Portfolio Reengineering:

Properties Unable to Cover Operating Expenses at Market Rents

RCED-97-202R: Published: Jul 14, 1997. Publicly Released: Jul 14, 1997.

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Pursuant to a congressional request, GAO provided information on properties that would be unable to cover operating expenses with market-level rents on the basis of GAO's analysis of Ernst and Young LLP's 1996 study on the effects of the Department of Housing and Urban Development's (HUD) proposal for restructuring the insured Section 8 portfolio, focusing on the: (1) basic methodology used in Ernst & Young's study; (2) data that the study developed on properties that would not be able to cover operating expenses (i.e., that would have a negative cash flow) after restructuring; and (3) increase in rents above market-level rents that would be needed for these properties to achieve a positive cash flow and a comparison between the rent levels and the fair market rents (FMR) for the areas in which properties are located.

GAO noted that: (1) Ernst & Young's study assessed how properties in the insured Section 8 portfolio would be affected by HUD's proposal by analyzing a stratified random sample of 558 out of 8,363 insured Section 8 properties; (2) in assessing the effects of restructuring, Ernst & Young assumed, among other things, that project-based Section 8 assistance would be replaced with tenant-based assistance; vacancy rates would adjust to market-level rates; operating expenses for some properties would decrease by up to 15 percent of the difference between their historical levels and industry averages for properties in their area; funding would be provided for covering a property's immediate deferred maintenance and short-term capital needs when the property was subject to reengineering; and required deposits to replacement reserves would cover the estimated annual replacement costs for all of a property's major systems, regardless of the length of their remaining useful lives; (3) GAO's analysis of Ernst & Young's data shows that 60 of the 558 insured Section 8 properties in its sample would have a negative cash flow after restructuring even if their existing mortgage debt were written down to $0; (4) by negative cash flow, GAO means that the properties' adjusted net operating income (net operating income after deposits or replacement reserves) after restructuring would be negative; (5) according to GAO's analysis, rents for the units in these 60 properties would, on average, need to increase above market-level rents by about $113 per unit per month in order for the properties to achieve positive cash flow; (6) if the restructured rents at these 60 properties were increased to the area's FMR, 25 properties (42 percent) would be able to achieve a positive cash flow, including deposits to replacement reserves; (7) an additional 24 properties (40 percent) would be able to achieve a positive cash flow if their rents were increased to 120 percent of FMR; (8) of the 11 that would need rents higher than 120 percent of FMR, 4 could cover operating expenses with rents from greater than 120 to 130 percent of FMR; 5 would need rents form greater than 130 to 140 percent of FMR; and 2 would need rents greater than 140 percent of FMR; (9) equally important, to the extent that the actual effects of restructuring differ from the assumptions used by Ernst & Young, properties may perform differently than projected; and (10) if project-based assistance is continued, vacancy rates at the properties may be lower, potentially resulting in higher adjusted net operating incomes.

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