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SR-08-25-2015-8A City Council Report City Council Regular Meeting: August 25, 2015 Agenda Item: 8.A 1 of 12 To: Mayor and City Council From: Andy Agle, Director, Housing Division, Housing and Economic Development Subject: Ongoing Affordability of Senior Housing at Neilson Villa Recommended Action Staff recommends that the City Council authorize the City Manager to negotiate and execute a modification and extension to the existing Contract with Shapell Government Housing, Inc., within the parameters outlined in Attachment A regarding the Neilson Villa senior affordable housing development, and approve the budgetary changes identified in the Financial Impact and Budget Actions section of the report. Executive Summary The senior housing development at 3100 Neilson Way is owned by Shapell Government Housing, Inc. (“Shapell”) and is currently struggling with maintaining affordability for 80 of the 100 apartments, since only 20 apartments are currently provided federal rent subsidies and operating costs continue to increase. Rents for the 80 unsubsidized apartments have risen over time to an unaffordable level for many of the seniors. Federal affordability restrictions will expire in 2017 and the City has an option to purchase the property in 2018 pursuant to an existing Contract with Shapell. Shapell is seeking to prepay its federal mortgage on the property, which under the Contract requires the City’s approval. Mortgage prepayment creates an opportunity for the City to negotiate a Contract modification to leverage new federal funding for the tenants. The proposed Contract modification would defer the City’s option to purchase the property in consideration for extending affordability covenants for an add itional 55-year period. The proposed extension of affordability covenants would provide a safety net for the seniors, establish long-term affordability, ensure property maintenance, finance rehabilitation, and incorporate direct City oversight of tenant selection, inspection, and monitoring. These goals can be achieved without a direct financial contribution from the City. Background The City’s former Redevelopment Agency (“Agency”) entered into a “Contract for Sale of Land for Private Redevelopment” (“Contract”) with Shapell in 1976 to facilitate the development of affordable housing located at 3100 Neilson Way (see Attachment B). 2 of 12 The land was owned by the Agency and sold to Shapell for $50,000 to develop the site. A United States Office of Housing and Urban Development (“HUD”) Section 236 low-interest loan financed the construction of 100 senior apartments for low- and moderate-income households, known as Neilson Villa and completed in June 1977. HUD also attached Section 8 rent subsidies (vouchers) to the property for 20 of the apartments. The discounted land price, low-interest loan and 20 vouchers facilitated the financial feasibility of Neilson Villa as affordable housing. The Contract provides that the City has an option in the year 2018 to purchase the land for one dollar and the improvements at fair-market value. However, the Section 236 loan matures in October 2017 (one year prior to the City’s purchase option), the point at which HUD affordability restrictions would expire for the 80 unsubsidized apartments (without vouchers). Furthermore, the property owner has notified the City that they desire to prepay the HUD mortgage in August 2015, which would accelerate elimination of the federal affordability restrictions associated with the Section 236 loan. HUD has recently approved the prepayment. However, the Contract requires City approval to prepay the loan. HUD renews the 20 Section 8 vouchers on five-year cycles, in which the owner receives a HUD ‘market rent’ and the tenants pay a reduced rent, subsidized by the voucher. Annual rent increases for the 80 unsubsidized apartments are evaluated and approved by HUD based on anticipated budget expenses. The affordability of the 80 unsubsidized apartments has been slowly eroding over time as a result of approved rent increases. Consequently, tenants are now rent-burdened and paying significantly more than 30 percent of their incomes for rent. HUD recently approved a $70 per month rent increase, which the owner has not implemented pending the outcome of Council action for a possible modification to the Contract. For some tenants on a fixed income, the rent increase poses a threat to their ability to remain housed at Neilson Villa. Although prepayment of the Section 236 loan would eliminate the federal affordability restrictions, prepayment also triggers the issuance of HUD “enhanced vouchers” for the 80 unsubsidized apartments (see HUD Notice PIH 2001-41 and H 2012-3). 