Author: Georgie Knight

As housing associations’ finances come under increasing pressure, how much will unsecured borrowing have a part to play? Gary Grigor of Devonshires and John Tattersall of Centrus Financial Advisors assess the situation

The housing sector has been hit by a number of challenges in recent months. What began as a cost inflation challenge quickly became a more acute operating margin challenge in the face of unspecified caps.

With borrowing costs now far higher than originally forecast, interest cover covenants are coming under increased pressure. 

The pan-sector response is still in development, but capex is likely to slow in the short term and efficiency savings will be needed.

Liquidity requirements are likely to fall too, as the temptation to reduce facilities and save carry costs to optimise interest cover performance appeals.

This strategy has risks, though, particularly where it takes time to put new facilities in place should requirements pick up again.

It is in this context that unsecured borrowing may have a strategic part to play.

Unsecured borrowing allows registered providers (RPs) to dispense with providing and maintaining a ring-fenced pool of property security either via a security trust mechanism and/or direct charging to the relevant funder.

Instead, the organisation must maintain a pool of unencumbered assets for the life of the facility. The upside of this is that the time, effort and expense associated with pledging a ring-fenced pool of property security under conventional funding arrangements is dispensed with, paving the way for a quicker and more decisive funding solution.

Unsecured borrowing can also be scaled up and down far quicker than conventional secured funding.

While an unencumbered pool of assets must be preserved at all times, there are not the same rigorous due diligence requirements to be satisfied.

Provided that the unencumbered assets stack up to meet the minimum threshold from a valuation perspective, then that, in itself, will be sufficient.

As a result, the composition of the unencumbered property pool can also dynamically fluctuate over time, facilitating easier asset management and offering protection should asset values fall, as potentially forecast next year.

The Pros and Cons

Pros

• Speed of execution: With no security charging process, facilities can be executed and available comparatively quickly. They can also be restructured and re-sized with greater ease. Unsecured facilities can offer strategic value where a debt capital markets programme is in train, but the timing is not quite right to launch.
• Flexibility: Release and substitution mechanics do not apply, so managing the unencumbered asset pool is generally straightforward – helpful where stock rationalisation is under way.
• Sweating the asset pool: Most portfolios have assets that wouldn’t otherwise be acceptable to a funder yet can still generate borrowing capacity via the unencumbered pool.

Cons

• Cost of carry: Margins and fees tend to be higher for unsecured facilities, albeit the differential to secured facilities has meaningfully narrowed in recent years, particularly on an undrawn basis (as low as five to 10 basis points per annum in some cases).
• Shorter tenor: To further offset the cost difference, most unsecured facilities tend to be structured on a three-year term, if with annual renewal/extension options sometimes available.
• Overall asset cover efficiency: Higher asset cover ratios tend to apply in sizing the unencumbered asset pool rather than would otherwise be expected on charged security.

We have advised on £540m of unsecured facilities in the past 12 months, and in several instances, facilities have been scaled up with the additional funding available in less than three weeks from the initial request.

Who should be thinking about it?

Funders will, of course, make decisions on a case-by-case basis, but in our experience, it is likely that an RP with the following would potentially benefit from this financing route:

• Reasonable scale: lenders have a strong preference to be one among many lenders, which favours larger treasury portfolios
• A strong credit profile – potentially supported by an external rating with a rating agency
• A diverse loan portfolio, which is looking to ‘right size’ liquidity, while baking in flexibility and the ability to scale dynamically if needed
• A big enough pool of residual unencumbered assets seeking to ‘sweat their assets’ more efficiently

The providers

While initially led by some of the newer entrants looking to make a footprint, most commercial funders will now entertain the prospect for the right RP.

In debt capital markets, some institutional investors have also demonstrated their ability and willingness to provide unsecured finance where suitably compensated in the spread, but experience informs us that this tends to be reserved for some of the larger RPs.

If debt capital markets funding is likely to be drawn, the cost differential can also be wider than seen on standby liquidity lines.

This is not to say there isn’t value in unsecured debt capital issuance, particularly where a portfolio contains challenging or quirky assets that would otherwise be challenging to leverage.

The increasingly challenging operating environment may dampen the appetite for unsecured lending among banking institutions, particularly should there be a general reduction in the sector’s credit standing.

However, for the time being we continue to see term sheets offering attractive unsecured funding from a broad range of lenders on a regular basis.

On that basis we consider this a viable solution that deserves due consideration in RP business plans across the country.

Gary Grigor, Partner at Devonshires, and John Tattersall, Senior Director at Centrus. Originally published in Social Housing Magazine, 2022.

Amid the changing financial environment, associations will need a clear focus on quantifying and capping off downside risks, write Jonathan Clarke and Phil Jenkins of Centrus

If any observers of the social housing market thought that the job of the treasurer was an easy one – rolling into one’s home study at 10 am and watching swaps slowly unwind or nudging along some security preparation for next year’s capital markets issue – then apart from being grossly misinformed, they certainly ought not to be thinking that now.

