If you are considering acquiring or refinancing an existing property with some age on it, you might be in the market for an FHA 223 (f) loan. These loans offer fixed rate, assumable, non-recourse financing for up to 35 years. But to protect themselves and the residents from the owner not being able to make capital improvements over time, the loan establishes an initial deposit to a replacement reserve and an ongoing contribution to the replacement reserve.
This makes sure the owner always can replace that mechanical item that goes out, and gives the landlord the opportunity to replace, say, an appliance, rather than having his staff or a hired technician spend an inordinate amount of time and money on the failing dishwasher.
Liberally using the reserve to make upgrades can ensure the property is maintained to a high standard and to perhaps use the capital improvements as a reason to increase rents, for both new and renewing tenants.
On the down side, even if the reserve is invested in near cash instruments, there will likely be a negative arbitrage between the interest rate on the loan proceeds and the interest paid on the reserve account. As a result, many clients try to get an understanding of what the account can be used for, hoping to extend the usage of the reserve into items that might otherwise be considered repairs or make ready.
HUD Handbook 4350.1 Rev 1 has a user-friendly guide between repairs and replacements. The handbook reads like this:
HUD Handbook 4350.1 Rev 1
4-9 Building components generally tend to fall into two categories:
1. Those items that are usually considered to be capital items and eligible for reimbursement from the Reserve Fund for Replacements to the extent of the availability of money in that account; and,
2. Those items that are usually considered to be routine maintenance items.
As a guideline, repair/replacement expenditures that are generally capitalized may often be eligible for payment from a project’s Reserve Fund, while those expenditures that are expensed are only occasionally eligible for payment from the Reserve Fund.
NOTE: As items, equipment, etc. that fall into either of these classifications are obtained for a project, HUD expects that mortgagors will be mindful of energy and environmental considerations and will be sensitive to issues involving handicapped/disabled persons.
A. Items traditionally contemplated as eligible for draws from this Fund include capital items such as (but not limited to):
1. Replacement of refrigerators, ranges, and other major appliances in the dwelling units.
2. Extensive replacement of kitchen and bathroom sinks and counter tops, bathroom tubs, water closets, and doors (exterior and interior).
3. Major roof repairs, including major replacements of gutters, downspouts, and related eaves or soffits.
NOTE: When replacing an entire roofing system, HUD encourages owners to seek energy efficient roofs and bonded roofs.
4. Major plumbing and sanitary system repairs.
5. Replacement or major overhaul of central air conditioning and heating systems, including cooling towers, water chilling units, furnaces, stokers, boilers, and fuel storage tanks.
6. Overhaul of elevator systems.
7. Major repaving/resurfacing/sealcoating (sidewalks, parking lots, and driveways).
8. Repainting of the entire building exterior.
9. Extensive replacement of siding.
10. Extensive replacement of exterior (lawn) sprinkler systems.
11. Replacement of or major repairs to a swimming pool.
12. For certain projects, requests for capital improvements or enhancements to the property could be considered. For examples, a personal computer and some associated software could be purchased, or perhaps individual air conditioning units could be added to a project that was not air conditioned when it was built, or perhaps gutters and downspouts could be added where necessary. Some improvements may be eligible if in HUD’s opinion such items:
a. Would result in enhancing the mortgage security.
b. Would upgrade the property and place the property in a more favorable competitive position in the rental market.
c. Would be necessary to comply with changes in local, state, or federal laws.
d. Would not inordinately deplete the Reserve Fund, i.e., the improvement must be affordable.
B. Items traditionally contemplated as ineligible for draws from this Fund include maintenance items such as (but not limited to):
- Repainting of interior areas of projects.
Note: A separate interior painting reserve for this kind of work may be established by mutual agreement and consent of the concerned parties.
2. Replacement of range burners, bibs, oven elements, controls, valves, wiring, etc.
3. Replacement of dwelling unit air conditioning components such as fan motors and window unit compressors.
4. Minor repairs to central air conditioning and heating systems such as valve replacements and the cleaning of boiler interiors.
5. Minor roof repairs, including minor repairs to gutters and downspouts.
6. Minor paving repairs.
7. Caulking and sealing.
8. Window and screen repairs.
9. Purchase of maintenance tools and equipment such as lawn mowers or snow blowers.
10. Purchase of minor office equipment.
11. Inspection/recharging/replacement of fire extinguishers.
12. Other items generally considered to be routine maintenance.
I have heard of owners trying to get FHA to approve a labor request for onsite staff installing various items. FHA should be consulted before taking such an approach. You would probably want to FHA to approve the money before undertaking the installation and to be sure that the person performing the work does not void a warranty or incur potential liability for not having the appropriate local license. Still, if onsite staff could install carpet or paint exteriors at a lesser price than a professional, you might have an argument. It could be worth a shot.
One last thing regarding the reserve: If you have at least $1,000 per unit in the replacement reserve, and you are current on everything including your reporting, you can ask FHA to temporarily suspend your need to continue to fund the reserve.
Say you have a 100 unit property that pays into the reserve on an ongoing basis, $300 per unit per year. If you are not drawing on that reserve and get the contribution suspended for 6 months or a year, you could find an additional $30,000 in surplus cash, come audit time.
That is well worth considering.