B y Paul K. Casey, Jane E. Sheehan and Jon M. Laria

Development of public housing is undergoing a radical transformation. Previously, it was the exclusive domain of public housing agencies (PHAs) and the federal government. Now a new player will participate_the private sector. Faced with the critical need to demolish obsolete and distressed public housing, an acute shortage of decent, safe and sanitary housing alternatives and cutbacks in federal development funds, PHAs and the U.S. Department of Housing and Urban Development (HUD) are aggressively exploring how to leverage limited federal resources with private and other public dollars. New rules allow PHAs to enter into partnerships with for-profit and non-profit developers and even permit the public financing of privately owned public housing. Lawyers will have an important role in structuring the legal relationships for these new types of developments.

Crisis in Public Housing
Most public housing arose from the Federal Low-Rent Public Housing Program created by the United States Housing Act of 1937, 42 U.S.C. 1437 et seq. (1937 Act). Public housing originally was intended to provide decent and safe rental housing for the working poor. According to HUD, 3,400 PHAs now own America's public housing and provide housing for 1.3 million households. Moreover, public housing is often the housing of last resort for America's poorest families.

By law, public housing must serve families with incomes below 80% of the area median income, and a PHA must rent most of the units in a pub-lic housing project to households with incomes below 50% of the area median. See 42 U.S.C. 1437a(a)(1), 1437n(a), 1437n(b)(1) and 1437n(b)(2). The median income of public housing residents is actually far below these thresholds. In 1995 the Council of Large Public Housing Authorities reported that the median gross annual income of public housing households was about $6,500, less than 20% of the national median income. Section 3(a)(1)(A) of the 1937 Act prohibits a public housing household from paying more than 30% of its income for rent. 42 U.S.C. 1437a(a)(1)(A).

Federal operating assistance under Section 9 of the 1937 Act covers the balance of operating costs. 42 U.S.C. 1437f. This Section 9 subsidy distinguishes a public housing unit from any other affordable housing unit. Many PHAs, particularly those in larger urban communities, must deal with problems created by badly deteriorated housing stock and concentrations of very poor families. In 1992 the National Commission on Severely Distressed Public Housing found that the total cost to modernize public housing would be between $14.5 and $29.2 billion, depending on the degree of modernization. Even worse, tens of thousands of these units are virtually uninhabitable and require demolition.

Since its inception, America's public housing has been developed and maintained with federal funds appropriated for that purpose and allocated to PHAs through HUD and its predecessors. Tenant rents originally supported the operation of public housing. Public housing rents were below market but high enough to cover project operating expenses. When operating costs increased, PHAs increased rents accordingly. Congress became concerned that public housing tenants were paying too much of their limited income towards rent and in 1969 passed the Brooke Amendment to the 1937 Act, which capped rents at 25% of household income.

When combined with the low income level of most public housing households, this 25% cap made it impossible for many PHAs to cover their operating costs. In 1974 Congress enacted Section 9 of the 1937 Act, authorizing the payment of a formula-driven operating subsidy to make up for the rental shortfall. Congress raised the cap to 30% in 1981 (see 42 U.S.C. 1437a(a)(1)(A)), but today rental income covers an average of just 47% of PHA operating expenses. The resulting shortfall has caused an increased reliance on federal operating assistance at a time when available federal funding is steadily decreasing.

Many proposed social and economic solutions attempt to address this crisis in public housing. Recent legislation authorizes PHAs to implement a "one strike and out" policy, allowing a PHA to terminate tenancies for illegal drug use or on-premises disruptive behavior resulting from drug or alcohol abuse. 42 U.S.C. 1437d(l)(5). In addition, PHAs are using new legal authority to establish local tenant selection criteria, including preferences for working families or families with members in job training. See Pub. L. No. 104-99, 402(d), 110 Stat. 26 (1996).

The most dramatic solutions are changing forever the way that public housing will be constructed and financed. PHAs are becoming housing developers and are engaging private sector partners and expert legal and financial consultants to help design, finance, construct, own and manage livable mixed-income communities. The goal is to replace distressed (frequently high-rise) public housing with socially and economically integrated housing designed to blend with surrounding neighborhoods and the broader community.

PHAs have completed, or are nearing the completion of, these types of projects in Atlanta, Baltimore, Pittsburgh, St. Louis, Minneapolis, San Francisco and other cities. HUD's Response: Real Progress Until recently, PHAs have encountered formidable legal obstacles to linking private parties with public housing development.

Traditionally, the 1937 Act was understood to permit the use of federal public housing development funds and operating assistance only in projects that PHAs owned. HUD's General Counsel, however, broke the statutory and regulatory logjam in 1994 by issuing an opinion that the 1937 Act permits private ownership of public housing. With certain limitations, this opinion allows federal public housing development funds to be used to construct units owned by a private entity, provided that the units are occupied by families eligible for public housing and are subject to applicable statutory and regulatory requirements. In addition, public housing owned by private entities and serving eligible families qualifies for federal operating assistance, subject to applicable federal requirements, including the conditions of a HUD Annual Contributions Contract.

