HC 1652 Communities and Local Government CommitteeWritten submission from Waterloo Housing Group

Executive Summary

1. This submission to the Committee is from Waterloo Housing Group (“WHG”), a housing association registered provider (“RP”) and one of the largest developers of affordable housing in the Midlands.

2. RPs’ development activity is currently constrained by a heightened need to maintain margins of comfort over bank loan covenants, in order to avoid re-pricing of the substantial amount of low cost debt finance on balance sheets. In consequence, surpluses earned from property sales activities, an important element of development project financing, cannot be exploited to the maximum potential and sales risk exposure in general must be reduced.

3. Better use could be made of the £42 billion of public Social Housing Grant (“SHG”) embedded in RP balance sheets. Controls on historic SHG should be removed, or grant should be converted to equity, to enable RPs to release property equity and attract more flexible private finance for the provision of additional affordable housing.

4. Using new RP controlled entities, new SHG allocations could be leveraged with both private equity and debt to sustain or increase housing output at current SHG rates. The obligation to repay SHG on sale of a grant funded property should be subordinated to equity investors’ interests as well as that of secured lenders, with returns on equity restricted in return for this concession and consequent much reduced investment risk. A real terms equity return of around 5% p.a. on 20% project equity finance would, combined with current levels of SHG, enable the current programme of mixed tenure housing to be sustained beyond 2015.

5. Taxpayers should expect a return of over £2 billion per year on SHG invested in RPs since 1974. The Homes and Communities Agency (“HCA”) should be empowered to collect this return in cash from RPs that are unable or do not wish to use their financial capacity, with proceeds directed to those best placed to invest.

6. The current HM Treasury review of Real Estate Investment Trusts (“REITs”) should, combined with SHG reforms, create a framework that RPs can engage with to release property equity, attract more private finance, and provide more new homes.

7. RPs should be empowered to provide more flexible forms of shared ownership housing which ought to remain eligible for SHG support and be capable of attracting private equity investment in order to better meet prospective home owners’ needs and to circumvent the current lack of affordable mortgage finance.

8. Local authorities and other public bodies should be incentivised to work in partnership with RPs by releasing land for development and deferring payment so as to better match this with scheme sales cash flows. These arrangements enable RPs to increase their output of new homes, potentially with lower levels of SHG.

9. Some legal restrictions placed on RPs created to receive the voluntary transfer of local authority housing serve no useful purpose given that these mostly charitable bodies are already highly regulated; their removal would help increase the supply of new housing by enabling the true value of housing stock to be used to secure loans.

About the Submitter

10. This submission is made by Waterloo Housing Group Limited. The Group comprises four charitable housing associations (“Registered Providers—RPs”) that together own or manage 18,000 homes across the Midlands region.

11. The Group is a long established major developer of new affordable housing with a significant annual output of new homes from our mixed tenure programme. We have received the largest single allocation of SHG (£39 million) in the Midlands, to develop 1,645 new homes over the period to March 2015 and will supplement this with other initiatives to provide additional housing in the region.


12. RP housing development activity has typically comprised a mixture of housing tenures: predominantly social rent, shared ownership and outright sale with surpluses earned on the latter two categories used to cross subsidise the capital cost of the former. For many years now SHG received has not been sufficient to finance the provision of new social, now affordable rented housing without these cross subsidies.

13. Since the introduction of mixed public and private financing of RP housing development under the Housing Act 1988 the SHG component of scheme financing has progressively declined and RPs have responded by increasing their private debt levels.

14. Prior to 1988 RP balance sheets contained a modest amount of publicly funded loans for housing development, with most of the cost of housing property assets funded by SHG. This balance has now changed although many RP balance sheets record substantial levels of SHG received over the years, eg WHG’s £750 million gross cost of housing properties has been part financed by SHG: £310 million and loans: £370 million.

