Back to Previous Section

Rural Housing Service's Section 538
Guaranteed Rural Housing Program:
A Guide For Developers

© Housing Assistance Council, 2000

Permission is granted ONLY to nonprofit community-based organizations to reproduce and/or adapt this document, and only for their own use. 

III.   A DESCRIPTION OF THE GUARANTEED RURAL RENTAL
         HOUSING PROGRAM

The Section 538 program provides government guarantees of loans made by private sector lenders (such as banks) for the development of affordable rural rental housing with at least five units. The program can be used to guarantee permanent financing, or a combination construction and permanent loan. It cannot be used for a loan that covers only construction.

A Section 538 guaranteed loan can be combined with other financing sources such as Low Income Housing Tax Credits, a HOME grant or loan, state or local assistance (including tax-exempt bond financing), or a second bank loan.

Proposed loans are selected for Section 538 guarantees based on criteria published each year in a Notice of Fund Availability in the Federal Register. In addition, in Section 3565.5(b) of the regulations RHS has established priority for projects "in smaller rural communities, in the most needy communities having the highest percentage of leveraging, having the lowest interest rate, having the highest ratio of 3-5 bedroom units to total units, or located in Empowerment Zones/ Enterprise Communities or on tribal lands."

As noted above, Section 538 differs in some important ways from USDA's longstanding Section 515 Rural Rental Housing Program. Section 538 focuses on partnerships between USDA and qualified lenders, whereas Section 515 makes loans directly to nonprofit or for-profit rural housing developers. Section 538 is intended to provide decent, affordable rental housing for low- and moderate-income rural households with incomes up to 115 percent of area median income, higher than those served by Section 515. Income calculations for Section 538 tenants do not take into account the deductions permitted under Section 515. Units developed with Section 538 loans can be larger than those financed by Section 515, though the dollar amount of loan per unit is subject to limits established under Section 207(c)(3) of the National Housing Act, listed in Section 3.24 of HB-1-3565. Either program can be used in conjunction with other subsidies.

A developer using Section 538 can benefit from an alliance with its state housing finance agency (HFA). An HFA may provide additional low-cost financing from an existing state program or from issuing bonds. Generally a federal guarantee cannot be used in conjunction with tax-exempt bonds, but legislation passed in 1998 specifically allows tax-exempt bond financing to be used with a Section 538 guarantee. A state housing finance agency can issue either private activity bonds or Section 501(c)(3) bonds to generate low-rate financing. Four percent Low Income Housing Tax Credits can be added to the mix.

A. RHS/Rural Development's Role

In addition to providing loan guarantees, the Rural Housing Service/Rural Development oversees the Section 538 program. Each lender must apply to RHS for approval to participate in the program. The agency conducts environmental reviews of sites for which guarantees are requested. Once a guarantee is issued, RHS monitors the lender to make sure program requirements are met.

B. Lenders' Role and Eligibility

Lenders have the same responsibility for Section 538 loans as for loans that are not guaranteed. They underwrite (process and evaluate) applications and service loans (collect payments, communicate with borrowers, and the like). They pay fees to RHS (described below) and report periodically on outstanding loans.

Eligible lenders fall into two categories. First, any lender approved by Fannie Mae, Freddie Mac, or HUD/Federal Housing Administration, and currently active in their multifamily housing guaranteed lending programs, is eligible for Section 538. Second, state or local housing finance agencies, members of the Federal Home Loan Bank System, or other lenders can be eligible if they demonstrate to RHS that they have knowledge and experience with multifamily lending.

A lender that meets the eligibility requirements may apply to USDA for approval to participate in the program. For details on approval process and requirements, see Chapter 2 of HB-1-3565. A lender is considered "approved" when a loan note guarantee between the lender and RHS is executed. Approval requirements include an origination and servicing plan explaining in-house policies and procedures, and verification of the lender's track record. Approved lenders must agree to comply with RHS procedures, or must have agency permission to do things differently. Additional approvals are required for a lender to receive a guarantee of a combined construction and permanent loan.

