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Changes to FHA financing approval requirements

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The Federal Housing Administration (FHA) released a detailed update to existing condominium underwriting regulations on June 30, 2011 with new requirements effective for all approval application packets submitted on or after August 30, 2011.  In 2010, FHA-insured mortgages accounted for more than one-third of all condominium purchases nationwide.  Many other lenders are also informally adopting FHA standards as a benchmark for condominium lending, so the new FHA requirements may have even farther reaching impact.  The following is a brief summary of some of the changes in FHA underwriting requirements:

Restrictions on Leasing:  FHA-approved condominiums must be at least 50% owner-occupied.  However, prior to now, associations were not permitted to amend their governing documents to limit the number of permitted rentals in order to qualify for FHA financing.  The new guidelines lift this restriction and now permit associations to have leasing restrictions that limit the number of rentals to ensure that the percentage of rentals does not exceed the current FHA  owner-occupancy requirement.

Right of First Refusal:  Section 2.2 of the new Guide states that Associations may have a right of first refusal so long as it does not violate any discriminatory conduct prohibitions under the Fair Housing Act.  However, Section 1.8.8 of the Guide cites to the federal regulations in 24 CFR 203.41 and indicates that properties with FHA-insured mortgages “shall be free of restrictions that prevent the borrower from freely transferring the property.”  That section then goes on to define “legal restrictions on conveyance” to include provisions in any kind of legal instrument that would cause a conveyance by the borrower (among other things) to be subject to the consent of a third party.  This appears to directly conflict with Section 2.2, which permits the non-discriminatory right of first refusal.  Of even greater concern, Section 1.8.8 further defines impermissible “legal restrictions on conveyance” to include any legal instrument that would cause a conveyance by the borrower “to be the basis of contractual liability of the borrower.”  As drafted, this provision would exclude all condominiums from approval, as all condominium governing documents necessarily create deed restrictions that impose contractual liability on purchasers.  It is assumed that this is not the intent of that section, so we will likely see further clarifying language in the near future.

Commercial Space:  No more than 25 percent of a property’s total floor area may be used for non-residential/commercial purposes.  However, the new guidelines permit for exceptions to be granted on a case-by-case basis for associations with commercial space comprising no more than 35% of the total floor area if the project has been 100% complete for at least one year, control of the association has been transferred to the unit owners, and the project’s use must remain primarily residential, that the commercial use be homogenous with the residential use and free of adverse conditions to the occupants of the individual condominium units.  Exceptions granted under this section will terminate with the expiration of the current project approval, meaning that associations will have to reapply for an exception if they wish to become recertified in the future.

Delinquent HOA Dues:  To be approved as an FHA condominium, no more than 15% of the total units may be more than 30 days delinquent in the payment of their condominium assessments, not including late fees or other administrative expenses.  Previously, FHA did not count bank-owned (REO) properties as part of this percentage.  However, under the new guidelines, the 15% includes all units, whether occupied, investor, bank-owned or vacant.  This change may make it harder for associations to qualify for FHA financing if the REO lenders (including HUD itself) are not paying their assessments.  Associations wishing to become approved may no longer be able to simply wait for bank-owned properties to be sold and to collect unpaid assessments at closing and may instead be forced to take a different approach to collecting assessments on bank-owned properties.  The new guidelines do provide for some flexibility, however, in that an association may have up to 20% of the total units in arrears if additional documentation is submitted showing that the association has excess funds to meets its operating and reserve requirements, the association has sufficiently accounted for bad debt and arrearages in its budgeting and the association provides evidence of action taken to collect the unpaid arrearages, including legal action, execution of payment plans or other similar efforts.

Special Assessments:  The new guidelines increase the information and detail that must be submitted regarding any approved and pending special assessments.  Specifically, the project submission must include information regarding the purpose of the special assessment; when the assessment is to be paid; whether other special assessments have been required and, if so, an explanation of the purpose and timing of those assessments must also be provided; a statement as to whether the assessment will affect the marketability of any of the units; and a statement regarding the impact that the assessment will have on future value and marketability of the property.  The requirement that the association or its agent certify as to future impact or marketability of any of its units has drawn wide criticism.  Unless or until this requirement is changed, it is very likely that associations with pending special assessments will simply not be able to become FHA-approved condominiums.

Pending litigation:  Similar to special assessments, the new guidelines require a much more detailed analysis and explanation of any pending litigation involving the association, including the reason for the litigation; the anticipated settlement or judgment date; whether there is sufficient insurance coverage to pay out a settlement or judgment without affecting the financial stability of the association; whether the pending litigation could impact the homeowner’s rights or their ability to transfer title; and whether the legal action could impact the future solvency of the association.

Fidelity Bond/Insurance:  FHA-approved associations are currently required to maintain fidelity insurance (also known as employee dishonesty insurance) for all officers, directors and employees of the association and all other persons handling or responsible for funds administered by the association in an amount no less than a sum equal to the total amount of the association’s reserve funds plus three months aggregate assessments on all units.  Under most fidelity policies, management companies and their personnel can be covered as employees or agents of the association.  However, the new guidelines state that if an association engages the services of a management company, the association must also require the management company to maintain this same type of coverage for its own officers, employees and agents handling or responsible for funds of the association.  For management companies, however, this coverage naming the association as an obligee or payee is typically in the form of a bond rather than an insurance policy.  FHA requires that such bond be in an amount not less than the estimated maximum amount of funds, including reserve funds, that are in the custody of the association or management agent at any given time during the term of such bond.  This may be a problem if the management agent is not in control of all of the association’s funds and therefore does not know the amount of any funds not in its custody or control.  Additionally, unlike fidelity insurance coverage, fidelity bonds require a third party to guarantee repayment to the association in the event of theft or dishonesty by the management company.  This requires each person employed by the management company who might possibly come in contact with the association’s funds to be separately screened and scrutinized by the bonding company.  New agents or employees of the management company are not automatically covered under an existing bond and would have to undergo separate screening and bonding.  The cost of this process may be prohibitive for many associations and their managers.

Certification:  Finally, the new requirements include an addition to the project certification that must be signed by an authorized representative of the association or mortgagee submitting the approval packet requiring the submitter to certify under criminal penalty that he/she “has no knowledge of circumstances or conditions that might have an adverse effect on the project or cause a mortgage secured by a unit in the project to become delinquent (including but not limited to: defects in construction; substantial disputes or dissatisfaction among unit owners about the operation of the project of the owner’s association; and disputes concerning unit owner’s right, privileges, and obligations).”   The submitter is further required to certify and agree to an ongoing obligation to inform HUD if any material information compiled for the review and acceptance of the project is no longer true and correct.  Not only does this requirement place a greater burden on a representative submitting an application on behalf of an association to continue to monitor the status of the association throughout the entire approval process and, presumably, for the entire approval period, but it also places an enormous burden on the association to attest to the ability of a purchaser to continue to meet his or her future obligations under the mortgage and to the fact that current conditions of the association will not have any future impact on the borrower.  This appears to be an impossible standard to meet, particularly under threat of criminal penalties, and may result in associations and their agents and lenders refusing to sign this certification.

Industry groups, including the Community Association Institute (CAI), have been working with FHA to continue to revise and clarify some of these project approval requirements to ensure that they meet the goal of requiring approved associations to be financially sound in order to protect the lender’s interest while not making it impossible for otherwise qualified associations to obtain approval.  However, it is unknown at this time whether further revisions will be forthcoming.