15. To date, the bulk of RP debt has been provided on a long term basis by banks and secured on housing property assets. RPs are obliged to adhere to a range of fairly conventional loan covenants in order not to default on their funding agreements. These covenants serve to limit the amount of additional debt RPs can take onto their balance sheets. The most important covenants which act as limiting factors on business growth are interest cover and gearing.

16. RPs’ core rental activities generate predictable and stable cash flows and it is fairly straightforward to forecast interest cover covenant compliance with considerable accuracy if reliance is placed only upon this income. Property sales cash flows are inevitably less predictable and much more volatile, so this income is often excluded from interest cover covenants agreed with banks. Even if not specifically excluded, prudent financial management requires that no reliance be placed upon such cash flows to meet loan covenants.

Graph 1


17. Prior to the 2008 credit crisis bank finance was readily available at low cost. Since the crisis and the related material increase in banks’ wholesale cost of funds, most existing loans to RPs are now unprofitable for lenders. Whereas prior to 2008 breach of a loan covenant could often be remedied by negotiation with the relevant lending bank at no or minimal cost, now it can be expected to result in very expensive re-pricing of existing debt with a potentially serious impact on capacity to provide new housing. Debt re-pricing from historic to prevailing market levels could easily eradicate most, if not all, an RP’s annual surplus. In consequence, RPs now take a more risk adverse approach to development growth, with increased comfort margins to allow for the uncertainty inherent in the process.

18. Most bank loan covenants operate at a corporate, whole business, rather than project level. A typical viable mixed tenure new housing development will, alone, fail to deliver financial performance that can meet these corporate interest cover and gearing tests. It is normal for schemes to record deficits in the early years after construction, offset by later years’ surpluses. An important feature of the business therefore is that new housing developments require cross subsidy from surpluses and balance sheet capacity generated by other, mature assets in order to meet corporate loan covenant levels.

19. From the above it can be deduced that the maximum sustainable level of new housing development for any RP is a function of both the cost, tenure mix and funding of new projects, along with the strength of the existing business and its capacity, through surpluses generated, to sustain normal early years deficits on new developments.

Graph 2


20. Our recommendations for action reflect this operating context for RPs.

21. As discussed below, in furtherance of its objectives, we believe that the Committee should recommend action that seeks to:

enable RPs more fully to exploit property sales revenues at an earlier stage, without prejudicing loan covenant compliance;

attract equity finance into the RP sector;

make better use of historic Social Housing Grant on RP balance sheets;

increase the range of home ownership options offered by RPs;

encourage public sector bodies to provide land in support of RP development; and

remove some restrictions placed on stock transfer RPs.

Recommendations for Action

Attracting private equity to finance new house building

22. SHG is repayable to the Homes and Communities Agency (HCA) if a property part funded by grant is sold; although repayment is not required if the grant is recycled for an approved purpose, usually the provision of a new affordable home in replacement of that sold. This obligation to repay or recycle SHG is subordinate to the interest of a secured lender, which has served to help attract private loan finance into the sector. In a default scenario the secured lender has a priority call on all the proceeds of disposal; the HCA is only repaid if the residual sale receipts are sufficient.

23. We propose that repayment of SHG should also be subordinated to the interest of equity investors or, potentially, providers of subordinated debt, with such finance raised via new subsidiary entities—probably companies limited by share capital—majority owned by RPs or RP controlled entities (this would need to be structured appropriately to ensure that consolidation of financial results does not create loan covenant breach within the RP). Equity investors and providers of subordinated debt would rank behind secured lenders in their ability to call on SHG to recover their investment after any default. Returns on equity should be capped as a condition of grant deferment, to reflect the nevertheless much reduced investment risk associated with this structure, effected via the HCA contract for SHG allocations. The RP would remain accountable to the HCA for the grant.

24. Given normal long term market value growth trends, at least in line with earnings, these vehicles could be re-financed in due course with SHG repaid to the HCA for recycling and with restrictions on equity returns removed, subject to protection of tenants’ interests. The residual RP role might eventually just be that of property manager.