The political and financial turmoil of the past couple of weeks have focused minds; S&P’s awarding on 30 September of a “negative outlook” to the UK’s (AA) rating is in our view a harbinger of negative ratings movements in the medium term. This new path can be navigated, but any hopes that post-COVID we were heading back to the financial world of, say, 2015 have by now been dashed.

The economic and financial markets are the most uncertain they’ve been since the financial crisis, with Credit Suisse’s chief executive being forced to defend the bank’s “strong liquidity position” over the weekend (1-2 October), as soaring credit default swaps suggested market concerns.

In that context, we thought it would be of interest to refresh a piece of analysis we did five or six years ago looking at sector profitability.

‘Innocent times’

A few years into the post-financial crisis period – in the middle of last decade – the macro-economic environment was working out pretty well for housing associations (HAs). Rates were held low and market participants were relaxed about the lack of long-term exit strategy from the various forms of government intervention that sustained that position.

Inflation was positive and low and generally flowing through to rents. Researching for this article, we were reminded of anguished debates over whether Consumer Price Index (CPI) plus one per cent was very slightly worse than Retail Price Index (RPI) plus 0.5 per cent and the ending of rent convergence. (Those were innocent times!) 

The broader issues around the lack of affordable housing were very real, but the job of the HA financial risk manager left plenty of strategic space for thinking about development and investment. 

The chart above shows the global net surplus for the sector. Pre-financial crisis, the sector net surplus was just a few hundred million pounds. It’s a lot more now, having grown steadily between 2010 and 2018 and peaking at nearly £4bn in 2018, before dropping back to a little below £3bn in 2020 and 2021.

This reflects these macro factors and the growth in surpluses from sale. We’ve analysed what the net surplus would have been had rates been a more constant five per cent (see dotted line), roughly where the weighted average cost of debt (WAAC) was in, say, 2009, since when it has dropped by about one per cent overall. On that basis, the past couple of years would have been circa £2bn per annum, so still well above pre-financial crisis levels.

On one level, this is a reasonably encouraging picture of health. But focusing just on surplus underplays challenges around higher indebtedness and therefore riskier balance sheets, as well as the emerging investment requirements of existing homes (ie fire safety and decarbonisation spend), which feature in only a limited way in the historic data.

Also, of the circa £3bn FY21 net surplus, surplus from all types of sale was circa £1.5bn. Without that (relatively) risky activity the net surplus with normalised finance costs is not so different from where it was 15 years ago. 

Debt per unit and rent policy

In terms of balance sheet profile, the chart below shows the path of indebtedness over the same time period.

Debt per unit growth has significantly outstripped CPI. The early years of this period saw an RPI link and the uplift of rent convergence, but we also have the more recent ‘minus one per cent’ years, and looking to the future the likely five per cent cap. More fundamentally, we are now in an environment where earnings and therefore market rents, to which social rents must in a loose sense be anchored, are not growing in real terms. 

In a nutshell, pre-financial crisis the sector made little profit but took little risk. For the past 15 years it has taken risks but been rewarded with much higher profitability, and most forays into development for sale have been successful. But profitability is now back under pressure and cash is being diverted to non-remunerative investments in fire safety and decarbonisation.

Even if these investment concerns are overstated (many associations do not have material fire safety issues, in particular), the underlying model in terms of letting the balance sheet take the strain is in a different place to where it was at the start of this period.

What does it all mean for HA finances?

We draw a couple of key conclusions for HAs’ finances. First, interest rates (and perhaps volatility) are likely to remain at elevated levels compared to the past few years, and perhaps return to being more grounded in the underlying realities of how much private actors require as compensation for delayed consumption (eg meaningfully positive real rates). 

Investment decisions will need to reflect this.

Second, while the need for more affordable housing and the investment requirements of existing stock are very real, HAs are at risk again of being seen as cash cows by government. And this is in the context of inflation pressures which may, if rent caps persist for any length of time, create a material inflation mismatch between revenues and costs. 

Other sectors and indeed actual people will be feeling the same (or greater) pressures. But if the risk profile of a business has changed, then the approach to corporate finance risk management changes too. 

For much of the past decade, financing and hedging decisions for many of our clients have been a relatively relaxing exercise in choosing the best option out of a relatively wide range of acceptable and easily obtained alternatives. 

What is needed now is a clear focus on quantifying and capping off downside risks in ‘technical’ areas such as interest rate hedging and access to financing (particularly for weaker credits), but also through ensuring that the financial management of the business as a whole is joined up. This extends to controls over the development programme, integrating financing and asset management decisions, and investing management time in high-quality processes around budget-setting and monitoring.

Jonathan Clarke and Phil Jenkins, Managing Directors, Centrus. Originally published in Social Housing Magazine, 2022

For more information, please contact phil.jenkins@centrusadvisors.com