Daily Rules, Proposed Rules, and Notices of the Federal Government


24 CFR Parts 5, 200, 207, and 232

[Docket No. FR-5465 F-02]


Federal Housing Administration (FHA): Section 232 Healthcare Facility Insurance Program-Strengthening Accountability and Regulatory Revisions Update

AGENCY: Office of the Assistant Secretary for Housing--Federal Housing Commissioner, HUD.
ACTION: Final rule.
SUMMARY: In 2010 through 2011, HUD commenced and completed the process of revising regulations applicable to, and closing documents used in, FHA insurance of multifamily rental projects, to reflect current policy and practices in the multifamily mortgage market. This final rule results from a similar process that was initiated in 2011 for revising and updating the regulations governing, and the transactional documents used in, the program for insurance of healthcare facilities under section 232 of the National Housing Act (Section 232 program). HUD's Section 232 program insures mortgage loans to facilitate the construction, substantial rehabilitation, purchase, and refinancing of nursing homes, intermediate care facilities, board and care homes, and assisted-living facilities. This rule revises the Section 232 program regulations to reflect current policy and practices, and improve accountability and strengthen risk management in the Section 232 program.
DATES: EffectiveOctober 9, 2012.
FOR FURTHER INFORMATION CONTACT: Kelly Haines, Director, Office of Residential Care Facilities, Office of Healthcare Programs, Office of Housing, Department of Housing and Urban Development, 451 7th Street SW., Room 6264, Washington, DC 20410-8000; telephone number 202-708-0599 (this is not a toll-free number). Persons with hearing or speech impairments may access this number through TTY by calling the toll-free Federal Relay Service at 1-800-877-8339.
I. Supplementary Information A. Background

Section 232 of the National Housing Act (12 U.S.C. 1715w) (Section 232) authorizes FHA to insure mortgages made by private lenders to finance the development of nursing homes, intermediate care facilities, board and care homes, and assisted living facilities (collectively, residential healthcare facilities). The Section 232 program allows for long-term, fixed-rate financing for new and rehabilitated properties for up to 40 years. Existing properties without rehabilitation can be financed with or without Ginnie Mae(r)1 Mortgage Backed Securities for up to 35 years. Eligible borrowers under the Section 232 program include investors, builders, developers, public entities, and private nonprofit corporations and associations. The documents executed at loan closing provide that the borrower may not engage in any other business or activity.

1Ginnie Mae is a registered service mark of the Government National Mortgage Association; see

The maximum amount of the loan for new construction and substantial rehabilitation is equal to 90 percent (95 percent for nonprofit organization sponsors) of the estimated value of physical improvements and major movable equipment. For existing projects, the maximum is 85 percent (90 percent for nonprofit organization sponsors) of the estimated value of the physical improvements and major movable equipment.

As the need for residential care facilities increased, requests to FHA to make mortgage insurance available for such facilities also increased. As with any program growth, updates to regulations are needed to ensure that program requirements are sufficient to meet increased demand, and prevent mortgage defaults that not only impose a risk to the FHA insurance fund but can also jeopardize the safety and stability of Section 232 facilities and their residents. HUD's regulations governing the Section 232 program are primarily codified in 24 CFR part 232.

B. The Proposed Rule

On May 3, 2012, HUD published a proposed rule at 77 FR 26218, in which it submitted, for public comment, revisions to the Section 232 program regulations. On May 3, 2012, HUD also published a notice at 77 FR 26304, which proposed revisions to the related documents used in the insurance of healthcare facilities under the Section 232 program. In the May 3, 2012, rule, HUD proposed regulatory revisions that would update terminology, require a single asset form of ownership, and reflect current policy and practices used in healthcare facility transactions today. The updates included in the proposed rule also included amendments to HUD's Uniform Financial Reporting Standards to include operators of projects insured or held by HUD as entities that must submit financial reports. In addition, in the May 3, 2012 rule, HUD proposed several revisions to strengthen borrower eligibility requirements, as well as HUD's oversight of the healthcare program and projects.

With respect to proposed revisions to the Section 232 documents, published in the May 3, 2012, notice, HUD will address public comments and advise of any changes through separate publication.

C. Key Changes Made at the Final Rule Stage

In response to comments, HUD made several changes to the regulatory text proposed by the May 3, 2012, rule. Key changes made at the final rule stage include the following:

Transition period for compliance.For several of the new or updated regulatory provisions in this final rule, HUD provides a transition period of 6 months before compliance with the requirements become applicable. The final rule, at SS 232.1(b), lists which regulatory sections become applicable 6 months after publication of this final rule.

Removal of an across-the-board long-term debt service reserve.The final rule removes the across-the-board requirement, proposed in the May 3, 2012, rule, to establish and maintain a long-term debt service reserve. The requirement was designed to provide a borrower facing operating difficulties, at any time throughout the life of the mortgage, the time to arrange a workout plan by providing a source of funds from which the borrower could make debt service payments and thus delay or avoid an insurance claim by the lender. Several commenters objected to the across-the-board nature of this reserve, and offered various alternatives to provide such additional time for workouts. Commenters recommended addressing the timing issues directly and expanding the time periods involved in a lender's submission of a claim for insurance and HUD's processing of such a claim. This recommendation builds from similar revisions implemented through the updates to the multifamily rentalhousing program regulations and documents.

This final rule adopts this recommendation. The final rule provides, at SS 232.11, that the long-term debt service reserve will be required only in cases where HUD determines a need for such a reserve. HUD anticipates that requiring a long-term debt service reserve will be the exception and not the norm. HUD may require such a reserve when underwriting determines there is an atypical long-term project risk. Atypical long-term risks could occur, for example, in circumstances in which there is an unusually high mortgage amount, or when some other risk mitigant, such as a master lease structure typically used in a portfolio transaction, is unavailable in a particular transaction.