3 of 12 An enhanced voucher is attached to the tenant, not the property, and only protects tenants from future rent increases. Current tenants may use the enhanced voucher either at Neilson Villa or at another property if they relocate. While enhan ced vouchers would provide some affordability protection for current tenants, vouchers are lost to the property once a tenant vacates. As a result, new tenants at the property may be subject to higher rents. HUD has notified the City that they intend to issue 80 enhanced vouchers for Neilson Villa tenants in conjunction with the prepayment of the Section 236 loan. HUD has established a process by which the 80 enhanced vouchers could be converted to Section 8 vouchers attached to Neilson Villa (known as P roject-Based Vouchers) and administered by Santa Monica Housing Authority. Project-Based Vouchers remain with the property, not a particular tenant, and provide more affordability than enhanced vouchers. Any tenant who is paying in excess of 30 percent of their income toward rent would likely receive a rent reduction with a Project-Based Voucher. Santa Monica’s Rent Control Law is applicable to Neilson Villa based on the 1977 completion date, but has been exempt during the term of the Section 236 loan and the 20 vouchers. Neilson Villa has also been deemed a housing asset of the City’s former Redevelopment Agency. Therefore, any revenue derived by the City from the property would be deemed as low- and moderate-income housing funds of the City. Discussion The proposed prepayment and approaching maturity of the Section 236 loan presents an opportunity to achieve deeper affordability and maintain quality senior housing at Neilson Villa without a City financial commitment or contribution. The guiding princi ples staff considered in preparing the recommended approach are: 1) preserve long-term affordability; 2) protect seniors with an affordable rent; 3) maintain financial feasibility of the property; 4) uphold property maintenance for quality housing; and 5) facilitate necessary rehabilitation. 4 of 12 The City can leverage its purchase option to negotiate a modification of the existing Contract. A Contract modification could provide specific long-term affordability, maintenance, rehabilitation and financial reserve requirements, City oversight of tenant selection, and inspection and monitoring, in exchange for deferring the City option to purchase the property. A Contract modification would ensure affordability for current and future seniors, maintain the quality of the property a nd effectuate necessary rehabilitation, and secure the financial viability of the project for the next 55 years. An advantage of modifying the Contract is that affordability, maintenance, and rehabilitation goals could be achieved without any City budget impact. To proceed with the extension, deal parameters could be approved by Council, including authorization for the City Manager to finalize a modification to the Contract. Such parameters are described in further detail below, summarized in Attachment A and include: 1) affordability level/mix; 2) extension term (i.e., affordability period and City option to purchase); 3) required rehabilitation; 4) use of net cash flow; and 5) financial reserves. Extension Proposal Summary The Neilson Villa owners desire to modify the existing Contract with the City to extend the term for 55 years to retain ownership in exchange for the continued operation of the property as affordable housing for seniors. The proposal targets 85 percent of the apartments to extremely low-income households (below 30 percent of area median income) and very low-income households (below 50 percent of area median income). The owners would invest at least $1 million toward rehabilitation of building systems (roof, elevators, exterior paint, and wood trim ) and apartment interiors (cabinets, heaters, stoves, refrigerators, flooring, and paint), as well as capitalize an “affordability reserve fund” in the amount of $1.7 million within the first four years. The affordability reserve fund would subsidize tenant rents in the event the federal government discontinues or reduces housing vouchers. Net cash flow would be retained by the owners, with a preferred return of $770,000 annually. The preferred return means that if net cash flow is less than $770,000 for a given year, the unrealized portion accrues to 5 of 12 future years. Otherwise, if annual net cash flow exceeds $770,000, the portion above that amount would be disbursed to the City annually. The City could then use the excess funds to support the production and preservation of affordable housing elsewhere in Santa Monica. Finally, the Neilson Villa owners have been good stewards of the property, as confirmed by inspection reports from HUD, indicating high scores reflecting a well-maintained property. Preserving Long-term Affordability Modifying the Contract to extend the affordability covenant period for 55 years would achieve long-term affordability, defer the City’s option to purchase the property during the term of the new Contract, and require no City funding. The extension proposal represents very deep affordability targeting. Under the proposed extension terms, if all 100 housing vouchers (20 existing, 80 proposed) were lost due to funding cuts from Congress, Neilson Villa would be subject to the following affordability requirements: # of apartments % of median income maximum income (1-person hhld) 2015 monthly rent limit 40 30 $17,950 $ 389 35 40 $23,900 $ 518 10 50 $29,900 $ 648 10 80 $47,850 $ 778 5 95 $56,700 $1,231 Protecting Seniors with Affordable Rent Current rents for the 80 unsubsidized apartments (other than the 20 apartments with Section 8 vouchers) are low in comparison to market standards, averaging below $500 per month. However, many of the senior households living at Neilson Villa are extremely low-income households (with only Social Security income) and currently pay more than 30 percent of their incomes toward rent, with some paying more than 50 percent of their incomes toward rent. Rents have continued to increase in conjunction with increased operating expenses. Approving prepayment of the Section 236 loan would trigger the issuance of 80 new enhanced vouchers by HUD to 6 of 12 be administered by the Santa Monica Housing Authority (SMHA). The four main benefits to these vouchers are: 1) Enhanced vouchers would hold tenants’ portion of rent at current levels with future rent increases paid by the voucher; 2) If HUD approves the conversion from enhanced vouchers to Project-Based Section 8 vouchers, rents could be reduced for many seniors who are currently rent-burdened; 3) Would add more than $800,000 in annual revenue for the property to enhance financial viability; and 4) Would increase the SMHA voucher allocation by 80 new vouchers, including voucher administration according to locally adopted regulations. The enhanced vouchers would be issued initially as “tenant -based” vouchers to the existing tenants. Tenants could remain at Neilson Villa or move if desired and use the vouchers elsewhere. Tenants would continue paying rent at their current levels, but would be protected from subsequent rent increases, which would be covered by the vouchers. However, federal rules allow the vouchers to be converted to Section 8 Project-Based Vouchers, if tenants agree to the conversion. In t his scenario, the vouchers would stay with the Neilson Villa property but the tenant portion of rent would be adjusted (most likely reduced) to an amount equal to 30 to 40 percent of the household income. This approach would bring financial relief to seniors who are currently rent-burdened, while strengthening the financial feasibility of the property. Maintaining Financial Feasibility As mentioned above, authorizing prepayment of the Section 236 loan would result in the addition of 80 new rental housing vouchers at Neilson Villa, issued by HUD and administered by the SMHA. The additional rental revenue, more than $800,000 annually, would allow the tenants to pay an affordable rent while concurrently strengthening the property's financial capacity. Consequently, the owners have agreed to fund a $1.7 million affordability reserve, as a form of voucher insurance, to protect tenants in the event Congress reduced the voucher allocation or funding. Additionally, the increased revenue stream from the vouchers would allow for setting 7 of 12 aside $45,000 per year in a reserve account toward future capital replacements or significant and unforeseen repairs. The anticipated operating expenses of Neilson Villa are projected at $5,500 per apartment per year, consistent with industry standards. Property management fees would be consistent with HUD-approved rates. Additionally, the proposal includes a preferred return to the owners of $770,000 annually, which would include any payments to entities related to the owners except for property management. Any net cash remaining after the payment of operating expenses, replacement reserves deposit, and preferred return would be paid to the City annually. Upholding Property Maintenance If the Contract is extended, oversight of Neilson Villa would be the jurisdiction of both HUD and the Santa Monica Housing Authority. Eligible senior applicants would be selected from the Housing Authority waiting list, eligibility determinations would be made by Housing Authority staff, and apartments would be inspected biennially by the Housing Authority. HUD would continue to inspect and monitor the 20 original Section 8 apartments. The combination of factors provides assurance that the property will be well-managed with ongoing oversight. As mentioned above, inspection reports from HUD (in conjunction with the Section 236 loan) reflect a well-maintained property. The property management firm, G & K Management Company, has managed Neilson Villa since its opening in 1977 and has the capacity to manage and operate a large property with its portfolio of residential properties in California (69 in total). G & K has demonstrated good overall property management at Neilson Villa. Continuing the current ownership and management structure would support consistent property management for the residents. Facilitating Necessary Rehabilitation Neilson Villa is a 38-year-old building and some of the building systems and apartment interiors are reaching the end of their useful life. The property would be nefit from preventative replacement or upgrading of various building components and the owners 8 of 12 