How to Convert Residential Unit to Another Use

You may be interested in converting some residential units at your tax credit site to another use. For example, your site might need a security office or childcare center. But before you can use residential units for other purposes, significant due diligence must be performed. And part of that process involves getting prior approval from HUD.

Even if units are vacant—and have been vacant for a while—you must follow HUD rules to properly convert them from residential to commercial use or into a nonrevenue common area, says property manager George Caruso, an expert in HUD rules.

Prior Approval from HUD Required

When a site is first developed or converted to HUD-assisted housing, the regulatory agreement and the initial Rent Schedule (HUD Form 92458) will indicate how many units must be used for residential purposes and whether any part of its space may be used for nonrevenue and commercial purposes. Most regulatory agreements also specify that the owners may not use a residential unit for another purpose.

Sometimes HUD will allow you to convert units from a residential use to another use. But changes must be approved in advance and noted on a revised rent schedule signed by the owner and countersigned by HUD.

If you don't get prior approval and HUD learns that you allowed a unit to be used for another purpose, HUD is likely to inform the site owner in writing that this is a violation of the regulatory agreement. And auditors will note an exception in their audit report, which could preclude owner distributions, among other sanctions. HUD will probably issue a notice that failure to correct this violation may result in HUD exercising its rights under the regulatory agreement. HUD might even deny the owner future participation in HUD programs, although this particular sanction is rare [Handbook 4350.1, par. 16-17(d)].

If the owner or the managing agent used a unit for its own commercial purposes without getting HUD approval, HUD auditors could recommend that the site be reimbursed for the rents that the unit would have generated if rented residentially, Caruso says.

PRACTICAL POINTER: HUD can approve a conversion retroactively. But if HUD doesn't approve it, then HUD can impose sanctions until “compliance is achieved” [Handbook 4350.1, par. 16-17(d)]. That means you must return the unit to its former state and residential use. Although a commercial lease can be canceled for cause based on this infraction, the owner usually owes the lessee compensation and must return the unit to full compliance. Therefore, in most cases, putting a residential unit back into compliance could be an expensive undertaking, Caruso says.

HUD's Standard of Approval

To get HUD approval, you'll probably have to show that:

• The conversion of the units from residential to your intended purpose will benefit the residents [Handbook 4350.1, par. 16-17(c)]; and

• If the conversion is to be for a commercial use, the rents charged will reflect commercial rents in the area for a similar commercial use [Handbook 4350.3, par. 16-17(c)].

Also, be sure that the conversion will not impede your site's ability to pay the mortgage or other expenses, Caruso says.

Consult Attorney Before You Begin

Assuming that your site is qualified under the low-income housing tax credit (LIHTC) program, you should discuss the proposed conversion with your attorney, accountant, or tax credit consultant because removing residential units could jeopardize all of your tax credits.

Also, review your mortgage and insurance documents before you make any plans. Your mortgage may require the lender's approval before converting the units from residential use. Your insurer may require notification if a change of use occurs on site as well. Your attorney and your insurance broker should be able to help with the review of these documents and advise you on how to get the necessary approval.

HOW TO REQUEST APPROVAL

Step #1: Contact Project Manager at HUD Field Office

Call your project manager at your local HUD field office early on to discuss your plan. Getting HUD involved before making the request can help smooth the way and speed up processing later.

You will want to put together a revised Rent Schedule (HUD Form 92458) and forward it to the project manager so that he can see the effect. Converting a unit or two to a use like a childcare facility or a computer lab space is not at all difficult to get approved. But larger conversions and moving to uses that are purely commercial will require a lot more discussion. In most cases, this initial discussion will give you a clear sense of how your proposal will be considered by HUD.

Prior to having the discussion, you should also work up a revised budget for the site, and make sure that debt-service coverage ratios, and other income- and expense- related covenants are not materially affected.

Obtaining approval for significant reconfigurations of space can take considerable time. And HUD will be very concerned about the loss of affordable and assisted units. You will have to address those concerns, Caruso warns.

PRACTICAL POINTER: Be aware that if you are considering converting more than 20 percent of the total square footage, you will have a much more complex approval process. Requests to increase the commercial use within your site to more than 20 percent of the site's total square footage require special permission from HUD headquarters—specifically, its Director of Operations Division, Office of Multifamily Housing Management [Handbook 4350.1, par. 16-17(b)].