In May 1996 HUD promulgated an interim "mixed-finance" rule as Subpart F to 24 C.F.R. pt. 941 (Interim Rule) that permits PHAs to form partnerships with private developers. When this article was written, a revised Interim Rule was expected in late summer 1997. Under the Interim Rule, non-PHA partners can receive funds to develop or manage projects containing some or all public housing units. The Interim Rule authorizes a combination of private financing and public housing development funds to construct public housing. Dwelling units developed under the Interim Rule with these funds remain subject to traditional long-term public housing restrictions, even if they are owned by a private entity. HUD enforces these restrictions through a Declaration of Trust that is recorded against the project and requires compliance with the 1937 Act, including a 40 year minimum period of occupancy by income-eligible residents.

Recent appropriations bills, combined with HUD's authority under existing law and the Interim Rule, provide the tools for implementing this radical transformation in public housing development. HUD anticipates that between 1993 and 2000 it will have approved the demolition of approximately 100,000 units of substandard public housing. HUD's objective is to replace some or all of these units with safe, attractive mixed-income residential communities.

In addition, Congress continues to make funding available for the demolition and replacement of severely distressed or obsolete public housing under the HOPE VI Program, first enacted as the Urban Revitalization Demonstration Program. Pub. L. No. 102-389, 106 Stat. 1579 (1993). Since 1993 HUD has awarded more than $2 billion to 52 PHAs. Originally limited to residents of America's 40 largest cities, the scope of eligible applicants has expanded. In 1996, 138 PHAs submitted applications for funding. HUD awarded 20 PHAs grants totaling $400 million to demolish and revitalize public housing in all regions of the country. The 1997 HUD appropriations bill allocates approximately $550 million for additional HOPE VI projects. Notice of Funding Availability, 62 Fed. Reg. 18,242 (1997).

HUD's Office of Public Housing Investments is actively and creatively cooperating with PHAs and private developers to facilitate the use of federal public housing development funds so as to leverage federal dollars with private sources of funds and other public funds. These mixed-finance projects may be owned by limited partnerships or other private entities in which the PHA ownership interest may range from none to 100%. HUD encourages PHAs to participate in projects in which the public housing units are fewer than all of the units developed and are integrated among other non-public housing units, both rental and owned. These projects promote the public policy of replacing distressed public housing with socially and economically integrated housing that will blend with the surrounding community.

Developments under this new approach are complex. These developments frequently involve sophisticated financing tools, such as the low-income housing tax credit, the historic tax credit and bond financing. Many also involve disposition issues unique to PHAs and complicated land use issues, such as subdivisions and mixed uses. They require the PHAs to either develop expertise or secure the necessary financial and legal experience through consultants so that the PHAs can effectively deal with the commercial real estate, finance and development issues. Expertise is especially critical in federal public housing requirements, such as total development cost limits, site and neighborhood standards and procurement, as well as traditional areas of land development, deal structuring and contract negotiation. Many opportunities await real estate lawyers to advise both PHAs and their private developer partners.

Public-Private Partnerships in Action This program is a work in progress. Consequently, it is premature to refer to any development model as the "preferred" model. PHAs have used a variety of approaches, including contracting with experienced private parties through a master joint venture, development agreement or general construction contract.

The federal procurement rules require that an open and competitive selection procedure govern the process by which the PHA strikes this strategic alliance and selects its partner. See 24 C.F.R. pt. 85; 24 C.F.R. pt. 941. The PHA publishes a request for proposals (RFP) or a request for qualifications (RFQ) that sets forth, at a minimum, the qualities the PHA seeks in its potential partner or general contractor. Key qualifications include the potential partner's prior development and financing experience, track record for access to private funding sources, involvement in low-income housing tax credit or tax-exempt bond financing deals, financial sophistication and ability. Significantly, the Interim Rule permits procurement based on qualifications. Price need not be the controlling criterion, as long as the compensation is fair and reasonable. Of course, there is no relaxation of conflict of interest rules.

As PHAs become more experienced and sophisticated developers of affordable housing, they will likely add other minimum requirements to the RFP or RFQ, such as a financial return on the PHA's investment in land and financing, a participation interest in the ownership entity and minimum cash equity contributions to the project by the PHA's potential partner. The private sector must recognize the PHA's critical contributions to the success of any development venture, including valuable tracts of developable land, capital funding through federal development funds and operating subsidies for the public housing units. Conversely, PHAs must recognize that venturing with a private developer will provide access to additional capital through private lenders and low-income housing tax credits, as well as development, financing and management expertise.

