In an effort to summarize the highlights of the U.S. Department of Housing and Urban Development (HUD) LEAN E-mail Blasts that we receive, and rarely have time to review in a timely fashion, we at Pepper are providing this quick synopsis of the latest LEAN update. Our aim is to provide pertinent information succinctly as a roadmap to the LEAN E-mail Blasts, not to replace the LEAN E-mail Blasts. We hope you find these summaries helpful. A link to the complete April 25, 2014 LEAN E-mail Blast can be found here.

MORTGAGEE LETTER ON PORTFOLIOS AND MASTER LEASES

The reason this LEAN E-mail Blast summary has taken a bit longer than usual is due to the density of subject matter. Mortgagee Letter 2014-06 “Portfolio and Master Lease Guidance,” released on April 17, 2014, is ORCF’s effort to clarify how it will be handling portfolios and master leases (we understand there will also be a master lease section in the new LEAN closing guide).

Background, Terms and Classifications

HUD requires a master lease because it wants owners and operators of multiple facilities to use cash flow from a well-performing facility to support any facility it also owns/operates that is having liquidity shortfalls. HUD believes the master lease is an important tool to lessen the financial risk to HUD’s insurance fund, which is posed by a portfolio.

A portfolio is defined as two or more borrower entities that are under common ownership and/or control – ORCF will also look to the ownership of operators in determining how to handle a portfolio. Common control is exhibited by any individual(s) or entity(ies) that control the borrower and/or operator, regardless of the percentage of ownership interest, so long as the individual(s) or entity(ies) are part of each borrower and/or operator.

There are now three portfolio classifications, all of which require the new Certification of Multiple Projects (described in detail in Section VI of the Mortgagee Letter):

1. Small Portfolio: Between 3 and 49 facilities with an aggregate mortgage amount less than or equal to $90 million (if there are two facilities with an aggregate mortgage amount over $15 million that also is considered a small portfolio). A corporate credit review is not required for this size portfolio.
2. Midsize Portfolio: Up to 49 facilities and an aggregate mortgage amount greater than $90 million and less than or equal to $250 million. A corporate credit review is required for this size portfolio.
3. Large Portfolio: 50 or more facilities and an aggregate mortgage amount greater than $250 million. HUD will not insure any portfolios that would be equal to or greater than 5 percent of the current unpaid principal balance of the entire pool of active Section 232 loans. A corporate credit review is required for this size portfolio.

Portfolio Corporate Credit Review

Sections VII, VIII and IX of the Mortgagee Letter discuss the corporate credit review process for midsize and large portfolios.

Section VII sets forth HUD’s general thoughts and philosophy behind the review process, including such pertinent information as the requirement that all midsize and large portfolios include a mortgage reserve fund and potentially other risk mitigation.

Section VIII sets forth the items that must be included in the corporate credit review application. Of note in Section VIII is Subsection H, which requires the lender to certify that the subject of the corporate credit review, as well as any parents, affiliates and subsidiaries, are not the subject of an ongoing investigation or judicial or administrative action involving any federal, state or municipal or any other regulatory agency, which may have a detrimental impact on the financial condition of any of the facilities. The certification must be renewed at the time of closing for all the facilities. Of particular interest to many of the readers of this article is that HUD is requiring a certification from the lender, not from the applicant – therefore, we recommend that lenders require very specific certifications from the applicants to support the lender’s statements to ORCF.

Section IX sets forth additional items that must be submitted to the Director of ORCF as part of the corporate credit review including the 2530s, the master lease submission (described below), insurance information, account receivable information and other required certifications.

Master Lease Policies and Guidance

ORCF has determined that owners of multiple FHA-insured facilities must provide additional protection in the form of a master lease. ORCF requires a master lease for two reasons: first, it creates a structure that requires a healthy property to assist another facility that may be struggling; and second, in the event of bankruptcy, it maximizes HUD’s recovery by combining all project obligations. Unlike conventional loans that would cross-collateralize all the projects, the master lease is a cross-default of only the individual operators – i.e., each property must financially stand on its own but if there is a default it can cut across the entire portfolio. There is a separate Cross-Default Guaranty of Subtenants executed by the operators, which further solidifies the cross-default requirements.

The master lease is the primary lease that controls the subleases, as all operators will be bound by the terms of the master lease.

Master Lease Structure

One of the most important aspects of the Mortgagee Letter is that HUD is not requiring that projects fit into the sample structures described therein. ORCF has repeatedly stated that it will work with lenders to achieve creative solutions to ensure that HUD is protected while not creating unreasonable demands on entities/individuals that are not related to each other or the other facilities in the portfolio. ORCF’s willingness to work with the industry and its lending partners is one reason why the LEAN program has been so successful.