Removal of requirement for segregation of operators accounts.In the proposed rule, HUD included several provisions requiring the segregation of operator accounts to address the need to isolate a particular healthcare facility's financial transactions from an account where the facility's funds have been commingled with the funds of other facilities. Commenters pointed out that the proposed approach differs from industry practice, is more costly, and is unnecessary in light of available accounting software systems. HUD agrees that accounting software available today is designed to accomplish the interests that HUD identified, and HUD has therefore eliminated the account segregation requirements in this final rule. (See SS 232.1013.) Additionally, operator compliance with the new financial reports required under the new 24 CFR 5.801, which was included in the proposed rule and remains in this final rule, will necessitate that the operator maintain accounts in a manner that will allow HUD and the lender to discern the funds attributable to the facility.

Revision of requirement to maintain positive working capital at all times.The proposed rule included provisions that would have required operators to maintain positive "working capital" at all times. In response to commenters' concerns that this requirement is inconsistent with other program obligations, and is infeasible, the final rule addresses working capital, at SS 232.1013, by prohibiting the distribution, advance, or otherwise use of funds attributable to the insured facility, for any purpose other than operating the facility, if the quarterly/year-to-date financial statement demonstrates negative working capital. The prohibition remains in place until a quarterly/year-to-date financial statement demonstrating positive working capital is submitted to HUD. In brief, the final rule provides that HUD will monitor an operator's distribution of funds through its quarterly financial statements to ensure that the facility is positioned to withstand distributions.

Removal of prohibition on payments to borrower principals without prior HUD approval.The proposed rule provided that no principal of the borrower entity would receive payment of funds (e.g., a salary) derived from operation of the project, other than from permissible distributions, without HUD approval. The final rule removes the prohibition against payment to principals of the borrower without HUD approval (SS 232.1009 at the proposed rule stage), as other sections of the regulations adequately address the issue of circumvention of distribution limitations. For example, SS 232.1007 of the final rule requires that the costs of goods and services purchased or acquired in connection with the project be reasonable and reflect market prices, which provides HUD with adequate protection in regard to the level of principals' salaries or other compensation.

Removal of HUD approval of any revisions to management agreements.The proposed rule would have required HUD to approve both initial management agreements, as well as revisions to the management agreements. HUD has determined to retain the requirement for initial approval of management agent agreements, but, in light of the inclusion of the limitation, in SS 232.1007, that goods and services be in line with the market, will require approval of only those revisions that are material. (See SS 232.1011 of this final rule.)

Removal of HUD approval of any commercial lease or sublease.The proposed rule would have required, at SS 232.1013, an operator to obtain HUD approval of any commercial lease or sublease. In response to commenters' concerns that changing industry needs and practices (e.g., the inclusion of beauty salons in nursing homes) often necessitated leasing and subleasing, HUD has determined to remove the restriction.

Establishing date of default for mortgages insured under Section 232.The final rule clarifies the amendments made to SS 207.255 at the proposed rule stage by defining the date of default for Section 232 insured mortgages.

Other changes.In addition to the changes discussed above, the final rule also--

* Provides for flexibility in SS 5.801 (uniform financial reporting standards) in the format and manner, as determined by HUD, that financial reports may be submitted to HUD, to the lender or other third party as HUD may direct;

* Adds language to SS 200.855, which was inadvertently omitted from the regulatory text but discussed in the preamble to the proposed rule at 77 FR 26222, and that exempted assisted living facilities, board and care facilities and intermediate care facilities from inspections by HUD's Real Estate Assessment Center (REAC) if the State or local government has a reliable inspection system in place.

* In SS 207.258, defines, in paragraph (a) the "Eligibility Notice Period," adds a new paragraph (a)(4) to provide for acknowledgment by HUD of the lender's election either to assign its mortgage or acquire and convey title to HUD, and removes language from the opening clause of paragraph (b)(1)(i), which was added in the update of the multifamily project rental regulations, but is no longer applicable;

* Removes the definition of "mortgaged property" in SS 232.9 of the proposed rule, as well as the definition section in new subpart F, SS 232.1003 of the proposed rule, because these terms are defined in the transactional documents and HUD agreed with commenters to limit transfer of certain terminology from the transactional documents to the regulations;

* Moves the definition of eligible operator set forth in the proposed rule to a separate regulatory provision at SS 232.1003, which establishes the eligibility requirements for operators in the Section 232 program;

* Withdraws the amendments proposed to be made to SS 232.251 regarding other applicable regulations, since the final rule addresses this issue in SS 232.1.

II. Discussion of Public Comments

The public comment period for this rule closed on July 2, 2012, and HUD received 27 public comments through thewww.regulations.govWeb site. Comments were submitted, through this governmentwide portal, by a wide variety of parties including: Commercial mortgage bankers; companies that own, manage, and operate skilled nursing facilities and assisted living facilities; national and state healthcare associations; and a federation of state associations representing nonprofit and proprietary long-term care providers, including nursing and assisted living facilities. Comments were also submitted by a coalition of national investment and mortgage bankers that participate in HUD's healthcareprograms, as well as a trade association of lenders and a coalition of national senior residential and healthcare associations. The "HUD Practice Committee" submitted comments on behalf of the Forum on Affordable Housing and Community Development Law of the American Bar Association. Private individuals also submitted comments. As a special outreach to the public on proposed changes to the Section 232 regulations, HUD hosted a forum, the "Section 232 Document and Proposed Rule Forum" on May 31, 2012, in Washington, DC. A video of this forum is available on the HUD internet site at While comments were raised and discussed at the forum, as reflected in the video, HUD encouraged forum participants to file written comments through thewww.regulations.govWeb site so that all comments would be more easily accessible to interested parties. All comments, whether submitted throughwww.regulations.govor raised at the forum, were considered in the development of this final rule.

This section of the preamble presents significant issues, questions, and suggestions submitted by public commenters, and HUD's responses to these issues, questions, and suggestions.

General Comments

Several commenters expressed their general support for the rule as improvements that are necessary and beneficial, stating that the rule provided the appropriate balance of risk mitigation while not overly burdening the borrower and operator or substantially altering demand for the program. Commenters also stated that several of the modifications, such as the limitation on REAC inspections and modification of the borrower surplus cash rules, were beneficial.

