This month’s commentary comes from our new offices and hot on the heels of our 5th anniversary. Our birthday celebrations gave us reason to pause and reflect on how much has changed since 2012, not only in our business but in the wider world around us. We are all now familiar with a whole variety of things now that would have left us scratching our heads with bemusement back in 2012, such as President Trump, almost Prime Minister Corbyn, Brexit (soft and hard), hipsters, crypto-currencies, beards, emojis, Leicester City and WhatsApp. I could go on but you get my drift.
Of course, the ever-coruscating world of housing association finance has also seen significant changes over the same period. We have seen:
- a continued shift of new financing from the banking to the institutional market
- the start of what we believe will be a long and structural process of consolidation
- a wave of restructurings as business models evolve beyond the realms envisaged when earlier debt facilities were put in place or as a result of mergers
- increasing divergence in terms of scale, business structure, business models and approach to financing
- political & regulatory disruption in the form of welfare reform, rent cuts and de-regulation.
More recently, there has been a flurry of activity in the listed REIT space, with funds having launched with a focus on social housing. I was interested in recent comments in the housing press which were along three broad lines:
- An observation that the returns being offered to investors are fundamentally higher than the yields on social housing assets
- A view that the only housing organisations undertaking deals with these REITs are ones which don’t have access to other sources of funding
- A question as to why housing associations would access expensive equity when they have access to much lower cost debt
The first is a very reasonable and pertinent point and links to the second. Core general needs and shared ownership stock deliver net yields of 2-4% (albeit with outliers on either side in certain circumstances and locations). Trying to manufacture a 5% dividend yield (net of REIT costs) and a total return of 8% per annum is clearly rather challenging. This is perhaps why the REITs launched to date appear to be targeting specialist or “assisted living” housing assets which tend to have fuller rent levels for various reasons and therefore are higher yielding. By the same token (i.e. the higher rent), these assets carry greater risk than general needs and shared ownership housing but there are underlying needs here not met elsewhere and in that sense this model “works”.
Reading the financial press one might be forgiven for thinking that, in buying REITs which are focused on this type of housing, investors are receiving a stonking return for quasi government risk. After all, to a layman investor looking for a quality income stream, what’s not to like about 25-year index linked leases with housing associations, particularly when the sector is described (slightly incorrectly) as having a “history of no defaults”? Well I suppose it all depends upon who the counterparty to those 25-year leases is. If it is a large investment-grade organisation with a significant balance sheet then investors should be (and are) all over the idea of a 25-year RPI or CPI linked lease with them, but most large HAs have avoided this type of arrangement to date for the reasons noted above and particularly cost. However, when the counterparty is an organisation with virtually no asset base or income source outside of the specialist asset(s) being financed and where the assets have alternative use value significantly below the value of the lease, then I would question both the value of the much vaunted leases and the robustness of the high-level credit story being presented to investors.
But for the general point that HAs who can access cheap debt should not be interested in equity, the story is in my view a bit more complex. It is undoubtedly true that investors who claim they are offering equity when in reality they are offering a lease with a long-term financial commitment which looks and smells like debt … are on a hiding to nothing with larger associations. But I would challenge the assertion that REITs and proper equity don’t make sense full stop. While this may well hold true for organisations which have developed modestly over time and have significant borrowing headroom, those which have delivered higher output and stretched their metrics are limited in the amount of additional leverage that they can employ. In answering the conundrum of how to deliver more and more output without taking on excessive risk or running financial metrics to nosebleed levels, there is logic in the strategy of accessing third party equity, even where this comes at a higher cost than HA debt. Any student of corporate finance will remember (perhaps dimly) the “Modigliani-Miller theorem” which argues that capital structure doesn’t matter but also leads to the observation that it can make sense to pay for expensive equity if it preserves the risk profile for debt providers, because of e.g. the adverse factor of bankruptcy costs associated with taking on too much debt. We suspect that the REITs issued to date are simply the first wave of equity investment in this asset class.
The main item in terms of market news during July was the £500m dual tranche (12 and 40yrs) issue by L&Q. The 12yr tranche achieved a spread of 105bps and a coupon of 2.75% with the 40yr at 100bps and 2.25%. We expect DCM activity to pick up in the second half of the year with a number of issuers expected to bring deals subject to market conditions.
Financial Markets and Economics Overview
There was a surprise reversal in the upward trend of inflation in the month. Notably, the annual rate of CPI inflation dropped to 2.6% from the 2.9% reported rate in June. This was primarily driven by a fall in the price of motor fuel and certain recreational and cultural goods and services, partly offset by a rise in prices of furniture and furnishings. Nonetheless, the Bank of England forecast inflation to continue on its upward path with CPI inflation projected to peak at close to 3% in October of this year.
There were mixed signals from macroeconomic data releases in the month of July. The ONS’s latest UK unemployment data showed unemployment at 4.5% – this being the lowest jobless rate since 1975. However, the ONS’s preliminary estimate for Q2 2017 UK GDP growth rate was 1.7% versus 2% for previous quarter. The MPC’s central forecast projects that UK GDP growth will “remain sluggish” in the near term, citing the drag on consumption from the continued “squeeze on households’ real incomes”, before recovering somewhat as consumption and investment shore up.
Against this backdrop, long term Gilt yields were relatively unchanged month on month with the 30 year Gilt yield of 1.86% at 31st July 2017 the same as at the end of the prior month. Swap rates were relatively unchanged versus the prior month at the long end of the yield curve – 1.59% at the 30 year tenor – whilst rates for shorted tenors reduced slightly – 5 year swap rates being 9bps lower at 0.9%.
Meanwhile, in the housing market Nationwide’s reported annual rate of house price growth remained relatively stable in July at 2.9%, representing a modest 0.3% increase in the month. Despite a clear cooling in demand for UK residential properties, current price levels are being supported by low supply of new properties (for illustration, recent RICS data shows that average stock of properties on estate agents’ books is close to 30 year lows).
*Market data in this report is as of the 31st July 2017 close of business