HC 1652 Communities and Local Government CommitteeWritten evidence submitted by the Tenant Services Authority (TSA): the social housing regulator

1. Executive Summary

1.1 The social housing regulator has been asked to provide written evidence to the inquiry covering:

1.1.1The impact of the Affordable Rent model on housing association capacity and financial stability, and tenant affordability

1.1.2The role of historic grant, and the possibility of converting this to equity

1.1.3The impact of the welfare reform agenda on housing association capacity and stability.

1.2 The economic regulation functions of the TSA, relevant to the subject matter of this inquiry, are continuing and will be delivered by a Regulation Committee of the Homes and Communities Agency (HCA) from April 2012.

1.3 The Private Registered Provider (“PRP” commonly referred to as Housing Association) sector came through the recent credit crunch and recession in good shape and remains financially stable with capacity for development.

1.4 Based on its review of Affordable Rent bids the social housing regulator is of the view that the current Affordable Rent programme should not of itself prejudice the viability of the sector or of individual providers, although participation in the scheme means that providers need to manage a broader range of risks effectively.

1.5 One of the key constraints on the future development of the Affordable Rent product beyond the current programme is the impact of gearing covenants in loan agreements. New forms of financing and constitutional structures that avoid problems with covenants are being developed but the situation needs careful monitoring. It is important the new solutions do not import unnecessary additional risk.

1.6 The social housing regulator is of the view that the possibility of converting grant to equity, as proposed by some providers, will not have a transformational effect on the capacity of the sector. It may give some providers access to finance in the short—to medium—term but more work is required to understand the potential downside effects.

1.7 Welfare reforms are likely to introduce risks to the rental income stream of PRPs. It is too early to say what the full range of impacts will be but the initial view of the social housing regulator is that providers should be able to continue to meet the regulator’s viability standard. However, changes may compound existing risks, and there will be a premium on providers managing their exposures effectively. Reforms may also reduce the financial capacity of PRPs, including to invest in new development. Risks would be compounded if lenders factored them into the price and/or longevity of future debt.

1.8 More generally, the current economic environment means that PRPs need more than ever to understand and manage risks to their business plans. Affordable Rent and welfare reform introduce specific risks that need to be managed alongside these broader risks and it is important that providers understand the cumulative impact of downside risk and not think about issues in isolation. The core business of economic regulation of the social housing sector is to work with providers to ensure these risks are being managed.

2. Background: economic regulation, viability and capacity of the sector

2.1 The Tenant Services Authority (TSA) is the independent regulator for social housing in England. Following the Government’s review of social housing regulation, the TSA will be abolished and its economic regulation and a reactive consumer regulation function transferred to the HCA in April 2012. The TSA is currently consulting on its revised regulatory framework. In order to ensure the continued independence of regulation, these functions will be vested in a statutory committee within the HCA, legally separated from HCA’s investment functions and with its membership appointed by the Secretary of State. The Chair of the Regulation Committee has been appointed.

2.2 The TSA’s current economic regulation role, which will largely be carried forward into the HCA focuses on the financial viability and governance of PRPs. In the future the regulator will have an enhanced role in respect of the value for money of PRPs. This brief therefore concentrates on the capacity of these providers.

2.3 PRPs own around 2.5 million homes, with a gross book value of £101 billion and a significantly higher market value (commentators of the housing market have estimated a value of circa £300 billion). This is financed by £40.4 billion grant and £42.8 billion debt. Most of the debt is long-term and from banks. The sector has £12.4 billion undrawn facilities, although much of this is debt arranged to fund Large Scale Voluntary Transfer (historically transfer of council stock) business plans and so is not available for general development. This debt is off the public sector balance sheet as Housing Associations are independent organisations that take a variety of constitutional forms. The sector Global Accounts 2010 show surplus after tax in the sector of £609 million on a turnover of £12.3 billion.1

2.4 The sector has grown from 600,000 units in 1990 to 2.5 million units in 2011, mostly through a combination of stock transfer (c.800,000) and new development.

2.5 The sector has come through the credit crunch in good shape. There were significant issues—notably unsold low cost home ownership stock and cash/collateral exposure on interest rate swap deals, but these were successfully navigated through a combination of flexibility on grant, effective risk mitigation in PRPs and regulatory support.