Step #2: Discuss Your Plans with Residents in Advance

The proposal, along with revised rent schedules and budgets, will in most cases have to be posted for residents' comments. HUD takes those comments very seriously, so it is a good idea to include the residents in this process early. Your final submission to HUD must include copies of all of the written comments received from residents. You will have to respond to, or explain, the residents' comments. HUD calls this an “evaluation” of the residents' comments [Handbook 4350.1, pars. 16-22(b) and (c)]. Because HUD will review and consider the residents' comments before approving your request, you should ask residents what they think of the proposal before you begin.

By approaching residents in advance, it is more likely that you will be able to persuade residents that they will benefit from the conversion. Residents may feel more involved; it could help to make them feel the conversion is in their best interest. Urge residents who are in favor of the conversion to submit written comments after they have reviewed the conversion plan materials.

Step #3: Prepare Initial Request

To meet HUD's requirements, and to have the best chance of success, you should send HUD a letter making the following points:

Describe your site. Include all the necessary site identification, such as: your site name and address, site number, name of managing agent, Section 8 number (if applicable), the total number of units at your site, the amount of subsidy that the site received, and the site income and expenses (including property tax) [Handbook 4350.1, par. 16-20(a)(2)].

Explain proposed conversion. Tell HUD the number of residential units that you plan to convert to another use, and the nature of the new use. If the use will be an income-producing commercial use, include the name of the operator of the premises and the type of business that will be there. Discuss the compatibility of the commercial use with the residential character of the site. Generally speaking, nonprofit providers of day care, tutoring, or other resident services are looked at in a different and more favorable light than profit-motivated businesses. Also, explain how the funds for the conversion will be paid [Handbook 4350.1, par. 16-20(a)(1) and (a)(3)].

Describe benefits of conversion, address negative effects. Specify how the plan will benefit residents. Indicate if any residents must move out of their units or from the site because of the conversion. You must agree to pay the relocation costs if a resident must vacate the site or his unit. While not specifically required, HUD will generally want to ensure that there is no permanent displacement of residents [Handbook 4350.1, par. 16-20(a)(5)].

Describe effect on site finances. Describe the effect that the proposed conversion will have on your site's finances. Note the rental and subsidy income that will be lost from the residential units, and provide an estimate or statement about the rent, if any, to be received from the new use. Be sure to provide the following items:

• A breakdown of the site's annual income and expenses;

• The site's rent schedule;

• The total number of residential units at the site;

• A list of the units to be converted and whether they are currently occupied; and

• The dollar amount of subsidy payments available to the site prior to, and after, the conversion.

Assess compatibility of conversion. Discuss how the proposed commercial use will be compatible with the needs of the residents. Address any concern that it may interfere with the residents' use and enjoyment of their units [Handbook 4350.1, par. 16-20(a)(3)].

Discuss relocation costs. Specify whether you anticipate that the conversion will require relocating any residents. If so, you will have to provide HUD assurance that you plan to pay their relocation costs [Handbook 4350.1, par. 16-20(a)(4)]. Displacement has become a major concern to HUD in recent years, as mentioned above, so if you are displacing residents, you will need to assure that they are relocated to a comparable site, or preferably elsewhere on the site involved.

Attach copy of resident notice. Attach a copy of the notice you give to residents informing them of the proposed conversion [Handbook 4350.1, par. 16-20(a)(4)]. See our detailed discussion of this point below.

Step #4: Submit Initial Request to HUD and Notify Residents

HUD requires that you submit the initial request to HUD, and that you also notify residents of your plan at the same time [Handbook 4350.1, par. 16-17]. You can submit your final request to HUD no less than 30 days after you've notified residents of your plan.

What notice to residents should say. Your notice should do the following:

> Describe the plan. Indicate that you intend to request HUD's approval to convert at least one residential unit to another use. Tell them how the units will be used after the conversion. If the units are intended for commercial use, tell residents who will be using them and for what purpose.

> Tell residents how they can participate. Provide the address where the residents can inspect and copy the background materials on the conversion, including your HUD submission.

> Give address for resident written comments. Tell residents that they can send comments on the proposed conversion to your site management office (give the specific address they should deliver comments to). Tell them that you will forward their comments to HUD. Let residents know also that they may send their comments to the local HUD office themselves.

How to deliver notice. You can notify residents of the conversion and their opportunity to participate in either of two ways: delivery or posting.

> Delivery of notice. This method requires either personal delivery, such as bringing a notice to each unit, or mailing a copy to each resident [Handbook 4350.1, par. 16-6(a)(1)].

> Post notice. Post the notice in three conspicuous places at your site, such as the site bulletin board or near the site entrance or the entrance to the management office. The notices must remain in place during the entire time available for residents to comment on the plan.