Notwithstanding the general support for the rule's objectives, one commenter objected to the rule overall, and other commenters offered suggested changes to several of the rule's provisions.

Comment: HUD's regulatory changes to the Section 232 program will deter participation by third-party operators.A commenter stated that the totality of HUD's regulatory scheme will discourage third-party (non-identity-of-interest) operators from participating in the Section 232 program.

HUD Response:As stated in the preamble of the May 3, 2012, proposed rule, operators now carry out significant day-to-day duties in the administration of healthcare facilities (as opposed to when the regulations were first promulgated in the 1970s), and this important role needs to be explicitly addressed in regulation. However, while seeking to ensure, through establishment of regulations, the requisite accountability by operators participating in the Section 232 program, it was not HUD's intent to deter participation by responsible operators. In response to public comment, HUD has made several changes at this final rule stage that address concerns that the requirements proposed to be imposed on operators are too stringent.

Comment: Make the final regulations effective as of the date that applications are received.A commenter stated that HUD should make the effective date of the final regulations the date that applications for insurance are received by HUD, rather than the date the firm commitment is issued.

HUD Response:As already discussed in this preamble, the final rule provides a 6-month transition period before compliance with several of the regulatory provisions becomes applicable. Section 232.1 of the final rule identifies the regulatory sections for which HUD provides a transition period but the transition period is linked to the date for which a firm commitment has been issued. Specifically, SS 232.1(b) of the final rule provides that the identified regulatory sections will become applicable only to transactions for which a firm commitment has been issued on or after the date that is 6 months following publication of this final rule.

HUD is basing the transition period on the date for which a firm commitment has been issued and not on the date that the application for insurance is received, because significant barriers exist to applying the regulations based on the date for application for insurance. Applications are often less than fully complete when initially received and current program systems lack the capability to determine and memorialize when an application is deemed fully complete. HUD therefore believes that basing the transition period on issuance of the firm commitment is the correct approach.

Comment: Place program requirements in administrative guidance, not in regulation.Commenters stated that several executive orders, such as Executive Orders 12866 and 13563, provide that "[F]ederal agencies should promulgate only such regulations as are required by law, are necessary to interpret the law, or are made necessary by compelling public need." Commenters suggested that unnecessary regulations could be addressed by publishing requirements in administrative guidance as opposed to in rules. These commenters suggested that HUD add the phrase "as otherwise permitted or approved by HUD" in various sections of the regulations to provide both industry and HUD with greater flexibility.

Commenters stated that several of the proposed regulatory changes would limit program flexibility with respect to process improvements, such as those recently embraced by HUD, in administering the Section 232 programs and achieved through nonrulemaking documents. A commenter also stated that including the debt service reserve in the regulations is not the "best, most innovative, or least burdensome" method for achieving HUD's goals.

HUD Response:The regulations provided in this final rule are those that HUD determined are necessary for purposes of updating and strengthening the Section 232 program, and are those which should not, or are likely not to, change frequently. However, as discussed below in responses to comments on specific provisions, HUD has identified certain proposed regulatory provisions, and HUD agreed with the commenters that the provisions did not need to be included in regulation.

Uniform Financial Reporting Standards (24 CFR Part 5; SS 5.801)

The proposed rule offered revisions to the reporting requirements of 24 CFR 5.801 to include operators of projects with mortgages insured or held by HUD under the Section 232 program as entities that must submit financial reports. Under current requirements, financial reports are submitted by borrowers, but not operators of Section 232 insured healthcare facilities. HUD had determined that the audited financial statements of a borrower were not sufficient to assess the financial status of a Section 232 project, because the viability of the project is heavily dependent on the operator's financial performance, and the financial statements of the operator should also be reviewed for an accurate assessment of the project's financial status.

The May 3, 2012, rule proposed to retain the longstanding requirement that owners submit audited financial statements annually and proposed to require operators to submit financial statements quarterly, covering separately the most recent quarter and the fiscal year to date.

Comment: Extend the financial report submission deadline.A commenter suggested that HUD should extend the financial report submission deadline in SS 5.802(c)(4) from within 30 days of theend of each quarterly reporting period to within 60 days of the end of each quarterly reporting period to provide operators sufficient time to submit required financial information. The commenter also suggested clarifying revisions with respect to the financial reporting requirements that apply when the borrower is also the operator. The commenter stated that the purpose of these suggested changes to the proposed rule was to eliminate duplicative submissions by the borrower and duplicative review by HUD that would result if the borrower were required to submit an annual unaudited financial statement followed shortly thereafter by submission of an annual audited financial statement.

The commenter also proposed that the financial reporting requirements set forth in this section should apply only to those projects that are governed by the new Section 232 loan documents and that received a firm commitment on or after the effective date of final regulations. The commenter suggested revised language in 24 CFR 5.802(d)(4) to limit the application of this section. The commenter stated that without this limiting language, the reporting standards would be retroactively applied to operators of existing insured projects that are not currently subject to these financial reporting requirements under the terms of the mortgage loan transaction documents and regulations in effect at the time the loan closed.

HUD Response:HUD declines to accept the commenter's recommendation to extend the timing for the submission of all reports from 30 to 60 days. Receipt of the unaudited quarterly and year-to-date operator financial statements promptly at the end of each quarter is needed for effective monitoring of a property's financial operations and the trend of those operations. However, in recognition of the intricacies involved in developing year-end financial statements, HUD has extended the submission of the final quarter and year-to-date operator-certified statements submitted for the 4th fiscal year quarter to 60 calendar days following the end of the fiscal year.

Due to the same need for effective financial oversight, HUD also declines to accept the commenter's recommendation to eliminate separate year-end operator quarterly and year-to-date reports when the borrower is also the operator. Operator reports will be submitted in separate systems that allow for more prompt submission than audited reports, and therefore HUD will receive timely and important trend information.