25. Based on our operating experience in the Midlands region, we estimate that if up to 20% of future long term project finance was derived from equity, with post tax real terms returns capped at around 5% p.a., we could at least sustain and potentially increase output of a conventional tenure mix of new housing development at the same SHG levels as allocated to us under the 201115 National Affordable Homes Programme. The market for this type of comparatively low risk equity investment would need to be tested in detail, but the working assumption of a return higher than the cost of bank debt but lower than conventional equity appears reasonable in relation to alternatives, particularly for more risk adverse investors.

26. Increased housing output is achievable because equity would be used to absorb the risk associated with the timing of property sales cash flows on the circa 15% of the development mix consisting of properties built for outright sale and 40% built for shared ownership. Loan covenants on core debt finance (up to 60% of development scheme funding) would be comfortably met from cash flows on the affordable rent properties developed, which would comprise around 45% of overall output. In this model equity returns would be closely related to the timing of property sales receipts, so investors would need to be prepared to accept some volatility in the timing of dividends.

Making better use of Social Housing Grant on RP balance sheets

27. As others have already observed, SHG on RP balance sheets is a “sunk cost”; it has served its primary purpose of funding the provision of new homes.

28. Input of SHG to finance a social or affordable rented property should produce a gross rental yield in the region of 4% to 5% on investment cost, depending upon the relationship between cost and value and rental tenure type, with a net cash yield, after operating costs but prior to loan financing charges, of at least 2% to 3% indexed in line with annual increases in RPI.

29. Given that SHG represents taxpayers’ investment in RPs it is reasonable to expect this level of return on the £42 billion of historic SHG allocated since 1974. The taxpayer ought currently to expect a net return on investment in excess of £2 billion p.a., after RPI indexation.

30. RPs can legitimately claim that an acceptable return is being demonstrated when they are exploiting their balance sheet capacity to maximise the new provision of affordable housing, with surplus net operating cash flows after interest re-invested in housing developments and key financial ratios maintained at prudent, but not excessively strong levels. Some analysis and debate is required in the sector to determine what level of interest cover and gearing might be considered excessively prudent, after having due regard to RPs’ pipeline financial commitments, therefore potentially indicating under-exploitation of financial capacity. It is important to understand the underlying trend of the business in making these assessments.

31. The global accounts of housing providers 2010 (Source: Tenant Services Authority) demonstrates that there is considerable variance between RPs in key financial measures such as interest cover and operating margin on an aggregated basis (eg interest cover varies from 103.5% at the lowest quartile, up to 246.5% at the highest) with some of the strongest interest cover ratios amongst the smaller RPs, many of which take a more conservative approach to development and use of private finance.

32. In cases where surpluses are not being re-invested in new provision and/or financial ratios are deemed to be excessively strong, it would seem reasonable for the anticipated return on SHG to be paid in cash to the HCA for distribution as additional grant to RPs that are better placed to invest. This approach would not threaten the independence of RPs but would make explicit the obligation to achieve optimum use of their publicly funded capacity. Real resources would be released through this approach, without any change in public sector borrowing. A consideration of the comparative value for money of RPs’ services would also need to feature in the capacity assessment; consensus is needed in the sector as to how much it is appropriate to invest in enhancing existing services to current customers as opposed to the provision of new homes.

33. Even more new housing output could be achieved if restrictions associated with historic SHG on the balance sheet could be removed, or if grant was to be converted into a form of equity, so that the full potential of housing assets to provide collateral could be exploited, including through sale to non RP vehicles able to attract private equity. HM Treasury’s current proposals for relaxing some provisions governing the operation of Real Estate Investment Trusts could potentially make these vehicles suitable for increased delivery of affordable housing, particularly if regulations governing REITS can be amended to accommodate the required RP development mix of housing for both sale and long term rent.

34. Our indicative model of a REIT structure suggests that for each existing housing property of an appropriate type and age sold into a REIT portfolio for affordable rent, sufficient surplus proceeds could be released to provide the equivalent of at least the current level of SHG funding towards a replacement property. A one for one replacement of properties could be achieved, therefore, without any additional SHG.