In addition, the notice must be posted conspicuously at the address where the materials on the conversion are available for inspection.

The posted notices must remain legible during the entire comment period, so replace any copies of the notice that get defaced or torn.

Step #5: Get Preliminary Drawings

While it is not necessary to actually pull building permits before getting HUD clearance, having your architect and engineer hold a pre-permit meeting with the city or town is a good idea. Since most HUD-insured sites are of an age where they would not be approved to be built as they are, any conversion of space can trigger a number of code compliance and retrofit issues. It is preferable to know that what you are proposing to HUD can actually be done. Anything other than very minimal work will require full drawings and reviews.

HUD requires additional information if the proposal includes a “major capital addition” [HUD Handbook 4350.1 pars. 16-20(b)]. If the proposed changes to the site's physical structure are substantial, you will need to address compliance with the Fair Housing Act's accessibility standards and, in the case of commercial space, compliance with the Americans with Disabilities Act. Additions or significant renovations may trigger issues like sprinkler retrofits and fire safety system upgrades that might not have been initially figured into the costs.

Drawings or sketches of the conversion should be included. If you have spoken with an architect or engineer about the work required for the conversion, ask for a written description of the work to be done. The written description should include an opinion by the architect or engineer that the proposed conversion is compatible with the residential character of the site. Architects and contractors sometimes produce detailed written descriptions, called “narratives,” to obtain building permits. If a narrative has been completed for the project, ask if you can use it as part of your request.

Step #6: Send Final Submission to HUD

After the 30-day comment period has passed, you can send your final request for approval to HUD. The most important part of your final submission is your response to the residents' comments. However, don't forget to do the following:

Include your initial submission packet. Be sure to resubmit your entire initial request to HUD. Review the information included in the initial request. Send a cover letter noting whether there have been any changes or corrections to the information previously provided.

Include copies of all written resident comments. You must include copies of all written resident comments that you have received regarding the conversion.

Evaluate resident comments. Summarize the resident comments. Be sure to discuss any positive responses you've received. If you've gotten any negative comments, be sure to respond to those as well. For instance, a resident might have commented that a proposed childcare center will be noisy or a nuisance. Tell HUD that the noise will occur during office hours only, or that more residents want the childcare center than those objecting to it.

Certify that you have complied with requirements. HUD requires that you “certify” that you've complied with the requirements in the HUD Handbook [HUD Handbook 4350.1, par. 16-22(d)]. To “certify,” you should list all the steps indicated in this article, and sign everything to indicate that you've followed them. Be sure that you covered the following:

> The delivery. Describe the date and manner of delivery for the Notice to Tenants. Include a copy of the notice in your final submission.

> Tenant participation. State where the materials were available for resident inspection, and what materials were available there.

> Initial submission to HUD. State that you submitted all the necessary documentation in your initial request. Then list the documents, noting that they are enclosed in your final submission.

HUD's Response

HUD's Director of Housing Management must notify you if the request is approved or disapproved. After receipt of the written determination from HUD, you must notify residents of the Director's decision by delivering a copy to them.

If HUD approves your request, you must also tell residents when the conversion will begin. HUD tells you to wait at least 30 days after you deliver HUD's approval to the residents to begin your conversion [HUD Handbook 4350.1, par. 16-23(b)(2)].

Further reading: For more information on this topic, see “Converting Studio Units into One Bedrooms,” Insider, July 2008, p. 5.

Insider Source

George Caruso, CPM, NAHP(e): Executive Vice President, Edgewood Management, 20316 Seneca Meadows Pkwy., Germantown, MD 20876; (301)562-1778; gcaruso@emcmgmt.com.

Sidebar

Checklist of Conversion Considerations

If you are considering conversions from residential to commercial spaces, don't overlook the following specific issues, says property manager George Caruso, an expert in HUD rules and the low-income housing tax credit (LIHTC) program:

• Because many cities don't permit commercial uses in residential areas, will the conversion require a change in zoning for the site?

• Because commercial space also is subject to the Americans with Disabilities Act, will your site's new commercial space comply with the law?

• If you are planning to reconfigure the space, will it be fully accessible under the Fair Housing Act?

• Are there any licenses or zoning approvals that the user must obtain before the new commercial space may be occupied?

• Will conversion of the space into another use (such as a childcare facility) require upgrades to your fire safety system?

• If the site is encumbered with bond obligations, have you obtained investor approval and HUD clearance?

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