Replacement Reserve: How HUD Sizes and Controls It

Key points

• An RfR escrow is required for all HUD-insured mortgages.
• Deposits come from the CNA e-Tool financial plan, which covers the lesser of 20 years or two years plus the remaining loan term.
• The first-year annual deposit may not be less than $250 per unit under the March 2021 MAP Guide.
• Annual deposits can grow over time, but never faster than the inflation rate applied to capital needs, and the change must pass a DSCR stress test.
• A new CNA at least every 10 years can reset the deposits.

What the reserve is for

The MAP Guide describes the purpose of the RfR escrow as setting aside funds to pay for the timely replacement of capitalized physical assets. It is different from a repair escrow. The repair escrow pays for specific deferred repairs identified at closing and is drawn down within about a year; the replacement reserve is a long-term account that pays for components as they wear out over the life of the loan. Some owners treat it as trapped cash, but it is better understood as HUD's way of making sure a 35- or 40-year fixed-rate loan is matched by a building that lasts that long.

Servicing of the account, including draws, liquidity and investment, is governed by HUD's asset management handbook for multifamily servicing, and the lender administers it.

How deposits are set

The lender's underwriter builds the reserve plan in the CNA e-Tool. The needs assessor lists each component, its expected useful life, remaining useful life and replacement cost; the underwriter then enters financial factors to produce a balanced plan.

• Estimate Period: the lesser of 20 years or two years plus the remaining term of the insured mortgage.
• Initial deposit: any lump sum required at endorsement, plus balances carried forward from an existing reserve in a refinance of an insured property.
• Year 1 annual deposit: expressed per unit per year, and never less than $250 per unit for any property.
• Rate of change: the lender may grow the deposit annually, but not faster than the capital needs inflation rate, and must show by stress test that coverage stays within underwriting requirements.
• Minimum balance: about one year of average needs (one-twentieth of total uninflated needs over a 20-year period) in each of years 3 through 10; only a positive balance is required in years 1 and 2.

The second-decade test

HUD allows the projected balance to fall below the minimum, even below zero, after year 10, but only within a limit. Any shortfall in years 11 through 20 may not exceed 50 percent of the loan's cumulative amortization for that year. If it does, the lender must increase the funding. The lender attaches a schedule comparing projected reserve balances with cumulative amortization for each of those years. The logic is that by the second decade the loan has paid down enough that a later reserve increase, set by the required 10-year CNA update, can close the gap.

How the reserve affects loan sizing

Annual reserve deposits are an operating expense in HUD underwriting, so they reduce the net operating income that sizes the loan under the debt service coverage test. A property with heavy near-term replacement needs can face a higher deposit, a larger initial deposit, or both. The initial deposit is a use of funds at closing, which in a refinance competes with cash out and in an acquisition increases the equity required.

This is where a bridge-period renovation pays off twice. Replacing roofs, mechanical systems or unit interiors before the HUD application lowers near-term needs in the CNA, which lowers both the escrow and the ongoing deposit.

Using the reserve after closing

Owners request reimbursement from the reserve for eligible replacements through the lender, which reviews the request under HUD's servicing requirements; for Section 232 facilities, ORCF's portal handles reserve for replacement requests. The minimum balance in the plan is a planning contingency and a trigger for asset management review, not a cap on legitimate draws. Expect the 10-year CNA update to revisit the deposit based on actual conditions, and keep records of completed replacements so the next assessor credits them.

Where to go next

For reserve requirements in Bravo's 223(f) loans, see HUD 223(f) loans.

For common questions on HUD escrows and reserves, see HUD loan FAQ.

Related guides: HUD Reserves and Repair Escrows: What Gets Funded at Closing; After the HUD Closing: Asset Management Obligations; How HUD Loan Sizing Works in a Bridge-to-HUD Plan.

Related terms: Capital Needs Assessment (CNA): What It Means in a HUD Loan; Repair Escrow: How HUD Funds Deferred Repairs after Closing; Debt Service Coverage Ratio (DSCR) in HUD Loan Sizing; Surplus Cash: How HUD Limits Owner Distributions.

For portfolio figures by state, metro and program, see the HUD multifamily data hub. Bravo Capital’s record: all 26 HUD firm commitments received since April 2022 have closed, totaling $526.0 million (HUD Closing Scorecard).