Increased home ownership options

35. Many households are unable to access home ownership due to the current lack of mortgage finance; this problem currently also impedes RPs’ shared ownership and outright sales activities.

36. In addition, the current shared ownership product eligible for SHG support offered in the sector has a number of limitations: the minimum equity purchase is 25%; many otherwise eligible applicants struggle to fund deposits required by mortgage lenders; RP initiatives to help finance deposits are not accepted by mortgage lenders; the leaseholder takes on a full repairing lease irrespective of the share of equity purchased; and subsequent purchases of equity tranches are for a minimum 10% each time. We would suggest that the same level of SHG should be made available to fund a more flexible form of shared ownership product.

37. We have developed an “incremental ownership” model which we believe addresses the above shortcomings and offers real benefits as a new route to affordable home ownership. The key features are as follows:

low initial minimum equity purchase of just 5%;

initial cash deposit set at 5% of equity (equal to the minimum purchase);

combined rent and repayment mortgage, a single charge, with all funding provided by the RP;

a higher rent than under conventional shared ownership but total outgoings (mortgage, rent and maintenance) initially within 80% of market rent;

total housing costs remain within 35% of applicants’ net income;

small incremental increases in equity shares—as low as 1% at a time;

ability for the purchaser easily to reduce as well as increase equity owned; and

a proportionate repairing obligation, pro-rata to equity purchased.

38. Various FSA and HCA regulations would need to be amended to accommodate this type of home ownership model but, if achieved, we are confident this product would provide a useful additional option alongside conventional shared ownership, helping to circumvent some of the obstacles of the current mortgage lending market and increasing access to home ownership. The model would also be suitable for part funding with private equity to supplement available SHG and increase total new housing supply.

Provision of public sector land

39. Waterloo Housing Group has forged mutually productive partnerships with local authorities whereby land is made available to us on a deferred payment basis. Payment is made over various periods after developments have been completed, designed to reflect the characteristics of scheme financial performance (paragraph 18). As planned sales are achieved, or scheme cash flows mature to the point where expected corporate loan covenant performance levels can be met, land payments are made to the local authority.

40. These arrangements enable us to produce materially more housing than would otherwise be possible, and with lower SHG levels. Local authorities benefit from both nominations to new housing and generation of New Homes Bonus income, some of which has been allocated to us as additional scheme subsidy, thereby further stretching limited SHG.

41. We would request that the Committee recommends local authorities should be encouraged, preferably with incentives, to promote many more such land partnerships with RPs. Incentives should be targeted at both District and County level authorities as it is now often the upper tier authority that holds most developable land. Other public bodies should also be encouraged to work with RPs to release value in their land holdings, using this land to provide more housing.

Controls over transferred local authority housing stock

42. Many larger RPs have been created since 1988 in order to receive the large scale voluntary transfer of housing stock owned by local authorities. These stock transfers have successfully raised a substantial amount of private finance and delivered major improvements to tenants’ homes. The businesses also have the long term potential to apply their financial capacity to developing new homes. However the transfers are subject to legal restrictions, including the Secretary of State’s control over stock disposals, which serve to depress the loan security value of ex local authority owned housing properties.

43. Extra value could be obtained from this housing stock if statutory and contractual controls over dealing in the transferred properties, rather than those intended to protect tenants’ rights, were removed. A removal of restrictions would enable most stock transfer RPs to fully exploit their latent strength by raising borrowing in line with their debt service capacity. As highly regulated, mostly charitable bodies, it appears unnecessary to retain much of the current legal framework applicable to these stock transfers.


44. Our recommendations in this submission are based on our practical experience as major developers of new affordable housing in the Midlands. Much more work is required to produce models that can be implemented and investor appetite would first need to be market tested for the type of low risk equity investment proposed. We believe that increased housing output is achievable with these new models. In addition to meeting more of the high demand for affordable housing, increased RP led construction activity would clearly provide a very welcome stimulus to the wider economy.

October 2011

Prepared 1st May 2012