Category: Market Insight

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

As part of their business planning and risk management processes, many of our clients pull together “perfect storm” scenarios in which multiple variables all hit negatively at once in a “what would it take to break our plan” type exercise.

To summarise the perfect storm facing the UK this winter:

• CPI Inflation is running at 8.8% with Bank of England forecasting a peak of over 13% in Q4 2022 and more extreme scenarios from other forecasters, as high as 22%
• Energy costs are likely to be 3x higher this winter than last year
• Base rates have increased from 0.1% in December 2021 to 1.75% today with more increases on the way
• Ten-year gilt yields have increased by c.2% over the last 12 months

This changes everything.

Take for example a household with a £250k mortgage relating to base rates (there are circa 1.9m of them). If they suffer the full impact of base rate increases, their interest payments will have increased by more than £4k per annum or just under £350 per month. Now, layer this on top of a possible increase of over £200 each month for energy bills, not to mention higher food and petrol prices. A perfect storm indeed.

Now, I use a household for illustrative purposes, but you can apply the same set of issues to pretty much every business in the country, particularly businesses like many of those that we advise which are capital intensive in nature and therefore utilise significant volumes of debt. Since all businesses are energy users and many businesses utilise debt at some level, it is safe to assume that the pain is being felt, or will be soon enough, right across the board. In many instances, you can track this same set of issues right through the product life cycle:

1. Commodities/extractive industries/agriculture
2. Manufacturing/processing
3. Logistics/Transport
4. Sale/Retail
5. Consumers

Energy costs, commodity/input prices (including by-products such as fertiliser which requires natural gas) and debt servicing costs will strike at every level of the system on the way through – and right at the end of that chain? The poor consumer, who is already seeing disposable income diverted in order to meet the calls on cash outlined above.

So, what gives?

There isn’t much sugar coating to be done here. The combination of factors at play here is a toxic one which does indeed present a perfect storm for many businesses. In my view we are likely to witness one of those periodic shake-outs of the system which will test the resilience of business models and the nerves of those charged with not only safe navigation but in many instances, survival. It didn’t quite happen post-financial crisis but maybe in due course some of the policy responses to that last ‘big event’ will be seen as a contributing (if not only) factor to the economic story of the 2020s.

Some thoughts on what the coming months and years may hold:

