For the past several years, the Sec. 538 loan guarantee program has been the flagship development program for the Rural Housing Service. For most of its existence, it has been a small, almost boutique program, and the Rural Housing Service itself is something of an outlier in the federal affordable housing effort, as the sole housing outpost of the U.S. Department of Agriculture.

The Rural Housing Service has been expanding the use of the 538 program for Sec. 515 preservations. The 538 program requires $6,500 of rehabilitation per unit. This tends to fit nicely with preservation efforts in the existing 515 portfolio, which has been the main program for development over the past 30 years in rural America. The 515 program now has some 16,000 apartment complexes, and because most are now 30 years old or older, the need for recapitalization is substantial. Subordinating the existing 515 loan to a new 538 loan on one of these properties keeps much of the lender risk with the agency and reduces the need to go begging for funding from other agencies, while creating substantial leverage with private loan dollars and new equity dollars. These new equity dollars are typically raised by the low-income housing tax credit, which works particularly well because the 538 program may not bear an interest rate below the applicable federal rate. Indeed, the 538 typically bears a market rate of interest, and occasionally you may find a lender that will provide a rate a little bit better than market. However, for up to 20 percent of the 538 loan guarantees authorized in any given year, Rural Housing can also provide interest credit subsidy that reduces the interest rate down to the applicable federal rate.

Developers are finding that many of the 515 properties were developed in tandem or in sequence by related developers and upon redevelopment have found success by using tax-exempt bonds with tax credits for multiple properties near each other or in the same general vicinity. The 538 guarantee works particularly well with these kinds of small portfolios by providing that much-needed federal credit enhancer. This is especially helpful because HUD has not typically processed FHA credit enhancement in rural areas.

Relatively few of the 16,000 properties in the 515 program have been recapitalized and preserved at this point, and Sec. 538 is an important preservation tool for 515 properties. But the 538 program still serves to expand affordable housing in rural America, where the need in some areas is overwhelming—especially considering that most federal resources go to urban areas, not rural.

The 538 program has been modeled in many ways on the Rural Business Services Business and Industry Guaranteed Loans (B&I) program. Both the 538 and the B&I programs provide a guarantee of 90 percent of the outstanding loan principal and interest (often 80%, for B&I), and both rely heavily on lenders for due diligence and loan administration. Because the 538 is a loan guarantee—and not mortgage insurance, which is more familiar to people who work with HUD’s Federal Housing Administration (FHA) programs—538’s federal credit enhancement functions as a reimbursement to lenders after the lender liquidates the loan, not as FHA’s payment and assignment to the government upon default. This distinction has created a barrier to participating in the 538 program by the secondary mortgage market community. Rural Housing has been chipping away at that resistance in recent years with the creation of memoranda of understanding between the Rural Housing Service and Fannie Mae and Freddie Mac, and holding stakeholder meetings.

Each year, the Rural Housing Service publishes a notice of funding availability and operates on what is essentially a structured bid concept. To adapt to market conditions, that Notice of Funds Availability (NOFA) remains open for much of the year, allowing lenders to bring loans for guarantee on a rolling basis, and helping to close the processing gaps that often appeared in past years when the NOFA was open for only a short period.

Richard Michael Price is a partner with Nixon Peabody, LLP, in Washington, D.C. His law practice focuses on real estate, real estate finance, housing and community development regulation, and government contracts and administrative law. He regularly represents clients in transactions, administrative proceedings, and civil litigation. He can be reached