
Funding options in social housing
This article was originally published by Arun Poobalasingam in Inside Housing on 10.05.24.
What does the current finance environment look like in the social housing sector, and what are the different options? Arun Poobalasingam, funding and marketing director at affordable housing aggregator The Housing Finance Corporation, explains more.
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Learning outcomes
After reading this article, learners will be able to:
- Describe how the current financial climate impacts on funding options for social housing providers
- Detail the different types of debt capital and explain the advantages and drawbacks of each
- Explain how interest covenants are affecting choices about debt
- Understand equity partnerships, including their possible advantages and drawbacks
What is the overall picture on financing social housing development and/or retrofit?
While there remains some grant funding available for social housing development and retrofit, debt funding has always been an important source of finance.
This involves a housing association borrowing money, repaying interest on the loan each year, and then repaying the borrowed money far off into the future.
There are two main problems with this method:
- Interest rates – interest rates have escalated recently. Just three years ago, it was possible to borrow money at a rate of 2-3%. Today the rate is 5-6%, so there has been at least a doubling. Loans frequently come with an ‘interest cover’ covenant. This is a maximum ratio of debt to earnings and a minimum ratio of earnings to interest costs which must be honoured. Some housing associations may be coming close to those covenant levels. All of this leaves leaders at associations needing to question the affordability of the interest bill on any sum of money borrowed.
- Strained balance sheets – some housing associations, particularly those with large-scale development plans, are operating with much more investment. This work is going on against the backdrop of increased inflation levels and lower grants from central government. All this leaves questions about whether it is sustainable to load balance sheets with the debt needed for the development of new homes or retrofit work.
A report published in August 2023 by Octopus Real Estate explored the situation, including through a survey with Inside Housing. Respondents said the three biggest barriers to realising development plans were:
- Construction costs
- Interest rates
- A need to refocus on existing stock
What are the challenges with associations taking on debt to finance the development of new homes or to improve existing ones?
For debt to be a viable option for the sector, it needs to be:
- Available
- Repayable
- Affordable
Availability is not a significant issue at present. When money is being used for development, repayment is not necessarily an issue either. Given the sector is using debt to build an asset, that asset will have value, which can be used to refinance or settle the debt when repayment becomes due.
It is the affordability of debt which is increasingly the challenge.
What are the current advantages and drawbacks of specific methods of debt?
Bank funding
Benefits
- Flexibility through revolving credit facilities – ie it is possible to withdraw money, use it to fund development, repay the loan, and to then withdraw it again when needed
- Can be cost effective
Drawbacks
- Typically comes with covenants
- Normally short term, so has to be refinanced on a fairly regular basis
- Usually on a variable interest rate, which leads to interest rate risks
Capital markets finance
1. Own-name public bond (these are bonds issued directly by housing associations themselves, rather than through a special purpose vehicle)
Benefits
- Generally no financial covenants and no restrictions on the likes of mergers
- Probably the lowest cost of any long-term debt option for social housing organisations
Drawbacks
- There may be high fixed costs involved in issuing the bond, and it is resource intensive
- Need to raise hundreds of millions as debt, as those investors that would hold own name bonds issued by housing associations only focus on larger deals
2. An aggregator (these aggregate and source large amounts of capital from the bond market, enabling the provision of loans with the terms but not the scale of a public bond)
Benefits
- Has most of the features of a public bond, but without the need for an individual organisation to raise hundreds of millions of pounds of debt
- Less resource intensive and opportunity to share fixed costs
Drawbacks
- There are management fees involved in using an aggregator, so it may not be as cheap as a public bond
3. Affordable Homes Guarantee Scheme (the government-backed loan scheme available for social housing development and upgrade in England)
Benefits
- Lowest-cost funding option of those available
- An additional £3bn of funds was committed to the scheme in February 2024
Drawbacks
- Application process can be time-consuming
- There are covenants and other terms and conditions. These can include specifying development schemes. This means that, to access money, the housing association has to submit a list of the development projects that the money will be used to fund, regularly report progress on those projects, and have shovels in the ground within three years of the money being lent
Private placements (a social landlord issues debt securities – loans the issuer is obligated to repay with interest – directly to small number of private investors)
Benefits
- Can offer flexibility on tenor (the length of time remaining before a financial contract expires)
- May be possible for the provider to tailor their requirements for specific needs
Drawbacks
- May need extra terms and conditions compared to public bonds, and even covenants
- Usually more expensive than public bonds. There is no one ‘best’ option for debt funding. Which method is most appropriate will depend on the nature and circumstances of an individual organisation.
The increasing importance of interest cover covenants
Loans can come with a variety of covenants. These are specific terms that require or restrict how a borrower can behave, or the circumstances in which it is allowed to find itself.
One of these covenants often relates to what is called interest cover. Borrowers must meet a maximum ratio of debt to earnings and earnings to interest costs.