A lender must provide a number of certifications for RHS, and its eligibility must be verified every year. In other words, this program requires lenders to do some paperwork. In exchange, approval enables the federal government to take the risk for some of their loans.

Other lenders may enter into an agent or broker relationship with an approved lender to participate in the program, or may participate in a loan. (Participation means that two or more lenders each provide part of the funds for the loan. In a participation arrangement under the Section 538 program, the lead lender must be RHS-approved.)

RD/RHS maintains a list of approved lenders.

In most cases RHS/RD will require the originating lender to service the loan and remain the mortgagee or secured party of record. A lender can sell a loan to Fannie Mae or Freddie Mac without prior approval from RHS, or to another entity only if it receives RHS approval first.

C. Borrower/Developer Eligibility

To be eligible, a borrower must:

  • be a creditworthy single-asset entity, or have received prior written approval from RHS;
  • not be in default under any other agency housing program, or have performed well for six months in an approved workout plan;
  • be able to and intend to operate and maintain the project in accordance with program requirements;
  • be in legal and regulatory compliance with respect to any federal debt;
  • be a U.S. citizen or legal resident, a U.S.-owned corporation, or a limited liability corporation (LLC) or a partnership where the principals are U.S. citizens or permanent legal residents.

Types of eligible entities include:

  • public agencies;
  • Indian Tribes;
  • individuals;
  • general partnerships, if formed for a term at least equal to the loan term;
  • limited partnerships, with certain limitations;
  • for-profit corporations;
  • nonprofit corporations;
  • limited liability companies; and
  • trusts.

Lenders are responsible for ensuring that borrowers have the experience and capacity to properly develop and operate the property. They must review experience and financial resources and must verify that the borrower can construct or rehabilitate rental housing, provide a financially sound operation over the life of the loan, and be legally able to meet all aspects of rental housing development and operation. The lender will examine construction and rehabilitation experience, property management experience, and financial capability in detail. The lender must also be sure that each member of the development team, as well as the eventual property manager, has the appropriate abilities and experience.

The borrower must contribute initial operating capital equal to at least 2 percent of the loan amount.

The borrower and lender must sign a regulatory agreement containing the terms specified in Section 7.14 of HB 1-3565.

D. Tenants

To be eligible, tenants must have incomes at or under 115 percent of area median income at the time of initial occupancy. The property deed must contain a restriction enforcing the income limits. The income limit does not apply after initial occupancy--in other words, tenants need not leave the property if their incomes rise.

The borrower/developer must certify the incomes of all tenants at initial occupancy. RHS does not require recertification, but another lender may require it, and if a project receives Low Income Housing Tax Credits it will need to comply with the recertification requirements imposed by that program. Certification or recertification may be performed on any industry accepted form, unless there are no other subsidies attached to the property. In that situation, RD Form 1944-8 must be used, but the borrower need only complete the portions of the form applicable to the Section 538 program (see Section 8.12B of HB-1-3565).

Income is defined to include all income for each adult member of the household. No adjustments to income are permitted.

RHS restricts rents in order to preserve affordability for the eligible income group. For each unit monthly rent, including utilities, may not exceed 1/12 of 30 percent of 115 percent of area median income, adjusted for family size. Appendix 9 of HB-1-3550 lists area median incomes. For an entire project, on an annual basis the average rent cannot exceed 30 percent of 100 percent of area median income, adjusted for family size.

Since utility costs are included in the rent caps, owners are required to establish an estimate of utility costs paid by tenants. Owners may use Exhibit A-6 to RD Instruction 1944-E for this purpose.

Tenant leases must be for 12 months or more, unless there is some special circumstance. Section 538 units may not be used for transient or migrant housing, nor as health facilities or student housing.

Borrowers and project managers must comply with fair housing laws. Any tenant or prospective tenant who believes s/he has been discriminated against because of age, race, color, religion, sex, marital or familial status, handicap, or national origin may file a complaint at any Rural Development office or any Department of Housing and Urban Development (HUD) office. Rural Development field office staff will help complainants to fill out forms and file complaints. HUD and USDA have established procedures for processing and investigating complaints.