have already committed a minimum of $1 million toward near-term rehabilitation needs. Funds for this purpose are already in a property-reserve account. Additionally, the owners have agreed to set aside $45,000 annually in a reserve account for capital replacement needs. The City recently commissioned a Property Condition Assessment (PCA) which evaluated the current condition of the building and identified necessary capital replacement items needed within the next 12 years. The PCA concluded that a total of $564,000 in rehabilitation work is foreseen at this time. Based upon the existing $1 million reserve fund, the annual $45,000 reserves deposit, and the esti mated net cash flow, there is sufficient funding to cover the anticipated rehabilitation. Alternatives City purchase: An alternative to Contract modification would be for the City to exercise its option to purchase the property. The existing Contract provides the City with an option to purchase the property in 2018 (41 years after completion of the property) by paying one dollar for the land and fair-market value for the improvements. A primary advantage of exercising the option is that it would give comp lete control to the City regarding the future of the property and allow the City to ensure affordability by setting rent levels. Also, the City would benefit from any net cash flo w generated by the property. However, if the City indicated its interest in exercising the option, the HUD- approved rent increase for existing tenants would be expected to be implemented immediately, potentially pushing many current tenants into an untenable position. In addition, existing tenants, as well as new tenants, would not be protected from additional rent increases prior to the City’s allowed exercise of the option in 2018. Another primary disadvantage is the City’s cost to exercise this option. The purchase price of the value of the existing improvements to the property could be quite significant, and there are a number of subjective judgments that could influence the value conclusion. This is evidenced by the fact that the property owners estimated the value at $30 million to $35 million, while three other perspectives on the value of the improvements result in estimated values of $0, $12.5 million and $32 million. 9 of 12 The issue of valuing the improvements, based upon the language of the Contract, is challenging and presents an unknown risk to both the City and the Neilson Villa owners. The Contract stipulates that the fair market value of the improvements shall be determined by a certified appraiser agreed upon by the City and the Neilson Villa owners. The Contract further stipulates that if the City and the Neils on Villa owners cannot agree upon a single appraiser, then each party shall appoint an appraiser and the two appraisers shall appoint a third appraiser to perform the appraisal. Whether the City and owners agree upon an appraiser or a third appraiser is a ppointed, the Contract does not provide a methodology for valuing the property improvements. The Appraisal Institute’s standard means for conducting appraisals does not include situation where improvements are to be valued without consideration for underlying land values. As a result, the valuation methodology that would be applied by an appraiser is uncertain, and the valuation conclusion could vary widely depending on the approach used by the selected appraiser. The range of methodologies that City staff has been able to identify can be described as follows: 1. If the improvements are valued based on a depreciated value scenario, the value of the improvements would be zero. This conclusion is based on the fact that the improvements have been fully depreciated for income-tax purposes. 2. The property owner estimated the improvements’ value at $30 million to $35 million, but did not provide the City with the analysis or assumptions that were applied. Based on a cash flow projection, it appears that the valuation is based on the assumption that all apartments would eventually be converted to market rents pursuant to the vacancy decontrol provisions of the Costa -Hawkins Act. The estimate also appears to attribute all of the property’s value to the improvements, with no value ascribed to the land. 3. If the value is estimated based on the income restrictions the property owner is proposing to apply, including HUD rental assistance payments, the value of the land and improvements is estimated at $12.5 million. As a result, the lack of a defined methodology for valuing the improvements presents unknown financial risks to the City and may end in a dispute. If the appraiser were to 10 of 12 determine that the improvements were of significant value, the City would also be challenged in finding funds to exercise the option. If City funds could be identified, the expenditure of funds would not result in the creation of an y additional affordable housing resources. The City would also assume financial risk if operating expenses exceed rental income (requiring annual operating subsidies) and the financial liability of any