Earlier this year, I posted an article to the blog about the problem of complying with federal requirements to avoid “choice limiting actions” prior to an environmental review. http://www.fhardee.com/starting-your-project-off-right/. To recap the problem: if a developer intends to use federal funds to finance an affordable housing development, the Department of Housing and Urban Development forbids taking any activity that would have the effect of limiting the development of a site without determining the environmental impacts of the development. “Completion of the environmental review process is mandatory before taking a physical action on a site, or making a commitment or expenditure of HUD or non-HUD funds for property acquisition, rehabilitation, conversion, lease, repair or construction activities.” HUD Notice CPD-01-11. As the HUD regulations state, “the environmental review process should begin as soon as a recipient determines the projected use of HUD assistance.” 24 CFR §58.30. The dilemma is how to comply and still obtain site control in order to begin the environmental review process required by the regulations. Catch-22 for sure.
The regulation that governs the environmental review process when developing affordable housing with any kind of federal funds (whether it is CDBG, HOME or other federal sources) is 24 CFR §58.22. The regulation states:
Neither a recipient nor any participant in the development process, including public or private nonprofit or for-profit entities, or any of their contractors, may commit HUD assistance under a program listed in section 58.1(b) on an activity or project until HUD or the state has approved the recipient’s [Request for Release of Funds] and the related [environmental review] certification from the responsible entity. 24 CFR §58.22(a).
It is important to note that a “recipient” is defined to include (a) a state that does not distribute HUD assistance under the program to a unit of general local government (ie. the state in nonentitlement communities); (b) a unit of local government (in entitlement communities); and (c) a public housing authority. 24 CFR §58.2(5). Developers are not recipients but §58.22(a) nonetheless forbids development entities from committing HUD assistance before the environmental review is complete. (It is not clear to me how a developer could commit HUD assistance before environmental review occurs since it does not have any control over such funds, at least not at the outset of a project. Interestingly, the HUD notice quoted above expands the type of funds to include both HUD and non-HUD funds even though the regulations only speak of the committing of HUD assistance.)
However, it appears that HUD must have recognized that obtaining site control would be nearly impossible for an affordable housing developer without paying the owner of the land some consideration for site control. Therefore, HUD added an exception to the prohibition on “choice limiting activities” to allow a developer to enter into an option contract obtain site control. Subsection (d) of 24 CFR §58.22 provides:
An option agreement on a proposed site or property is allowable prior to the completion of the environmental review if the option is subject to a determination by the recipient on the desirability of the property for the project as a result of the completion of the environmental review in accordance with this part and the cost of the option is a nominal portion of the purchase price. There is no constraint on the purchase of an option by third parties that have not been selected for HUD funding, have no responsibility for the environmental review and have no say in the approval or disapproval of the project. 24 CFR §58.22(d).
Some developers have been concerned about drafting an option agreement for “a nominal portion of the purchase price.” What is nominal? How can a developer get site control if the payment to the owner is only “nominal”? Since the word “nominal” is not defined in the regulations, the development community has operated in the dark regarding the parameters for consideration for the option agreements.
However, in my view, a private affordable housing developer (one that is not a PHA) is protected by the second sentence of 24 CFR §58.22(d). This sentence allows a nonprofit developer greater freedom to enter into options as long as:
- The developer has not yet been selected for HUD funding;
- The developer is not responsible for the environmental review (and, according to §58.4 this is the role of the Responsible Entity, not the developer); and
- The developer has “no say” is the approval or disapproval of the project.
While this last requirement is poorly drafted, it appears to mean that as long as the developer does not control the determination of whether the project is approved for funding, the developer can enter into the option agreement “without constraint.”
I would certainly urge caution in entering into an option agreement that looks like a purchase agreement. Option agreements should generally allow for the return of the option payment for some period of time that is at least concurrent with the due diligence period. I also think it is advisable to recite the regulation in the option agreement so that both parties recognize the importance of complying with the rules on choice-limiting activities. Finally, it may be useful for the parties to characterize the option payment as nominal, in case the recipient takes a contrary view regarding the interpretation of sec. 58.22(d). These precautions (and a close reading of the regulations) should be helpful to developers trying to obtain site control at the beginning of the development process.