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Social Housing REITs: Risks and returns

Readers of Social Housing will have followed the recent spate of activity in Initial Public Offerings (“IPOs”) by listed funds set up to invest equity in affordable housing. This is part of a wider theme in the investment market where “alternative income” is the theme du jour. Private investors are no longer forced to buy annuities with paltry rates of return and the market has responded with gusto by launching a wide range of funds. These have been set up targeting not only this pool of money but a wider and predominantly retail investor base hungry for yield, after almost ten years of financial repression by global central banks. As well as affordable housing, income funds have been launched focused on a diverse range of underlying assets including peer to peer lending, litigation proceeds, reinsurance, distribution warehouses, ground rents, GP surgeries, PRS, infrastructure debt and real estate long income from hotels, theme parks and supermarkets, to name but a few.

“The range of funds have been set up
targeting not only this pool of money but
a wider and predominantly retail investor
base hungry for yield”

These funds tend to be distributed through the private wealth manager networks as well as institutional money in some instances. Being slightly controversial, we would suggest that the underlying investor base shares some characteristics with the retail bond market in perhaps being more focused on direct yield comparisons and benchmarks than risk adjusted cash flow or returns based upon the underlying credit quality of the income producing assets and contracts. Investors in this market have certain expectations around target dividend yields which tend to start at around the 5% level, hence the yield objectives of the funds recently launched into the affordable housing space.

When you factor in the fees and running costs associated with these funds, in order to deliver a 5% net dividend yield, the gross running yield generated from the assets needs to be more like 6.25-6.5%. For those readers familiar with the returns generated by core social/affordable/shared ownership housing assets, this level of gross return looks challenging, even with some imaginative use of leverage. It also goes some way to explaining why nearly all of the cash raised by these funds has so far been deployed in specialist and supported housing schemes which provide both higher returns and in our view, materially higher risks.

“From a fund investor’s perspective,
the marketing proposition looks compelling”

From a fund investor’s perspective, the marketing proposition looks compelling. Looking back at one article covering a social housing fund launch, the reporter referred to “rents indexed to rise in line with inflation…long term leases of 10 to 40 years…income paid directly by the government or by local authorities… [in a sector] yet to see any loss suffered by investors due to a registered provider going bust and defaulting on its debts”. With all of that and a 5% dividend yield, what’s not to like?

Well for starters, there has been a steady queue of institutional investors seeking long term index linked leases with investment grade housing associations in recent years, but deals have been few and far between. The small scale and financial profile of the RPs operating in the supported living space mean that few, if any have much underlying financial substance beyond the funding frameworks they have in place which in turn are linked to current government welfare policy. Furthermore, the valuations of the properties being acquired are primarily a function of the lease arrangements and if these are altered or fall away, then the alternative use value of the properties is likely to be some way below the value with the lease in place. Fundamentally, the credit of a lease is only as good as the counterparty to that lease and/or the payment flows underpinning it. Indeed, the HCA has recently expressed reservations about placing too much reliance on government welfare policy in delivering long term index linked payments to investors or on the financing framework remaining in its current form.

“deep pools of untapped equity capital
will play an important role in providing
additional capacity to housing associations”

As with any investment, “you pays your money and takes your choice” and investors looking for net dividend yields of 5% from affordable housing assets will inevitably end up holding assets at the higher risk end of this asset class. Nonetheless, the recent REIT launches have demonstrated that deep pools of untapped equity capital exist which can and will play an important role in providing additional capacity as housing associations look to increase their output while maintaining their creditworthiness and financial strength. The current yield requirement of investors in REIT structures makes it very difficult for selling housing associations to obtain a sensible or fair value for their mainstream assets. However, applying similar equity models to core social/affordable and shared ownership assets presents a different challenge in meeting investors’ risk-adjusted return expectations, but would represent the real game changer for the sector.

Social Housing Magazine and originally published on the 29th September 2017.