Typical Master Lease

Below is a diagram showing the typical master lease structure. In this structure there is a parent company/individual that has control of three single-asset entity owners of three facilities. Each of the owners executes a master lease with the newly formed master tenant (an entity that is created by the parent of the operators). The Master Tenant then enters into individual subleases with the operators of each of the facilities. The operators will pay a base rent to the master tenant, which is then passed on to the individual mortgagors, the minimum base rent is based upon the mortgagor’s mortgage payments plus required escrows and reserves.

(If you are having difficulty reading this, please download the PDF.)

Multiple Minority Owners

HUD is seeing a growing number of facilities that have one member that has common control or owns a majority interest in multiple facilities, but where each facility has different minority owners – thereby preventing the ownership structure from being identical across all the facilities. In those instances, the cash flow may be segmented so that minority partners do not share their profit with projects in which they do not have an ownership interest. However, the member that has common control or owns a majority interest in multiple facilities will be required to pledge its cash flow interest (or a portion thereof) in all of their facilities, should one of the facilities falter.

The diagram in the Mortgagee Letter is one potential scenario and lenders should not feel the need to shoehorn a deal into the arrangement described in the diagram. The key is that the party who is a majority member, or holds a controlling interest in multiple facilities, must execute a guarantee pledging surplus cash received by the majority member to be put into an underperforming project. In addition to pledging surplus cash received in the future from the date of enforcement, we have also seen HUD require an ability to reach back to the previous six months and obtain the surplus cash received during that period.

Multiple Operators

Projects with common ownership but which are leased to multiple third-party operators cannot be required to enter into a master lease. Operators unrelated to both the owner and each other are not required to pledge support to other facilities. If there are some properties in a portfolio that have operators with common ownership, those facilities will still be required to enter into a master lease, as shown below, but it will only include those related facilities and not the entire portfolio. Nonetheless, the owner of the individual mortgagors will still be required to pledge financial support to all projects in their portfolio. The Mortgagee Letter included a diagram describing a Master Landlord structure, but based on our discussions with some of the decision makers at ORCF, it appears that the Master Landlord concept is still a work in progress and may not be the favored method of dealing with this situation.

(If you are having difficulty reading this, please download the PDF.)

Multiple Lenders

If the same borrower uses multiple lenders for its FHA-Insured financing, the borrower will be required to enter into separate master leases with each lender. If HUD deems that it is necessary, in consultation with the FHA lenders, the member with common control or majority interest may be required to execute a cross-default guarantee across lenders, which would pledge surplus cash across the master leases.

(If you are having difficulty reading this, please download the PDF.)

Legal Restrictions

HUD acknowledges that in certain states, such as New York, legal restrictions exist that negate the advantages of a master lease structure, or make the use of a master lease extremely onerous due to asset transfer taxes. In those instances when a master lease is not possible, ORCF will seek comparable remedies that offer the utmost protection to HUD’s interest, such as requiring guarantees to ensure that properties struggling financially will be supported by facilities producing cash surplus.

Master Lease Criteria and Terms

Section XI of the Mortgagee Letter sets forth HUD’s criteria for a master lease. A master lease is required for portfolios requesting insurance under Section 232, 223(a)(7)s, or 223(f), but a TPA in the owner or operator can also trigger the master-lease requirement.

In addition, HUD will require any project that has the same ownership and operating structure as an existing FHA-insured portfolio, with an application received within 18 months from the last project in the master lease, to be added to the existing master lease. The Mortgagee Letter also states that HUD will not reach back and require existing FHA-Insured facilities be placed in a new master lease except when they are within a portfolio of properties submitted within the 18-month window, or when other considerations would warrant a master lease to mitigate risk.

The master lease is expected to run at least as long as the mortgage having the longest remaining term. While that may not always be feasible due to a variety of circumstances (i.e., third- party operators), any alternative proposals at a minimum must specify (a) the subleases shall be coterminous, and (b) the borrower’s regulatory agreements will be required to include a statement that in the event the master lease is terminated prior to the maturity date of the FHA-Insured mortgage, the borrower shall enter into a new master lease with a party acceptable to HUD covering all remaining properties subject to the master lease executed at closing.

Master Lease Review Package

The final section of the Mortgagee Letter, Section XII, includes the requirements a lender must follow, including the questions that must be answered, for applications that will contain a master lease. Please note that for midsize and large portfolios, the master lease documents must be in final form prior to any applications being submitted to the queue – therefore, proper lead time must be built in for these documents to be finalized.