Details about tenant occupancy requirements are provided in Chapter 8, Section 5 in HB-1-3565.

E. The Site

To be eligible for Section 538, a property must be located in an area defined by RHS as rural (see Section II.B, above) and must have at least five rental units. RHS prefers units to be on single or contiguous sites, but will accept scattered sites if the sites are all in one market area, managed under one management plan, and owned by one entity.

A site must also:

  • have necessary public facilities such as central water and sewer;
  • be conveniently located to services such as shopping, schools, medical, hospital, and pharmaceutical;
  • not be located in a less desirable area, i.e., located adjacent or close to train tracks, industrial areas, sites with environmental concerns, grain elevators and storage bins, older declining neighborhoods, gas stations and car lots;
  • meet all federal, state, and local codes, laws, ordinances, and zoning requirements;
  • have necessary infrastructure;
  • have soil compatible for the use and sufficient grading;
  • be free of undesirable physical characteristics such as costly rock condition, noise, and pollution; have a density compatible with the neighborhood and market; and
  • be of sufficient size to accommodate the features needed and not to negatively impact overall cost.

The borrower must control the site at the time of loan closing and must have fully marketable title thereafter. RHS states that fee simple title is the only form of ownership accepted, but the agency does accept leases under the conditions listed below (also see paragraph 3.17B in HB-1-3565):

  • The lessor owns the land in fee simple.
  • There are no prior liens or unpaid taxes.
  • The loan does not exceed the market value of the property.
  • The unexpired lease term is at least 125 percent of the mortgage term.
  • The lease rent is no more than the rate for similar leases in the area.
  • The lease is recorded.
  • The lease is in writing and includes provisions that:
    • the lessor must approve all required improvements;
    • the lessor approves the right of the lender and the agency to foreclose and transfer the lease;
    • the lender and the agency have the right to bid at foreclosure sale or accept a deed in lieu of foreclosure;
    • the lender or the agency has right to sublet the property and sell the leasehold when acquired via foreclosure, deed in lieu of foreclosure, or abandonment;
    • the borrower can transfer the leasehold in the event of default or inability to continue;
    • the lessor must give the agency and the lender a notice of default and 60 days to cure the default.

The Rural Development State Office must approve the written lease agreement prior to loan closing, and approve any subsequent changes.

F. Eligible Uses of Funds

The eligible uses of loan proceeds are detailed in Section 3565.205 of the regulation. In brief, they are:

  • new construction;
  • moderate or substantial rehabilitation (with some limitations), and acquisition when related to the rehabilitation;
  • acquisition of existing buildings for special needs (must be approved by RHS);
  • acquisition and improvement of land;
  • development of essential on- and off-site improvements;
  • development of related facilities;
  • on-site management and maintenance offices;
  • appliances;
  • parking development, landscaping, etc.;
  • limited commercial space costs, with specified limitations;
  • professional and application fees;
  • technical assistance and packaging fees to and by nonprofit entities;
  • board of director education fees for cooperatives;
  • interest on construction loans;
  • relocation assistance when applicable;
  • developers fees; and
  • refinancing applicant debt when authorized in advance to pay for eligible purposes prior to loan closing and approved by RHS.

Structures and sites must meet the standards in RD Instructions 1924-A and 1924-C.

Refinancing is not an authorized use of funds unless RHS grants an exception.

Projects must comply with applicable requirements in Section 504 of the Rehabilitation Act of 1973, the Fair Housing Act, the Americans with Disabilities Act, and other applicable statutes. For a list of statutes and a summary of Section 504 requirements, see Appendices D and E to this guide.

G. Environmental Requirements

Rural Development and the guaranteed lender(s) include environmental risk management in their lending procedures in order to minimize negative impact on their security and establish a process to limit liability. Chapter 11 in HB-1-3565 outlines the agency's environmental review requirements for Section 538 loans. They are similar to those used for the Section 515 program.