1. More bailouts – one way or another, UK and European governments face a massive bailout bill to mitigate the societal and economic impacts of what many would consider to be their mismanagement of energy policy over recent years. Some estimates have suggested that just in the UK this may reach as much as twice the cost of the Furlough Scheme at well over £100bn. The incoming Truss Government will have to square this impact on public finances with its desire to stimulate economic growth and investment through tax cuts. Either way, UK and EU countries face huge bills which will worsen national debt and likely maintain Sterling and the Euro under significant pressure against the US Dollar for the foreseeable future.
2. Political uncertainty – there will continue to be many and varied views on how to run a democracy, but it’s fair to say that in the US and Western Europe the “range of normal” is widening compared to, for example, the post war period through to the Global Financial Crisis (perhaps with the notable exception of the 1970s). One can see obvious tensions in the US, to a lesser extent in the UK and many European countries, and a mixed bag around the rest of world including for example some evidence of tensions emerging within the Chinese polity in response to somewhat faltering growth there. And this piece isn’t about the war in Ukraine but that clearly has triggered some of the factors noted above; it would be wrong not to acknowledge the unfortunate level of uncertainty for people living there and the surrounding countries.
3. Security & self-sufficiency – regardless of pressure on the public finances, the Government will be under intense political pressure to step up to a wartime footing in respect of greater energy (and food) resilience and self-sufficiency. So, expect to see large investment programmes and policy support in agriculture, fossil fuel exploration/production, gas & battery storage, renewables and nuclear, along with associated grid infrastructure.
4. Technology – this investment boom, along with increased re-shoring of supply chains (again driven by security of supply, even at higher cost) will drive and accelerate technological advance and adoption as countries with high labour costs and ageing populations seek to compensate with technological advances
5. National Finances – the urgency of spending commitments outlined above and in terms of increased defence spending will likely trump orthodoxy around control of the national debt and it is interesting that these factors appear to be aligning with an apparent desire on the part of the incoming Government to “de-fang” HM Treasury. Wartime style spending commitments may also require continued “financial repression” in the form of further QE type programmes and ultimately perhaps capital controls, in the event that this feeds through to currency instability (as the Bank of Japan is realising at the moment, you can cap JGB yields when the rest of the world is raising rates, but this feeds through to the currency in the shape of a massive Yen depreciation).
6. “Creative Destruction” – What about businesses? Margins will be key to navigating the choppy waters ahead. Businesses operating on wafter thin margins or reliant on ultra-low borrowing costs for their survival are unlikely to last the course – brutal perhaps (and unnerving for business owners, including ourselves…) but on the other hand, a normal part of the capitalist cycle, which was arguably put on hold following the global financial crisis and Covid.
7. Essential Service Industries – the policy predictions above are likely to present a mixed bag for businesses operating in regulated and/or essential service industries. On the one hand, Government will be keen politically to be seen extracting its pound of flesh through hard-nosed intervention around price settlements to benefit the beleaguered consumer. On the other, large scale and capital-intensive investment programmes will see the Government needing to tap private capital and therefore not wishing to destroy its credibility as an investment partner in key infrastructure. Opportunity beckons for professional tightrope walkers.
8. Risk Management – some businesses are fortunate enough to be able to pass on their own cost inflation to customers – think scarce commodities, specialist manufacturers or luxury brands. Most however, will see margins squeezed by higher debt, input and energy costs. Larger businesses may have hedging in place to mitigate one or more of these cost increases, even if only for a relatively short period. Hedging and risk management will likely be more widely used by these and other businesses as a result of the recent levels of volatility and the desire to reduce further risk in future.
9. Credit Ratings – rating agencies will be running the rule over businesses to understand the impact of these changes and risks to their models. Sovereign rating downgrades as the result of deteriorating public finances may trigger corporate and sub sovereign downgrades where there is a clear link through the ratings methodology for essential service sectors.
10. Higher Debt Costs – in the real assets space, growth in the “Alternatives” asset classes has provided investors with reasonable, low risk, fixed income like returns, during a period of abnormally low interest rates. Bringing some of these asset classes into the investing mainstream has had many positives, in particular, the ability to harness long-term pensions and savings into societally useful asset classes such as infrastructure, PRS, Affordable Housing and Logistics to name but a few. However, the resilience of the case for equity investment in these sectors will be tested as fixed income returns return to levels only marginally below equity cash yields.
11. Asset Prices – there is little doubt that ultra-low (or even negative) interest rates have distorted pricing mechanisms and inflated prices of many real assets. Ultimately, a sustained higher cost of debt capital will likely feed through to lower asset prices. There is already some evidence of yield expectations rising in commercial real estate for example.

Concluding Thoughts:

Many of the issues highlighted above point to a recent “reveal” of the fragility of many aspects of the current system, not only in Western Europe and the US but globally. If Central Banks and policy makers were repeatedly “kicking the can down the road” the current crisis certainly has the feel of the impending brick wall. In addition, this lack of resilience is showing itself not only in energy but in housing, health, water, transport and other areas, not only in the UK but beyond.

This is providing a rude wake-up call and forcing governments to at least consider whether the current system is fit for purpose and may herald more fundamental and radical changes. One can’t help but feel that there is a neat (albeit not entirely comforting) confluence of these issues with a re-shuffling of the geopolitical deck and the end of global US and Dollar hegemony. Certainly, the dollar based global financial system is starting to crack and it is likely, that we will, in the not-too-distant future see a co-ordinated monetary re-set at least amongst the US aligned nations a la Bretton Woods, Plaza Accord etc.

On a positive note, many of these changes will force system re-sets, partly market led, partly policy led and will likely herald a new wave of accelerated technological advance to help address current shortcomings across many areas which will bring about new high growth sectors together will employment opportunities, particularly in parts of the UK which are still awaiting the “levelling up” dividend.

This will likely be an unsettling period for both households and businesses and may see some further political turmoil along the way. However, as with most systems, decay gives way to growth and out of the current challenges we face, new opportunities will abound, so sit tight!