2.6 No lender has ever had to enforce their security on a loan with a regulated provider. However, the banks who lent to the sector ahead of the credit crunch did so on generous terms and typically the loans are no longer economic for the banks. This is limiting the ability and willingness of the sector’s traditional funders to continue to supply long term loans to social housing providers.

3. Affordable Rent

3.1 The traditional development model has involved units being funded by a combination of grant, debt and finance from other sources with grant contributing around half of the total. Units were typically offered at significantly lower than market levels, although the gap between social and market rents varies considerably between localities. In more recent years capacity has been augmented by planning gain (S106) contributions and some cross-subsidy from shared ownership and outright market sale.

3.2 Affordable Rent is a different model. Grant accounts for around 20% of the funding for new units. The capacity to service the debt on the rest of the costs of a new home comes from higher rents (up to 80% of market) on the new home, and the ability for providers to convert some existing units to a higher Affordable Rent, or possibly to dispose of some units, increasing debt-servicing capacity. In addition PRPs are still able to use the means of cross-subsidy referred to in paragraph 3.1 above.

3.3 TSA examined all Affordable Rent bids and advised the HCA on whether they were consistent with each bidding PRP’s ongoing viability, one of the key requirements of the regulatory regime. All of the bids met this test, although in a few cases the regulator highlighted particular risks and exposures, which the HCA took into account when making allocations. The regulator is monitoring the PRPs concerned more closely as a result.

3.4 Over the longer term (most likely beyond the lifetime of the current programme) there may be issues to be managed with Affordable Rent as a model of new supply. Whilst the model, with its higher rents, does not create new problems with interest cover requirements (ie that providers have sufficient free cash to meet their interest payments), which is traditionally the key constraint on PRP finance, it does impact on gearing covenants where they exist in loan agreements. Gearing covenants in this sector are typically set with a ratio of debt to equity of 80% where equity is interpreted as grant plus surpluses. Over time participation in the programme will lead to higher gearing, and where gearing or similar covenants exist reduce borrowing headroom. Ultimately (beyond 2015) this is likely to mean some PRPs could need lender approval to take on more debt for development.

3.5 The potential need for lender approval because of gearing is a particular issue given that lenders are typically losing money on existing deals, which were priced at pre-credit crunch levels (c 30–50bps above LIBOR) with a borrowing term of 30 years. It is now common for new bank lending to be both at much higher margins (c 150–200 bps) and for the term to be five or at most 10 years. At the same time lenders are looking to reprice existing debt whenever an opportunity arises, eg if more finance is required or there is a change to the risk profile of the borrower through, for example, a new group structure.

3.6 The regulator is analysing the impact of this, which is not straightforward. Some associations are unconstrained by gearing covenants, for others covenants may prove a significant constraint by the end of this Spending Review period. Of itself this may not stop further development by those PRPs affected as there may be ways they can take on more debt without breaching covenants, although this could mean taking on risk in other parts of their businesses. The sector is already diversifying its sources of finance through bond issues but also other innovative ways of funding including private finance raised through institutional investors. In addition there is growing capacity in the LSVT sector, although because of typical covenant structures for LSVTs they will struggle to access this without having to look at potential repricing of existing debt.

3.7 Another important risk to the Affordable Rent model is the impact of its link to market rents, which may go down as well as up. The main impact of this for PRPs is that they need to more actively manage their exposure to rental markets.

3.8 The two points mentioned above indirectly relate to the issue of tenant affordability. Rent policy is largely a matter for DCLG. The regulator’s standard on rents—and specifically the parts of the standard relating to Affordable Rent—is subject to a direction from the Secretary of State. The regulator has not looked directly at the affordability of future rents. It is however looking at the changes in terms of their impact on future viability, as per the above discussion and commentary that follows on changes to housing benefit.

3.9 Overall, at least at this point, risks to viability are manageable, and it is highly unlikely that Affordable Rent would of itself prejudice viability, although it could compound other viability risks. However, its impact in the longer term remains to be determined, but the need to raise more finance, combined with the reduction in traditional bank funding, is already causing providers to look at new and innovative financing proposals.

4. The role of historic grant and the possibility of converting this to equity

4.1 Grant reflects the subsidy needed to offer a unit at sub-market rent, and is in effect the price Government pays to secure a lower rent and a unit as part of the regulated sector. For the majority of the sector the balance sheet valuation of social housing assets is historic cost less grant.