There are different types of interest cover tests but, historically, lenders have used the EBITDA MRI (Earnings Before Interest, Tax, Depreciation, Amortisation, Major Repairs Included) interest cover. EBITDA MRI seeks to measure the level of surplus that a registered provider generates compared to interest payable.
The urgent requirement to address building safety in the aftermath of the tragedy at Grenfell, and the need to invest in decarbonisation, means that the capital expenditure of many social landlords has increased in recent years. This in turn makes an EBITDA MRI interest cover more challenging to meet, and could affect organisations’ ability to borrow money and to invest in improvement works. It is crucial that thought is given to the type of interest cover test agreed with lenders.
Are there forms of capital other than debt which could help meet the sector’s needs?
Given the challenges over balance sheets, there are questions over whether the for-profit sector might be able to offer types of capital beyond debt. This could enable organisations to pursue development and improvement plans in a way that might be more financially sustainable.
In 2022, research by the British Property Federation (BPF) and Legal & General concluded that there will be a shortfall of 95,000 affordable homes if a new funding structure is not developed.
In the Regulator of Social Housing’s most recent Sector Risk Profile, it is noted that: “While debt accounts for the majority of providers’ funding, alternative models have become increasingly prevalent in the sector. An increasing number of private investors have looked to invest in social housing products.”
What are the main alternative funding models at present?
‘Equity partnerships’ are enabling some social landlords to secure additional capital, avoiding the current issues with increasing their debt capital. These arrangements can take several forms. They unite traditional, not-for-profit social housing organisations with newer, for-profit registered providers of social housing. The associated capital can make it possible to deliver or expand development and retrofitting programmes. Some argue a further benefit is that it allows each party to capitalise on its strengths and areas of expertise, leading to a better overall experience for residents.
Equity partnerships can see partners buying ownership stakes in a company or venture – with different investors purchasing equity to become shareholders. This compares to debt capital, which involves borrowing money from investors or institutions, but those investors do not have ownership rights.
A report from the BPF outlines some of the possible set-ups for such collaborations:
- A for-profit owns a property, but outsources its day-to-day management to a housing association
- A for-profit owns the property, but leases it to a housing association
- The housing association sells assets to a for-profit
- An ownership joint venture between the for-profit and housing association
With new stock, it could be that a for-profit directly invests in such property. Alternatively, there could be development joint ventures with housing associations.
Are there potential drawbacks to these alternative funding models?
In its most recent Sector Risk Profile, the Regulator of Social Housing emphasised that alternative funding models “can bring their own risks”.
It noted that while private investment “has allowed some providers to target rapid growth in units under management”, the funding has the potential to be more expensive than debt. It also expresses concern that managerial capacity may not be able to keep pace with such growth.
Speaking at the National Housing Federation Treasury in Housing conference in October 2023, Will Perry, director of strategy at the RSH, argued the approach is not a “panacea” for tackling the housing crisis. He urged social landlords to take account of potential risks.
“It is in some ways even more challenging than debt because getting equity involved will involve ceding more control,” he said. “And it will involve a greater level of expected return, at some point in the process – the two go together. Equity will be taking more risk and it will expect more return than simply lending you some capital for a little, while expecting a return and then getting it back at the end. The dynamics of that relationship are going to be different.”
He concluded: “There are plenty of providers for which getting involved with equity or getting involved with partnerships would be a very bad idea because it’s just not the right solution to the challenges that they face.
“The important thing is figuring out what your organisation needs to do to deliver its objectives, how they align with potential partners, understanding the economics and the risk/return dynamics of it and the contingencies if it doesn’t all play out quite how you intended.”
Even those who are advocates of equity partnerships are clear their creation requires due care and attention from each party. The BPF highlights the need for careful selection of a partner, based on factors including reputation, financial position and track record.
What will social housing finance leaders consider when making decisions about funding options?
There is no one universal best approach to funding. Individual leaders will need to consider the specific make-up and circumstances of their organisations.
What does remain uniformly true, however, is the need to carefully review how a funding choice works for an organisation, not only in the here and now but into the future.
Boards must understand the funding decisions they are making, drawing on advice from sector professionals where appropriate.
Areas to reflect on
- What do you think would be the key factors at play when considering the best funding options for your own organisation? Are there models which would be particularly well suited, or particularly poorly suited? Why?
- What are your personal reflections on equity partnerships? Do you think they present a promising avenue, or do you have reservations? Does your view depend on the type of organisations involved?
- What one point in this piece do you want to share with colleagues who may not have read it? How will you share it?
Summary
The current financial environment presents potential funding challenges to social landlords.
This is particularly problematic at a time when there is a desperate need to build more homes, and to improve safety and energy efficiency in existing stock.
Debt capital does often remain a viable option, but one which involves more complex considerations than it perhaps once did.
Alternative funding models are increasingly being used, yet are not without risk.
What remains clear is that there are challenging decisions to be made on how best to finance social housing, both within individual organisations and at a national level.
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