Rural Development requires the lender to conduct due diligence in accordance with the current ASTM Standard E-1527, Phase I Environmental Site Assessment prescribed by the American Society for Testing and Materials. RHS/Rural Development then conducts an environmental review to demonstrate compliance with environmental requirements, based on the requirements in RD Instruction 1940-G (7 CFR Part 1940 Subpart G).

In practical terms, this means the applicant must provide the information necessary for the lender and RD/RHS to conduct their reviews. A description of any known environmental issues must be included in the response to the NOFA. Later, with submission of a full application, the applicant must include:

  • Form RD 1940-20;
  • Phase I Environmental Site Assessment report;
  • lender comments on any off-site conditions;
  • a land survey; and
  • FEMA Form 81-93, standard Flood Hazard Determination.

Guidance about the environmental information-gathering and review processes is available in two HAC publications: Environmental Concerns in Choosing a Site for Rural Housing Development and FmHA [RHS] Environmental Regulations: A Guide for Rural Housing Applicants.

H. Loan Amounts and Terms

Section 538 loan amounts are capped at maximum costs per unit established by HUD and available from HUD offices.

The lender may set the loan term, but the maximum is 40 years.

Generally RHS requires a first lien.

The lender determines whether the borrower has a prepayment option, but RHS will not pay any penalties for prepayment.

Interest rates must be fixed. Each year's NOFA will specify the maximum allowable interest rate.

For details, see Section 3565.208 in the regulation.

I. Fees to RHS

RHS charges fees to lenders receiving loan guarantees. For details, see Chapter 6 in HB-1-3565. Exhibit 6-1 lists the loan guarantee fees:

  • initial loan guarantee fee: 1% of the total guarantee amount, multiplied by the guarantee percentage;
  • annual fee: 0.5% of the outstanding principal and interest;
  • application fee, paid at the time the application is submitted: $2,500;
  • extension fee, for extension of the commitment term: $500;
  • reopening fee, after the commitment ends, at RHS's option: $500 per reopening;
  • transfer fee if property is transferred from one owner to another: $1,250.

J. Extent of Guarantee

The lender determines how much to lend. RHS requires the loan amount to be less than 90 percent of the total development cost or property value. Nonprofit borrowers and Indian tribes can borrow up to 97 percent of cost or value. The Section 538 program will guarantee a maximum of 90 percent of the unpaid principal and interest of the loan.

RHS will guarantee construction contracts to 90 percent of work in place if there are protective credit enhancements, such as:

  • surety or payment and performance bonding (RHS's preference);
  • an irrevocable letter of credit acceptable to RHS; or
  • lender's pledge of acceptable collateral.

RHS/RD may guarantee less than 90 percent, based on its evaluation of the loan. Once issued, a guarantee can be cancelled in the event of fraud, misrepresentation, abuse, negligence, or failure to adhere to the guarantee terms.

K. Interest Credit (Subsidy)

To help the Section 538 program serve low- and moderate-income tenants, the law requires that at least 20 percent of Section 538 loans made each year must receive interest credit subsidy sufficient to reduce the effective interest rate to the Applicable Federal Rate (AFR) defined in Section 42(I)(2)(D) of the Internal Revenue Code. The AFR is available at http://ftp.fedworld.gov/pub/irs-utl /afrs.pdf or in the Wall Street Journal on the third Wednesday of each month, labeled the "Long Term Monthly Rate."

According to HB-1-3565, this rate will reduce the interest rate by 100 to 200 basis points (1 to 2 percentage points). Lenders can receive interest credit on up to $1.5 million for a single loan.

RHS selects which loans will be subsidized. All loan applications requesting interest credit subsidy are ranked along with other applications, as described below, and the highest ranked projects, representing 20 percent of all loans, are selected. Preference is given to applications for which interest credit would lower tenant rents or provide a higher level of tenant services than would otherwise be available.

On to Next Section

Back to Table of Contents