With respect to the commenter's statement that the requirements should be applied only to those projects that are governed by the new Section 232 loan documents and that received a firm commitment on or after the effective date of final regulations, HUD declines to adopt the change. As stated in the preamble to the proposed rule, HUD determined that the financial statements that HUD currently receives are insufficient to assess the financial status of a Section 232 project. The viability of the project is heavily dependent on the operator's financial performance, and this information is not currently part of financial reports on Section 232 projects. HUD is requiring this information to improve the accuracy of its assessment of a project's financial status, and thus the solvency of the fund. Application of these financial reporting requirements to existing facilities is consistent with authority provided in paragraph 3 of most, if not all of the existing operators' regulatory agreements that provide for the Secretary to request financial reports. This rule implements such a request through regulation. Receipt of these reports will significantly improve HUD's ability to manage and maintain the finances of the FHA insurance fund.

Introduction to FHA Programs: Physical Condition of Multifamily Properties (24 CFR Part 200, Subpart P) Physical Condition Standards and Physical Inspection Requirements (SS 200.855)

The proposed rule would have narrowed and streamlined the scope of Section 232 facilities that are routinely inspected by REAC. In particular, the proposed rule provided that facilities such as assisted living facilities and board and care facilities, and properties that are routinely surveyed pursuant to regulations of the Centers for Medicare and Medicaid Services, would not be subject to routine REAC inspections if the State or local government had a reliable and adequate inspection system in place. The remainder of the Section 232 properties would be inspected only when and if HUD determined, on a case-by-case basis and on the basis of information received, that inspection of such facility is needed to help ensure the protection of residents or the adequate preservation of the project.

Comment: Support for the proposed changes.A commenter representing a federation of state associations of nonprofit care providers expressed support for the proposed changes, which the commenter characterized as the REAC multifamily standards, and described such standards as suitable for apartment buildings, but unsuitable for healthcare facilities. Another commenter expressed agreement that facilities should be exempt from the FHA physical inspection requirements on the grounds that the State inspection is thorough and sufficient. The commenter also stated that in addition to the dollars savings outlined in the proposed rule, the exemption would eliminate the conflict between the HUD inspection requirements and the State requirements. The commenter stated that this approach would relieve the facilities of the administrative burden of continually asking for exceptions or waivers to address those conflicts.

HUD Response:HUD appreciates the commenters' support of this regulatory change.

Multifamily Housing Mortgage Insurance (24 CFR Part 207) Contract Rights and Obligations (Subpart B)

Subpart B of the part 207 regulations addresses contract rights and obligations and the rights and duties of the mortgagee under contract of insurance, and HUD determined that certain revisions were necessary as part of its updating of regulations applicable to the Section 232 program.

Defaults (SS 207.255)

The proposed rule's revisions to SS 207.255, "Defaults for purposes of insurance claim," included language defining the date of defaults. The proposed rule would have revised SS 207.255(a)(4) by clarifying the dates on which certain monetary and other defaults occur.

Date of Default (SS 207.255(a)(4)(ii))

Comment: Revise the Date of Default.A commenter stated that 24 CFR 207.255(a)(4)(ii) requires revision to take into consideration HUD's ability to prevent the lender from accelerating the debt due to a covenant event of default. The commenter stated that this proposed change is appropriate because the lender is not able to control the time period between when a violation occurs and the date of an assignment.

HUD Response:HUD agrees with the commenter that the Date of Default for a covenant default should not be the date on which the underlying covenant violation occurs, but for reasons different than those advanced by the commenter. In addition, the language in SS 207.255(a)(4) is not intended to apply to loans insured under Section 232, and, as stated in the proposed rule, HUD proposed to adjust the language thatcurrently reads "for purposes of paragraph (b) of this section," to read "for purposes of paragraph (a) of this section." Therefore, the comment actually relates to the similar language set forth in SS 207.255(b)(4)(i), and in response to this comment, HUD is adding SS 207.255(b)(5), which applies to mortgages insured under Section 232, to clarify the dates of default applicable to the Section 232 program.

In the final rule, HUD also specifies that a covenant violation does not become a default for purposes of payment of an insurance claim until the lender has accelerated the debt and the borrower has failed to make that accelerated debt payment. Namely, the regulation now provides that for mortgages insured under Section 232, the date of default shall be considered as: (a) The first date on which the borrower has failed to pay the debt when due as a result of the lender's acceleration of the debt because of the borrower's uncorrected failure to perform a covenant or obligation under the regulatory agreement or security instrument; or (b) the date of the first failure to make a monthly payment, which subsequent payments by the borrower are insufficient to cover when applied to the overdue monthly payments in the order in which they become due.

Section 207(g) of the National Housing Act (12 U.S.C. 1713(g)) provides the authority for payment of a claim for mortgage insurance benefits. Pursuant to that statutory provision, there must be a monetary default in order for the mortgagee to become eligible to receive mortgage insurance benefits. Therefore, the date of default for purposes of payment of a claim, premised on a covenant violation, must be associated with a monetary default. A covenant violation does not become a default for purposes of payment of an insurance claim until the lender has accelerated the debt and the borrower has failed to make that accelerated debt payment. In light of the statutory language and pursuant to HUD's regulation at SS 207.255(b), a covenant violation does not become a default until after the mortgagee has accelerated the debt. Accordingly, the date of default referenced in SS 207.255(b)(5)(i) should be read to directly correlate to the default referenced in SS 207.255(b)(1)(ii); e.g., associated with the acceleration of the debt.

Corrective Change (SS 207.255(b)(3))

HUD did not propose any revisions to SS 207.255 in the May 3, 2012, proposed rule. Despite the fact that HUD did not seek comment on this section, one commenter proposed that HUD modify SS 207.255(b)(3) to remove the general reference, and limit it to SS 207.255(b)(1).

