Policy Alert - Use of Operating Subsidies for Mixed-Finance Project Reserves

Use of Operating Subsidies for Mixed-Finance Project Reserves

September 4, 2001

HUD is issuing this policy alert to clarify policies regarding the use of public housing operating subsidies for mixed-finance project reserves. This alert does not reflect a change in policy or the implementation of a new one; rather, its intent is to clarify existing policies for all mixed-finance transactions.

Types of Project Reserves

Real estate developers typically include reserves as part of a project’s structure to protect against unforeseen expenses or loss of income and to ensure the long-term sustainability of the project. In mixed-finance projects, the following types of reserves are common:

• Initial Operating Period Reserve: Operating subsidy for public housing units begins after the development reaches the end of the initial operating period (EIOP), as defined at 24 CFR 941.404(a). For mixed finance projects where units may come on line for occupancy over a long period of time, there will be a period where some units are occupied but not yet eligible to receive operating subsidy. Mixed-finance projects may capitalize an Initial Operating Period Reserve (also called a Lease-Up Reserve) from development funds as part of the development budget to fund initial operating deficits related to the public housing units prior to receipt of operating subsidy.
  
  
• Operating Deficit Reserve: An operating deficit reserve is often created for projects to guard against insufficient income. The reserve is used when a project’s income cannot cover its operating expenses, either because rents are lower, or expenses are higher, than expected. Often, this kind of reserve is capitalized from equity (non-PIH capital sources) at the beginning of operations and is part of the development budget. Typically, this reserve covers both public housing and non-public housing units and must be proportionally replenished from public housing and nonpublic housing sources. It is not meant to fund income shortfalls due to delays in the start of operating subsidy. Those shortfalls are funded by the Initial Operating Period Reserve.
  
  
• Operating Subsidy Reserve¹: This type of reserve is unique to projects that include public housing units. Because funding levels for operating subsidy can be unpredictable, mixed-finance projects carry the risk of a subsidy shortfall. As a result, many developers and other investors in mixed-finance transactions have required an Operating Subsidy Reserve to support the PHA’s annual operating subsidy obligation to the project. The project would use funds from the Operating Subsidy Reserve if there were a shortfall in the amount of operating subsidy pledged to the development. This reserve covers only the public housing units.
  
  
• Replacement Reserve: The replacement reserve is created to fund the replacement of long-lived capital items such as heating or roofing systems. After the construction of a project is complete, a per unit amount is contributed annually to build the reserve. In a mixed-finance project, this reserve covers both public housing and nonpublic housing units. Public housing and nonpublic housing funds must be contributed proportionately to the reserve based on the percentage of each type of unit.
  
  
• Exit Tax Reserve: Mixed-finance projects that involve tax credit financing may include a reserve to pay for the investor limited partner’s exit taxes at the end of the compliance period. Public housing funds (including public housing tenant rents) may not be used to capitalize, or to make incremental contributions to, the Exit Tax Reserve as this expense is not an eligible use of operating subsidy. The mixed-finance public housing units must be public housing replacement units.

Use of Operating Subsidy for Reserves

In a mixed-finance project, some portion of the PHA’s operating subsidy is allocated to the project’s public housing units. (Chapter Five of the Mixed-Finance Guidebook discusses a number of approaches to allocating operating subsidy.) The amount of subsidy and the manner in which it is allocated must be negotiated between the PHA and the developer, documented in the Regulatory and Operating Agreement and approved by HUD. Operating subsidy may only be used for "allowable" public housing expenses. HUD has made the following determinations with regard to the use of operating subsidy for reserves:

1. Initial funding of operating reserves is not an allowable use of public housing operating subsidy. Public housing capital funds may be used only to establish an Initial Operating Period Reserve. Otherwise, all operating reserves must be funded initially from tax credit syndication or other nonpublic housing development proceeds.
   
   EXAMPLE: As a condition of making their initial contribution, a project’s tax credit investors require the establishment of an operating subsidy reserve equal to three years of the projected ACC needs for the development. The Owner Entity may not capitalize this reserve from public housing operating or capital funds but may use tax credit equity or other nonpublic housing financing.
   
   
2. Operating subsidy and public housing tenant rent contributions may be used to fund a proportionate share of the annual contributions to a replacement reserve, depending upon the number of public housing units versus nonpublic housing units in the development. In the case of Replacement Reserves, HUD allows operating subsidy to be contributed to the reserve over time. In other words, an owner entity may provide operating subsidy and public housing tenant rents, in addition to market rate rents, incrementally over time to the reserve account.
   
   EXAMPLE: An owner entity agrees to allocate $250 per unit per year for all units to fund the development’s Replacement Reserve. If there are 100 public housing units and 50 nonpublic housing units, $25,000 of public housing income (which may be a combination of operating subsidy and public housing tenant rents), and $12,500 of nonpublic housing rents would be deposited into the reserve account each year.
   
   
3. Operating subsidy and public housing tenant rents may be used to replenish reserves under certain conditions. In the case of Operating Deficit Reserves and Operating Subsidy Reserves, HUD has determined that operating subsidy may only be used to replenish the reserve, meaning that operating subsidy can replace funds that have been disbursed for allowable public housing expenses. A PHA may not agree to make incremental contributions of operating subsidy to the reserve account; it may only agree to replace funds which have been disbursed for allowable public housing expenses for the project. Furthermore, operating subsidy can not be used to increase the initial funding level of the reserve account.
   
   EXAMPLE: A project’s Operating Deficit Reserve is initially funded with $300,000 of tax credit equity. In Year 4, there is a $10,000 operating subsidy shortfall and funds must be drawn from the reserve account. At this point, the PHA can provide $10,000 in operating subsidy to replenish the Operating Deficit Reserve. However, the contribution of operating subsidy cannot exceed the amount disbursed, meaning that the subsidy cannot be used to increase the value of the reserve to more than $300,000.
   
   
4. No operating subsidy, public housing tenant rental contributions, or other public housing funds may be used to fund or replenish an Exit Tax Reserve.
   
   EXAMPLE: A project’s exit tax liability is estimated at $500,000. An exit tax reserve of up to $500,000 may be capitalized from tax credit equity as part of the development budget.

Long Term Ownership and Use of Reserve Funds

HUD considers all of the above-described reserves, other than the Exit Tax Reserve, property of the development which remains with the development and may not be used for items such as deferred developer fee or debt repayment.

The portion of any reserve that is funded with operating subsidy or tenant rents may be used only to pay for an expense that is an eligible use of operating subsidy or public housing funds. Ineligible uses such as partnership exit taxes or deferred developer fee must be funded from nonpublic housing sources. If public housing funds are used to replenish reserve accounts, projects will need to track which funds are contributed from HUD sources (including operating subsidy, public housing tenant rents, and program income) and which are from other sources such that other sources pay for any ineligible uses.

Summary

The following chart summarizes the types of reserves and the availability of operating subsidy and/or tenant rents to funds those reserves:

¹ Operating Subsidy Reserve is also called "ACC Reserve," "PHA Reserve" or "Affordability Reserve."