Affordability Isn’t Always Cheap

Although enacted just over one year ago, the impact of California Senate Bill 2—commonly referred to as the Building Homes and Jobs Act (SB 2), has not yet been felt by lenders and loan servicers. However, as the revenue from SB 2 comes pouring in at a higher than expected rate, lenders and servicers will start to see more affordable housing construction throughout California, which in turn will mean more loans on affordable housing units to originate and service.

The act was designed to address California’s affordable housing dilemma by bringing in an estimated annual revenue of $250 million through an increase in the recording fees for the recording of documents in real estate transactions. The funds would be dedicated to developing affordable, low-income housing in California.

It seems that this revenue goal has been achieved, as California’s 2018-2019 budget allotted $5 billion to address the affordable housing and homelessness issues, $255 million of which came from the SB 2 fund. Accordingly, in the near future Californians will likely be provided with new, affordable, low-income housing units for purchase. While this is great news for Californians and local governments (which will obtain additional funding from state and federal government), it is important to understand the potential impact of an influx of low-income housing units will have on lenders and servicers who fund and service loans secured by low-income housing units.

California generates new “affordable” or “low income” housing units through either new construction or rehabilitation/reclassification of the existing housing units. These new units are then offered for sale through various housing programs administered by local (city) governments and are eventually sold to qualified individuals at below-market-rate prices. Because of this, these units are subject to various value and/or use restrictions, which are enforceable over a period of time (generally, between 30 and 45 years), are binding on lenders as well as the borrowers, and are senior to any mortgage liens.

Generally, these restrictions limit the use of property to a principal residence use only, constrain the borrower’s right to refinance or sell the property, and provide the locality where the property is located with a “right of first refusal” and other rights in the event of the borrower’s default, a catastrophic event, or condemnation of the property. Failure to comply with these restrictions subjects the lenders, servicers, and foreclosure trustees to potential liability from not only the borrower but also the locality, exposing the industry to damages not generally foreseeable in regular residential mortgage transactions.

With the volume of loans on low-income projects likely to increase in the near future, lenders and servicers should understand the risks associated with these loans and limit their potential exposure and liability through a thorough investigation process.

As part of their due diligence in connection with purchase loan transactions, in addition to obtaining a title report/guarantee, the lender should specifically review and understand the restriction agreement recorded against the property. There have been many instances where the title company excepted from coverage the low-income housing restrictions, leaving the lender and subsequent investors, and servicers subject to the often onerous restrictions without any knowledge of their existence and/or understanding of the consequences of failure to comply with them. The lender should study the restriction agreement in detail to ensure that the loan transaction does not violate its terms. The lender should also ensure that the restriction agreement is included in the collateral file, provided to the loan servicer and the system noted for future use—i.e., at the time of foreclosure.

In addition, since the localities that offer affordable housing units for sale ensure that they have certain rights in the event of the borrower’s default, restriction agreements and requests for notice of default (recorded by the city or agency) should be reviewed and studied before the commencement of (and also during) the foreclosure process to ensure that these rights are not violated.

While this additional due diligence is recommended in purchase loan transactions, it is even more important in refinance transactions. The restriction agreements placed on low-income housing units often prohibit or significantly constrain refinance loans. Accordingly, it is imperative for the potential lender to study the restriction agreement and ensure that the refinance loan is permitted in the first place, or whether additional steps are required to satisfy the restriction agreement—such as, for instance, obtaining pre-approval of the refinance from the city.

Finally, in the event of a lawsuit involving a low-income housing unit, the lender, servicer, and/or trustee should consult attorneys who are experienced in litigating the low-income housing matters to fully understand its potential liability and exposure.