Comment: Revise the references.A commenter suggested that HUD remove the reference to "paragraph (b)" and replace this reference with a more limiting reference to "paragraph (b)(1)". Paragraph (b) of SS 207.255 describes the actions constituting a default applicable to multifamily mortgages for which HUD issued a firm commitment for mortgage insurance before September 1, 2011, and for multifamily projects insured under section 232 of the Act (12 U.S.C. 1715w) and section 242 of the Act (12 U.S.C. 1715z-7). Paragraph (b)(1) provided categories of mortgages covered by the default provisions. In the regulatory revisions of the May 3, 2012, proposed rule, HUD restructured SS 207.255 to provide in SS 207.255(a) for a "two-tiered" default and in new paragraph (a)(5) for a "grandfathering" of multifamily projects for which firm commitments were issued before September 1, 2011, and for mortgages issued under sections 232 and 242.

HUD Response:HUD is not accepting the suggested change. The revised regulation at 24 CFR 207.255(b)(3) is accurate.

Insurance Claim Requirements (SS 207.258)

The May 3, 2012, rule proposed to modify SS 207.258, "Insurance claim requirements," by further clarifying in paragraph (a)(2) the applicability of the lockout and prepayment premium periods. The May 3, 2012, rule also proposed to modify SS 207.258(b)(1)(i) by clarifying the time period within which a mortgagee may elect to assign a mortgage insured under section 232 of the Act to the Commissioner.

Comment: Proposed change to claims process delays payment of the claim.A commenter expressed opposition to the revision to the claims process. The commenter stated that a lender may not file its application for insurance until "HUD acknowledges the notice of election." The commenter stated that HUD could now delay payment of a claim by refusing to provide acknowledgment of the notice. The commenter stated that this provision undercuts the incontestability of the FHA insurance, as provided in the National Housing Act (12 U.S.C. 1706c(e)), by implementing a practical barrier to the realization of the lender's insurance benefits. The commenter stated that this requirement allows HUD to deny benefits to a lender even though the lender has followed all claims processing requirements.

HUD Response:HUD declines to accept the commenter's recommendation. The imposition of a waiting period does not undercut the incontestability of the FHA insurance, as suggested by the commenter. Receipt of FHA insurance benefits is not instantaneous, because certain procedures must be followed. Where there have been delays in a lender's receipt of insurance benefits or rejections of a lender's claim, it is HUD's experience that such outcomes were due to the lender not meeting program requirements; for example, impermissible liens on the property having not been resolved.

Mortgage Insurance for Nursing Homes, Intermediate Care Facilities, Board and Care Homes, and Assisted Living Facilities (24 CFR Part 232) Nomenclature Change

In its review of the regulations in 24 CFR part 232, HUD noted that the regulations use both the terms "borrower" and "mortgagor." These terms have the same meaning, and to avoid any misunderstanding that they have different meanings, the May 3, 2012, rule proposed to substitute the term "borrower" for "mortgagor" throughout the part 232 regulations. That said, the healthcare financing and transactional documents for the Section 232 program may sometimes refer to the borrower as the "mortgagor," "lessor," and/or the "owner."

Eligibility Requirements (Subpart A) Eligible Borrower (SS 232.3)

The May 3, 2012, rule proposed to revise the definition of eligible borrower to provide that the borrower shall be a single asset entity, determined acceptable to the Commissioner, and that possesses the power necessary and incidental to be operating the project. The proposed rule also provided that the Commissioner may approve an exception to this single asset requirement in limited circumstances based upon such criteria as specified by the Commissioner.

HUD identified one error in the proposed rule definition. Rather than stating "incidental to operating the project," HUD intended to state "incidental to owning the project," and this change should address several of the concerns by commenters about the definition of borrower, as discussed below.

Comment: Modify requirements for single asset entities to address identity-of-interest issues for operators.A commenter stated that the proposed rule would hamper workouts by limiting thenumber of potential operators that can assume responsibility for the operations of a facility. The commenter stated that the proposed rule would cause significant time and cost burdens on the State licensing agencies that will be required to address the changes of owners and operators on HUD transactions. Commenters also stated that the requirement should be limited to new construction and acquisitions and not be applicable to refinancing transactions. Commenters stated that under the current regulatory regime, operators typically could operate a number of different facilities and own separate properties in the name of the operator. Commenters stated that requiring operators to be single asset entities means that many operators would need to either: (i) Transfer operations at the project level (including licenses and provider agreements) or (ii) transfer other assets, including licenses and interests in other facilities, all of which can be time consuming and expensive. The commenters stated that particularly where there is no identity of interest between the owner and operator, the operator may be unwilling to transfer property to comply with HUD's single asset requirements.

HUD Response:HUD recognizes the concerns raised by the commenters about single asset entities but believes that the language in the proposed rule, as modified by the correction of "operating" to "owning" in this final rule, gives adequate flexibility in this respect, and therefore HUD declines to adopt the commenters' recommendations. The proposed rule language in 24 CFR 232.3 explicitly authorizes HUD to approve "a non-single asset entity under such circumstances, terms and conditions determined and specified as acceptable to the Commissioner." In addition, the proposed definition of operator provides the same flexibility for the Commissioner to specify non-single asset entities. The final rule retains this explicit authorization and flexibility. However, HUD has removed, in this final rule, the separate effective date for the implementation of this particular section. There is no overriding need for a phase-in requirement because the flexibility provided to the Commissioner to allow non-single asset entities in the rule language can be exercised where necessary.

Establishment and Maintenance of Long-Term Debt Service Reserve Accounts (SS 232.11)

The proposed rule provided that to be eligible for insurance under the Section 232 program, and except with respect to the regulatory provisions applicable to supplemental loans to finance purchase and installation of fire safety equipment (24 CFR part 232, subpart C), the borrower must establish, at final closing and maintain throughout the term of the mortgage, a long-term debt service reserve account.

Comment: Eliminate or modify the long-term debt service reserve.Commenters stated that requiring establishment of a long-term debt service reserve inappropriately restricts funds, is unnecessary for well-capitalized and well-performing properties, and is inconsistent with the practices of private lenders. Commenters stated that there are a number of problems with this proposal, which are outlined as follows.