After a PHA selects a compatible partner, the two parties will establish their relationship and the framework of the project through a number of agreements, each of which will require legal advice and counsel. A joint venture, development or construction agreement will delineate the con- tractual relationship of the parties and outline their goals and the obli-gations that the parties owe to each other, to the project and, in certain instances, jointly to the project. These agreements will provide a detailed description of the development, including the number and type of units, the extent to which they will be public and non-public housing, whether they will be rented or owned and the ancillary facilities. The documents will also memorialize the ownership structure of the project.

Ownership may or may not involve either the PHA itself or a specially created affiliate. If it does, the PHA or affiliate may be one or the only general partner in a limited partnership or a managing or non-managing member in a limited liability company. In addition, the parties must agree on the appropriate mechanism to ensure that the project's public housing units are developed, operated and maintained in accordance with the 1937 Act. These mechanisms can include any combination of a ground lease by the PHA to the developer, covenants running with the land and a PHA purchase option. The various agreements will also provide the PHA with the preliminary elements of the proposal that HUD requires under the Interim Rule.

Under the Interim Rule, a PHA seeking public housing development dollars for a mixed-finance project must submit a proposal to HUD for review and approval. 24 C.F.R. 941.606. The amount of informa- tion that the PHA submits will vary depending on the complexity of the project and the submitting PHA. The requested information includes: identification and relationship of the parties; a description of the terms and conditions of other financing; a methodology for the use of operating subsidies; a description of the development; site information; market analysis; construction costs and schedule; a description of the adequacy of the facilities and services for the tenants or potential homeowners; displacement and relocation information; demonstration of operating feasibility; certification and assurances about procurement; identity of interest contractors; and local government review and comment.

The PHA and its partner must anticipate extensive discussions with HUD's Public Housing Investment officials and the corresponding attorneys in HUD's Office of General Counsel before HUD finally approves the proposal. HUD officials enter these discussions with a positive attitude and a willingness to be creative and flexible within existing legal requirements. These discussions will likely result in revisions to the proposed project and plan of financing. If the circumstances justify it, HUD will consider issuing appropriate regulatory waivers. Only with HUD's approval can the PHA and its partner proceed toward a mixed-finance closing with certainty that the project is viable and the public housing development funds are assured.

As with any construction financing, standard requirements, such as title, survey, insurance, zoning and subdivision approval, must be satisfied. Because HUD is providing public housing development funds, it will have the final approval of all closing documents. Consequently, all of the closing requirements for, and negotiations with, the other sources of financing must be completed and the documents reviewed by HUD before HUD authorizes the closing and funds its contribution to the transaction.

The Interim Rule applies in all cases in which federal public housing development funds are to be combined with other financing sources. 24 C.F.R. 941.600(a)(1). Private developers and PHAs should understand that PHAs can provide operating assistance to units owned by private developers that have not been constructed with federal public housing development funds. Baltimore's PHA has developed these kinds of projects, with the advantage of fewer federal requirements. For example, HUD does not review or approve closing documents for the construction financing. In these projects, HUD is also willing to waive the regulatory requirement that certain use and occupancy restrictions continue for up to 10 years after the subsidy terminates. For these projects, as well as for others developed under the Interim Rule, HUD has allowed lease provisions permitting the owner to relocate tenants who cannot pay market rents if the Section 9 operating subsidy terminates. The owner can replace the relocated tenants with persons from a site-based waiting list who are able to pay the market rent necessary to make up for the lost subsidy.

These solutions represent great strides forward in PHA and HUD thinking about the future of public housing. They demonstrate a willingness to be flexible but are only interim solutions. Public housing advocates recognize that substantive legislative change is required to reorient public housing for the coming decades. Change, in the form of sweeping legislative reform, is on the horizon. Each house of Congress passed public housing reform bills in 1996. These bills did not emerge from conference committee before adjournment, but most observers believe the current Congress will totally overhaul the public housing system. Toward this end, H.R. 2, 105th Cong., 1st Sess. (1997), was introduced in the House of Representatives on January 7, 1997, and S. 462, 105th Cong., 1st Sess. (1997), was introduced in the Senate on March 18, 1997.

Although many fundamental issues remain unresolved, Congress probably will reorganize public housing funding to PHAs into two block grants, one for capital costs and the other for operating costs. The new legislation is expected to give PHAs much greater discretion to use these funds to facilitate mixed-income projects, to leverage private investment in public housing and to ensure that these public-private partnerships become the standard for developing viable public housing projects in communities of all sizes. The legislation will both solidify and expand the radical transformation in public housing development already well under way through the creative efforts of HUD, PHAs and private sector developers. Paul K. Casey is a partner with Ballard Spahr Andrews & Ingersoll in Washington, D.C. and Baltimore, Maryland and is Group Chair of the Section's Community Development and Affordable Housing Group. Jane E. Sheehan is a partner and Jon M. Laria is an associate with Ballard Spahr Andrews & Ingersoll in Baltimore, Maryland.

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