartment and raise rents by $500 a month and perhaps all in, and the net operating income is increasing by $5,000 a year.

Depending on what exit cap rate you’re using, you’re potentially adding $100,000 of value per unit for every $7,000 in renovations. We’re still seeing a lot of good opportunities or starting to see some assumptions. Those that were conservative and went in with a fixed rate are now at a premium, as you’ve mentioned, even on the HUD loans.

Loan-to-values are a little bit lower. I honed in on your mezzanine and asked about pref equity there because there’s an era of entering at 80% that seems to be gone for a while. We’re seeing a lot of loans where they’re entering at 64% loan-to-value, whether it’s on the assumption or going very conservative with senior debt. They need to raise more LP equity.

The majority of the deals are not institutional deals with large family offices or institutions. It’s a lot of syndicates where raising $100,000 to $200,000 from 20 to 30 different investors, and that’s becoming a heavier and heavier lift for typical sponsors. Having new avenues to go to get some larger checks, whether it is a mezzanine that’s compliant so that the raise from traditional LPs ranging from friends and family up through a network of accredited investors.

A lot of people can raise $5 million with emails and some phone calls, but when you start off to go $10 million to $12 million, it’s a real heavy lift. It’s been a major dislocation in the market for the last several months. There are a few prominent pref equity lenders who have backed off for their terms or are not accretive anymore. To the extent that gap can be filled in the market, it’s a golden opportunity this year.

The last point is on the distressed side. For those sponsors that did get into some level of trouble, we are paying very close attention to potential recap scenarios where we can come in on the equity side and certainly not wipe out current investors but look for opportunities to come in and update the capital stack and provide some liquidity. The people that, for whatever reason, are in trouble that needs to do a cash-in refinance instead of a cash-out refinance, we’re paying very close attention to those types of deals where we can come in with a few million dollars of equity potentially and help reposition a property and the right size of the capital stack, and ensure continuity into a new loan that’s DSCR compliant.

We’re seeing a lot of what you pointed out. I’m sure that will be helpful for the readers. On our end, in terms of keys for 2023 and key takeaways, first, relationships are key, especially in a recessionary and fractured market. We found historically, even when transactional activity dips, it’s a great time to form new relationships, speak with new lenders, stay active, and get to know the market.

Within the financing sector, more specifically, there are three keys I would urge readers to think about. 1) Finding a path to fixed-rate financing, which is extremely helpful. 2) Focusing on who in the market is providing higher leverage, given that there is a pullback with many lenders, as we both are mentioning. 3) This is the most critical, which is reliability. A lot of deals are getting done based on the certainty of execution. We’re seeing sponsors get better pricing when they’re working with a lender like us that is known in the market for doing what they say and coming through in all types of climates. Those are a few keys everybody should keep in mind.

HUD Loans: Fixed-rate long-term debt is the place to be.

That’s great stuff, Aaron. Tell everyone your website, key social media, LinkedIn, etc., so that everyone can finally connect with you.

Our website is BravoCapital.com. They can connect with us best by contacting Elon Goldberg, one of our originators. His email is EG@BravoCapital.com. I’m looking forward to building new relationships with your readers.

I appreciate your time doing this. This is a great chat. Hopefully, we can do it again sometime, and I’m sure we’ll be exchanging some deals over the course of this year as well.

I’m looking forward. Thank you so much, Jack. It’s always a pleasure.

Thank you.

Take care.

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About Aaron Krawitz

Aaron Krawitz is the Founder and Chief Executive Officer of Bravo Capital. He sits on its Management Committee and its Credit Committee. Mr. Krawitz was formerly the President at Dwight Capital and previously held various positions at Gibson Dunn and Skadden Arps.
Mr. Krawitz has overseen a number of the most sophisticated real estate transactions in the nation, including a $2 billion construction financing, as well as joint ventures and acquisitions on behalf of multifamily developers, skilled nursing facility and assisted living facility sponsors.
Mr. Krawitz received a BA from the University of Pennsylvania (with honors), and a JD from Michigan Law School (Michigan Law Review).