Commenters stated that the cost of the required extra capital far exceeds the small amount of interest one earns when investing in the loan servicing account, given the cost of capital and the interest earned on the funds deposited. Several commenters stated that this would add incremental costs that would make the program noncompetitive with Fannie Mae, Freddie Mac, and the Rural Housing Service of the U.S. Department of Agriculture (USDA), commercial banks, and finance companies. A commenter further stated that this requirement defeats the purpose of the mortgage insurance premiums (MIP), which is already equivalent to an approximate 15 percent premium on the stated rate of interest. Commenters also stated that the proposal would contribute to adverse selection of FHA borrowers that would deprive FHA of the benefit of MIP payments on higher-quality lower-risk transactions.

Commenters also stated that the debt service reserve would not reduce the number or severity of mortgage insurance claims. Commenters stated that the requirement as proposed would be imposed on all properties whether or not they are well capitalized or are well performing. Commenters further stated that the debt service reserve was unnecessary, in particular, for those projects included in a master lease structure as that structure: (1) Results in all project funds being available to service the debt of a struggling project, and (2) provides a strong incentive to the operator to support the struggling project. The commenters also stated that under conventional loan standards, impositions of a debt service account are limited to under-performing loans.

Commenters further stated that maintaining a minimum balance throughout the life of the loan greatly extends the amount of time a borrower must restrict funds for this purpose.

Commenters stated that debt service reserves should not be required for SS 223(a)(7) (refinancing) loans because, in refinancing, the borrower will: (1) Reduce debt service costs, increase the debt service coverage ratio, and increase funding of the reserve for replacement and/or the completion of necessary repairs, and (2) will not have mortgage proceeds available to fund the debt service reserve because they are limited by the amount of the original insured mortgage.

Commenters stated that HUD should modify SS 232.11 to state that the long-term debt service reserve would be required at the discretion of HUD.

Several commenters also provided suggestions on how HUD may implement the long-term debt service reserve, if HUD chose to retain this requirement at the final rule stage. These suggestions include the following:

* The lender, not HUD, should recommend the reserve as part of the application for insurance and minimal reserves should be allowed for strong projects.

* The date of establishment of the debt service reserve should be flexible, rather than requiring the reserve to be established by the date of final closing.

* The entire reserve should be mortgageable even if the reserve results in a mortgage over the 80 percent loan-to-value (LTV) created during the conversion to Section 232 program financing. Commenters stated that this is common in the industry as cash secured lending is dollar for dollar and does not affect the collateral position. A commenter stated that HUD should allow the debt service reserve to be included as an eligible cost up to the 85 percent level.

* Flexibility should be allowed in the release of such reserves. Commenters stated that it is difficult for a borrower to agree to "HUD's sole discretion." Commenters stated that rights must be given to the lender and that the lender can use its discretion on release of reserves. Also, commenters stated that there should be some benchmarks that allow the borrower to tap into the funds such as: (a) A debt service coverage ratio (DSC) that is below 1.0 for some period of time or (b) a certain threshold of capital the borrower must have contributed before the reserve can be tapped.

* Use of the Master Lease agreement should be eliminated or reduced if a longer debt service reserve is established.

* Extend the time that HUD can require a lender to advance mortgage payments from 90 days to 180 days(multiple commenters made this comment).

* Allow borrowers, with lender approval, to consider funding the reserve with letters of credit.

* Establish the reserve in a handbook as opposed to a regulation.

* Remove the "long-term" qualification.

Commenters suggested that alternative strategies would have similar results. These included:

* Require debt service reserve payments under certain events such as a DSC below 1.0 or negative working capital with the reserve to be released and/or suspended upon some threshold of DSC being met.

* Require a debt service reserve payment in the event of a default of the regulatory agreement or of any pertinent loan document.

* Require the servicer to make debt service payments for some period of time before or otherwise extend the time before servicers can assign the mortgage to HUD, which the commenters stated would encourage servicers to implement early warning and workout strategies.

* Build in additional flexibility by, for example, adding language to give HUD the flexibility to allow for a reduction in the minimum balance required to be maintained in the debt service reserve and to allow for the release of funds in the debt service reserve in excess of the required amount.

HUD Response:HUD accepts the commenters' recommendations in part, and is modifying the language establishing the long-term debt service reserve in two major respects. First, the final rule modifies the proposed rule to provide HUD with the discretion as to when a long-term debt service reserve may be necessary. Second, the final rule provides for extensions of the time periods involved in the claims process, set forth in SS 207.258, prior to the mortgagee's assignment of a mortgage to HUD, in order to provide HUD the same protection as was intended by the proposed long-term debt service reserve. Namely, such extensions to the claims process provide time and space for the parties involved to attempt a workout.

Because HUD does not intend to require long-term debt service reserves across the board, there is no need to address the issue of refinanced loans. HUD anticipates that the use of a long-term debt service reserve will be rare (unlike the short-term debt service escrow account that has been frequently used in the Section 232 program, and which is not a mortgageable item). HUD envisions that a long-term debt service reserve will be necessary in circumstances in which underwriting indicates an atypical long-term risk. Examples of circumstances in which HUD may require the establishment of a long-term debt service reserve include an atypically high mortgage amount, or if a key risk mitigant (such as a master lease structure typically used in a portfolio transaction) is unavailable.

HUD declines to accept some of the commenters' recommendations, such as waiting to establish the long-term debt service reserve when the need arises, as such an approach would be imposed too late to serve a useful financial purpose. HUD has also determined to retain the "long-term" qualification to distinguish these accounts from short-term escrow accounts. HUD also determined to retain the minimum balance requirement contained in the proposed rule to assure that reserve funds are not diverted and are used for the intended purpose.

Contract Rights and Obligations (Subpart B, Part 232)

Subpart B of the part 232 regulations addresses contract rights and obligations and the rights and duties of the mortgagee under the contract of insurance. The May 3, 2012, rule proposed several changes to the subpart B regulations.