4.2 Grant is obviously important to the financial position of PRPs: as set out above, grant is fundamental to the gearing of providers and forms a key part of their asset base. However, lenders typically value stock as security on other measures based on rental income (Existing Use Value or market value Subject To Tenancies).

4.3 The fundamental constraint on the sector is the availability of revenue (cash) to service debt. The writing off of historic grant would have no bearing on this, as it would not generate any additional cash flow. If it was in some way replaced by equity, unlike grant this would need to be serviced with a return for the investor.

4.4 The main reason some PRPs are interested in writing off grant and converting it to equity is to address gearing constraints highlighted above thereby potentially increasing the headroom to borrow more without revisiting existing loan agreements. Propositions that involve writing off grant to allow it to be converted to equity will not transform the sector’s development capacity as a whole although a few individual providers may free up more capacity. They would also have as yet unknown consequences in terms of balance sheet valuations, which may not be positive. These propositions would also have wider ramifications—for example:

4.4.1the system of recycling grant on sales plays an important part in funding new homes across the sector as a whole, which is facilitated by the regulator’s role in granting consents to disposals (sales of properties outside of the sector).

4.4.2There are legislative barriers to converting a not-for-profit PRP to a for-profit PRP, which may be relevant to these proposals.

4.4.3PRPs would need to consider whether the costs of offering an equity return—which may be higher than conventional debt—outweigh the potential initial increase in capacity.

4.5 The regulator’s current view is that more work is needed on equity conversions, and that there are a number of barriers and risks to address. If these are managed successfully, in certain circumstances equity may help unlock capacity. However, since the major constraint is still cash to service debt, this is unlikely to have a transformational effect.

5. The impact of the welfare reform agenda on Housing Association capacity and stability.

5.1 To date housing benefit has underwritten rent on social housing properties in full. Typically provider receive 53% of their total rental income from housing benefit (reflecting the general socio-economic characteristics of people who access social housing) much of which is paid directly to providers.2

5.2 The principal (though not only) changes to welfare that could affect the sector are:

5.2.1reforms relating to levels of benefit paid where social housing is “under-occupied”.

5.2.2reforms capping benefits.

5.2.3introduction of universal credit and the possible end of the system of direct payment of housing benefit to landlords

5.3 The impact of these measures in isolation, and together, is not yet clear, not least because not all the policy and practical issues are settled. In broad terms the ultimate risk to PRPs is a weakening of the relationship between rent and benefits leading to an increase in levels of non payment of rent.

5.4 It is very difficult to model the impacts on PRPs accurately, as much rests on assumptions about the behaviour of tenants and the ability of landlords to mitigate risks effectively (eg by putting in place measures to prevent arrears arising or dealing with cases swiftly if they do build up). There are also important geographic and other differences which means providers will be affected differently. In broad terms under-occupation changes could have a bigger impact in the North, whereas the impact of the benefit cap is more likely to be felt by PRPs in London, the South East and the East of England.

5.5 Initial work by the regulator suggests that welfare changes will not, of themselves, typically undermine the viability of PRPs, but will mean that PRPs will need to carefully manage their exposures. Welfare reforms do compound existing risks, and may be more problematic for some PRPs. Any loss of income would have to be managed by PRPs, and would typically lead to some combination of reduced development capacity, reduction or slippage to major repairs, or reduced community activities.

5.6 It is vital that risks to lender confidence as a result of welfare reform are managed effectively, given the sector’s need to attract more debt, including in the region of £7 billion to finance the development of new Affordable Rent homes. Lender concern about future risks could affect the price and availability of future debt, which in turn would also erode the sector’s financial capacity.

6. Concluding Comments

6.1 More generally as a result of the current economic environment but also as a result of the Affordable Rent programme and proposals on welfare reform, PRPs are facing an increased range of risks that they need to manage. One of the key roles of the social housing regulator’s economic regulation function is to understand and engage with providers on their management of these risks. PRPs are exploring a range of solutions to enhance their capacity in the longer term but more work is required in the sector and with the regulator to understand the downside risks of these proposals.

January 2012

1 Source: 2010 Global Accounts for housing providers (TSA)

2 Source: English Housing Survey 2009-2010

Prepared 1st May 2012