deferred maintenance or necessary replacements of major building systems (requiring a significant financial commitment). For example, the $1 million of rehabilitation investment that is currently needed would have to be funded by the City. Furthermore, the 80 enhanced vouchers discussed above would not be available to the property when the loan reaches maturity in 2017 (i.e., is not prepaid), one year before the City’s option arises (in 2018). The allocation and value of the enhanced vouchers would therefore be lost and equates to an operating loss of more than $800,000 in annual revenue to the property, as well as a loss of $1.3 million in new budget authorit y for the SMHA. Finally, residential property management does not fit well within the core competencies of City operations. City ownership of the property would entail contracting with a property management firm to handle daily operations, as well as after-hours responses in emergencies. Oversight of property management by City staff can be time consuming and detract from the Housing Division ’s core mission of facilitating the production and preservation of affordable housing. City purchase with transfer to non-profit: A variation of the City purchase option would be for the City to exercise its option and then transfer the property to a nonprofit affordable housing organization to own and operate as affordable housing. The advantage of this approach would be ownership by a mission-driven affordable housing entity. In addition, the deal could be structured so that the City shares in any net cash flow. A disadvantage would be the lost opportunity to leverage 80 new vouchers from HUD and the financing liability of deferred maintenance and needed rehabilitation. Obtaining a bank loan to fund deferred rehabilitation would be more challenging without the benefit of the voucher rental income and may not provide sufficient financing to cover the cost of the necessary rehabilitation. 11 of 12 Private owner purchase: Another alternative would be for the City to allow its option to lapse under the existing Contract, which would then require the owners to purchase the City’s land interest. The existing Contract establishes that if the City does not exercise its option to purchase, the property owners must then pay to the City the value of the land, based upon highest and best use. In this scenario, Neilson Villa would likely be subject to Santa Monica’s Rent Control Law, including the vacancy decontrol provisions. The main disadvantages to this alternative are: 1) no affordability covenants once the Section 236 loan matures in 2017; 2) lost opportunity to leverage 80 new rental housing vouchers from HUD; and 3) currently rent-burdened seniors would have no relief in the form of lower rents; 4) rents could increase immediately for existing tenants. 12 of 12 Financial Impacts & Budget Actions Implementation of the recommended action requires the following FY 2015-16 budget changes: 1) Increase revenue budget at account 12269.40038V in the amount of $1,300,000 for Santa Monica Housing Authority Housing Assistance Payments. 2) Appropriate $1,300,000 at expenditure account 122691.577344. 3) Increase revenue budget at account 12269.40038A in the amount of $18,750 for Santa Monica Housing Authority Administrative Fees. 4) Appropriate $18,750 at expenditure account 122691.544390. Prepared By: James Kemper, Housing Administrator Approved Forwarded to Council Attachments: A. Neilson Villa term sheet B. Aerial photo Attachment A TERM SHEET for EXTENDING CURRENT AGREEMENT Staff Recommendation Term of Agreement 55 years Income Targeting and Rent Affordability 40 apts. @ 30% Area Median Income, 35 apts. @ 40% AMI, 10 apts. @ 50% AMI, 10 @ 80% AMI and 5 @ 95% AMI [Rent limits pursuant to State redevelopment methodology] Prepayment Allowed? Yes, triggers issuance by HUD of enhanced vouchers for unsubsidized apartments/tenants Capitalized Rehab. Budget $1 Million [already funded in property account] Affordability Reserve $1.7 Million capitalized within first 4 years [to be used in event HUD ceases/reduces vouchers/funding levels] Annual Reserves Deposit $450 / apartment / year Use of Net Operating Income (NOI) Preferred Return of $770,000/year, but this amount includes any payments to ‘Related Entities’ with ownership interest by Neilson Villa owners, except property management fees. Amount above Preferred Return paid to City on annual basis. Debt Allowed? City review and approval required regarding amount and use of debt proceeds [e.g., debt for rehabilitation/repairs which exceeds existing replacement reserves]. Operating Expenses $5,500/ apartment / year [with future adjustments per City review/approval] Property management fees capped at HUD allowed rate Depreciation Not allowed as an expense for purposes of calculating NOI Reporting Annual audited financial statements and HUD-required reports City Option to Purchase Deferred for term of new agreement; Revise option language to “fair market value of improvements, based on depreciated replacement value” Attachment B Aerial View of Neilson Villa