Withdrawal of Project Funds, Including for Repayments of Advances From the Borrower, Operator, or Management Agent (SS 232.254)

The proposed rule would have added a new SS 232.254 to provide that borrowers may, to the extent allowed in their transactional loan documents and applicable law, make and take distributions of mortgaged property under certain conditions. The proposed rule also included a definition of surplus cash.

Although previously, the borrower could take distributions only annually (or, in limited circumstances, semi-annually), the proposed rule would have allowed borrowers to take distributions more frequently, provided that, upon making a calculation of borrower surplus cash, no less frequently than semi-annually, such borrowers can demonstrate positive surplus cash in their semi-annual surplus cash calculation or repay any distributions made during the fiscal period if a negative surplus cash position is shown. HUD included language in the proposed rule to clarify that it does not intend to override existing transactional agreements.

Comment: Remove the 30-day repayment limitation.A commenter stated that it is unnecessary to include a specific time period in the regulations for repayment of disbursements taken during a negative surplus cash period. The commenter stated that paragraph 16(d) of the "Healthcare Regulatory Agreement--Borrower" (HRA-B) document includes provisions on repayment, and in the interest of promoting flexibility in the regulations, the commenter proposed a revision. The commenter suggested the following: "30 days or within such shorter period as may be required by HUD", be replaced with "within such time period as may be specified by HUD."

HUD Response:HUD adopted the concept of the commenter's recommendation. The final rule clarifies that borrowers will receive a minimum of 30 days, but HUD has the discretion to approve a longer time period, which will provide additional flexibility when a facility or project is in a workout situation.

Comment: Revise definition of "surplus cash" to include cash and cash equivalents and exclude amounts payable from escrows.A commenter suggested that the definition of surplus cash be revised to be consistent with paragraph 15 of the proposed HRA-B document. The commenter suggested that the definition of surplus cash in the regulations should include cash and cash equivalents (i.e., short-term investments), less the payment and segregation of amounts as thereafter set forth in 24 CFR 232.254(b).

The commenter further stated that when calculating surplus cash, accounts receivable and accounts receivable financing should either: (1) Both be included in the calculation, or (2) both be excluded from the calculation. The commenter stated that the best way to address this issue would be to exclude as a deduction any accounts receivable financing approved by HUD and to exclude accounts receivable from cash. The commenter stated that its proposed approach is the more conservative option as, due to the borrowing base requirements, the accounts receivable will be higher than accounts-receivable financing, so including it in the calculation would create more surplus cash than the method of calculation that HUD proposes. The commenter stated that its proposed approach would also be more consistent with normal and past experience, and has the additional benefit of being easier to administer because it does not require a determination of the age of accounts receivable, whether the accounts receivable are collectable or similar types of information.

A commenter suggested excluding the "amounts payable from escrows held pursuant to the mortgage" from thecalculation of "all other accrued items payable by Borrower," to avoid double counting.

HUD Response:HUD understands the commenter's concerns, and appreciates the comments submitted regarding the calculations involved in a determination of surplus cash. Given the commenter's concerns about the components of this calculation, and the effect that changes to the definition would have on distributions, the final rule removes this definition from the regulatory text. The term surplus cash has historically been defined in the borrower regulatory agreement, and HUD will retain the definition in that document.

Leases (SS 232.256)

The proposed rule would have added a new SS 232.256 to require that a borrower may not lease any portion of the project or enter into any agreement with an operator without HUD's prior written consent.

Comment: Section is overly onerous and ineffective.Several commenters stated that inclusion in the regulations of the requirement to obtain HUD approval prior to entering into leases is unnecessary, and suggested removal of this section in its entirety. Commenters stated that, historically, HUD has regulated operating and commercial leases through the terms of the Regulatory Agreement. The commenters stated that, therefore, imposing limits on leasing of the project is adequately addressed through existing mechanisms. Commenters further stated that although the multifamily regulations were recently updated, there was no analogous limitation with respect to leases in the recently adopted regulatory changes.

Commenters also stated that if HUD did not accept the suggestion to remove the requirement in its entirety, HUD should consider revisions that would add necessary flexibility to the regulation, such as giving HUD the ability to categorically permit certain types of leases across all projects through "Program Obligations," a concept expressed in the discussion of HUD's recent May 2011 rule on multifamily rental projects and in the notice advising of document changes to the multifamily rental project documents. Alternatively, commenters suggested that HUD approve project-specific leases on a case by-case basis.

HUD Response:HUD accepts the commenters' recommendations and has removed this section.

Maximum Mortgage Limitations (SS 232.903)

Section 232.903 describes the maximum loan to value limits and the specific items that can be included as mortgageable items.

Comment: Include limits for public entities in SS 232.903.A commenter suggested an addition to the existing regulation at SS 232.903 to address public entity borrowers. Although this provision was not addressed by the proposed rule, the commenter suggested revising the existing regulatory language to add reference to public entity borrowers. The currently codified SS 232.903 specifies the limits that apply to profit-motivated borrowers and private nonprofit borrowers, but does not address public entity borrowers, which are a class of borrowers contemplated in the Regulatory Agreement.

HUD Response:HUD declines to accept the commenter's recommendation. A suggested change was not proposed in the May 3, 2012, rule, and the commenter did not provide specific examples of the types of borrowers that would be covered by this term. Although HUD is not adopting the commenter's suggestion for this rule, HUD will give further consideration to the proposal.

Comment: Revise project-refinancing limitations in order to account for a change in ownership.A commenter stated that new SS 232.903(c)(1)(i) (which addresses refinancing by an existing owner) prohibits a change in ownership, without specifying any time limitations as to when the change in ownership is prohibited from occurring. The commenter suggested adding the phrase "subsequent to the date of application" to this provision.

HUD Response:HUD accepts the commenter's recommendation and has included this language in the regulation.

Comment: Revise the cost to refinance in SS 232.903(c).A commenter suggested that while HUD revised the paragraphs providing a description of existing indebtedness, those mortgageable items should more appropriately be included in the costs to refinance.

HUD Response:HUD appreciates the commenter's recommendation and agrees that these costs are appropriately listed as costs to refinance. HUD accordingly adopts the commenter's recommendation and has revised the regulation to address this issue.

Changes to SS 232.903(c) and SS 232.903(d) are needed to clarify proposed references to long-term debt service reserve.In this final rule, HUD revises SS 232.903(c) and SS 232.903(d) to improve clarity by providing a cross-reference to the long-term debt service reserve in SS 232.11. HUD further clarifies that the debt service reserve contemplated by this final rule is "long-term" and added this qualifying term in SSSS 232.903(c)(2)(vi) and 232.903(d)(6). These changes are intended to eliminate any potential confusion between this reserve and a short-term escrow. HUD is allowing the long-term debt service reserve to be a mortgageable item. The traditional short-term debt service escrow account has always been funded by the mortgagors themselves and is therefore not a mortgageable item. Examples of short-term debt escrow include the escrows on new construction/substantial rehabilitation projects, or escrows established because a project may lack a lengthy adequate financial history. Such short-term escrows have a separate escrow agreement.

Comment: Revise the cross-reference to Mortgagee Fees (SS 232.903(c)(2)(iii) and (d)(3)).A commenter stated that SS 232.903(c)(3) and SS 232.903(d)(3) contain cross-references to "mortgagee fees under SS 232.15". The commenter further stated that there is no SS 232.15 in the current regulations. The commenter suggested that the revised regulation could reference SS 200.41, Maximum Mortgagee Fees and Charges.

HUD Response:The commenter is correct and the cross-reference to 24 CFR 200.41 has been added.

Eligible Operators and Facilities and Restrictions on Fund Distributions (New Subpart F) Definitions (SS 232.1003 in Proposed Rule--Removed in Final Rule)

At the proposed rule stage, HUD defined the following terms in a proposed new SS 232.1003: identity of interest, management agent, operator, owner operator, and project. On further consideration, HUD determined that the term "operator" in proposed SS 232.1003 established Section 232 eligibility requirements for operators more than simply providing a definition for this term. With respect to the remaining terms, all of which are addressed in the transactional documents, HUD is removing these terms from the regulations, agreeing with commenters that the better location for these terms remains the transactional documents. Therefore, SS 232.1003 at this final rule addresses eligible operators only.

Although the final rule removes the definition section for new subpart F of part 232, several comments were submitted on the proposed definitions,and HUD responds to these comments below.

Single Asset Entity

Comment: "Operator" as a single asset entity is unworkable.Commenters stated that although many organizations have adopted the single asset structure, it is very common for a single legal entity to act as operator for multiple facilities. Commenters stated that segregating operations is a time-consuming process due to the need to transfer multiple licenses, establish new bank accounts, and revise numerous legal documents and agreements, and that these are particularly time consuming issues for facilities that are managed by national chains for a single asset borrower. Another commenter stated that, in some states, the single asset entity operator requirement would trigger the need for the healthcare facility to obtain a new Certificate of Need. Commenters stated that all of these changes, and the costs associated with them, make the alternative unworkable and unattractive.

Other commenters stated that the single asset entity operator be recommended but not required. Commenters also recommended that the existing organizational structure remain in place in refinancing, given that such a structure is difficult to unwind.

HUD Response:The definition of operator in the proposed rule provided flexibility for the Commissioner to approve non-single asset entities, and HUD retains that definition in the final rule.

In reviewing its portfolio of healthcare loans, HUD found that a large number of the operator entities in the Section 232 program are, in fact, single asset entities--for prudent business purposes not necessarily related to FHA-insured financing. The approach of these operator entities is also helpful to HUD's effort to assure that the operator's viability and accountability is not adversely affected by the operation of other businesses (as in the case, for example, of bankruptcy or other litigation). Nevertheless, HUD recognizes that there are operating entities in the industry that successfully operate multiple facilities without facility-specific operating entities. HUD did not intend to impede this practice where it is effective, and therefore, the proposed definition of "operator" also explicitly authorized HUD to approve "a non-single asset entity under such circumstances, terms and conditions determined and specified as acceptable by the Commissioner."

In SS 232.1003 of this final rule, which now only addresses eligible operators, HUD retains this language from the proposed rule and anticipates that in situations in which licensure or other issues make utilizing a separate operating entity problematic, a non-single asset operating entity will be approved.


Comment: Specify that a master tenant is not an operator.Some commenters expressed concern that a single asset form of ownership was particularly inappropriate where Master Leases are concerned. A commenter stated that in some instances, a single project may have multiple operators. For example, a project may have a separate operator for each of the skilled nursing and assisted-living portions of a single healthcare campus. Additionally, the commenter stated that it should be specified that a master tenant is not an operator, as master tenants are not operators once they sublease the property to operators under HUD-approved subleases.

Other commenters stated that the requirement for operators to be single asset entities is a significant change. They stated that they do not object to the language as proposed, because it provides appropriate flexibility for HUD to approve non-single asset entities. The commenters requested, however, that, prior to issuing further guidance in the form of a handbook or otherwise, there should be a conversation between HUD and the healthcare industry, as there are many situations in which it may not be possible or appropriate to have a single asset operator.

HUD Response:With respect to the master lease issue, HUD clarifies in this final rule that, in a master lease context, the term "operator" refers to an entity that operates a facility (generally the sublessee).

With respect to establishing dialogue with industry on regulatory and transactional document changes in the Section 232 program, HUD has a good record of reaching out to industry for its input, first in the context of updating the multifamily rental project regulations and transactional documents, and now in the updating of the Section 232 program regulations and transactional documents. HUD plans to continue with such outreach.

Comment: Define arms-length or "third-party operator" to allow the inclusion of real estate investment trusts (REITs) and private investors.A commenter stated that the lack of a definition for an "arm's length" or "third-party" operator, together with a set of new provisions that considers the unique characteristics of this ownership group, will limit participation in the Section 232 program of one of the largest and fastest growing ownership types that include REITs and private