Investment Appraisal in a New Environment
The recent volatility in financial markets and fears of a possible slowdown in the global economy have moved the discussion away from questions around the timing of tighter monetary policy and towards a ‘lower (or negative) for longer’ position for central bank policy.
This shift emphasises two interesting questions for housing providers considering their approach to investment appraisal.
- If interest rates stay this low, should investment appraisal discount rates fall?
- If interest rates stay this low, what are the political consequences of registered providers (RPs) producing ever-larger surpluses?
These two questions are connected. Readers of Social Housing magazine will of course be aware that ‘surplus’ does not equal ‘cash’. But if low interest rates encouraged more aggressive investment decisions, financing that investment with debt, then surpluses would erode because the immediate uplift to net rental income (before expected inflation in the longer term) would be less than the immediate additional interest.
Now, there is no point incurring losses just to prove a point and if there are enough strong investment opportunities to use up the risk capacity generated by projected surpluses then no one can criticise. But is that the case?
Let’s explore a simple example, where one builds a rented home without grant and with a net initial yield of 3 per cent, and then appraises it using a 5.5 per cent nominal discount rate, with the key assumptions of net rental inflation at 2.5 per cent per annum and appraisal over a forty-year period with no terminal value (i.e. ignoring any cash flows after year forty).
In this instance, net present value (NPV) is negative to the tune of a third of the up-front cost (i.e. a home costing £150,000 has a NPV of around negative £50,000).
The cash flow from the property, if assumed to be funded with debt at a cost of 4.5 per cent (say our 5.5 per cent had some buffer for risk), will in the first year of operations only cover roughly two-thirds of the interest bill. The cash flow will not repay the debt initially incurred for a very long time and relies on inflation ever to achieve that.
The graphic (above) illustrates the relationship between (i) NPV and (ii) proportion of the original debt outstanding after 30 years, both as a percentage of initial cost.
Many RPs look at these measures. The left-hand side of the graph is more appealing from an investment perspective – with positive NPV and low debt outstanding (note the latter is against the right-hand axis) – but has pretty low discount rates. RPs are not typically using discount rates of 3 or 4 per cent.
In rough figures, the sector is producing a surplus of £2.5bn p.a. from around 2.5m homes (£1,000 per home) and has around £60bn of debt (£25,000 per home).
If the sector were to expand by 20 per cent, or a further 500,000 sub-market rented homes, in very rough terms the incremental debt would be as much again and the annual loss from those homes in the first few years could be £1-1.5bn.
A few things are obvious with this thought experiment: firstly, that are a lot of new homes and debt and if the appraisal of these homes is negative NPV of a third of cost these homes will not be built. Secondly, it still leaves a surplus of at least £1bn.
Now maybe a sector-wide surplus of £1bn is starting to look tight, even if it is much more than in the years running up to the financial crisis.
But if low interest rates are here long enough to fix most of the debt for these new homes at low rates for a long time, then maybe it doesn’t look so silly, even if a few gearing covenants would need to be renegotiated or structured around – and even if that came at a cost.
Perhaps a more robust challenge to such a level of ambition is that it is foolish to bank on inflation in that way (and inflation-linked funding is not a panacea). Rather than wear such negative NPVs and early-year losses with a hope of inflation driving long-term value, RPs should be making up for the lost grant by turning a profit on sales activities.
That is a perfectly reasonable approach so long as the risks are managed effectively and it does actually add to output. For some RPs and geographies this is the case and for some not.
I avoided the question earlier of whether there were enough investment opportunities which turned a positive NPV at standard discount rates.
Arguably there are not enough which satisfy RPs’ return expectations given the insufficient numbers of new homes being produced, and maybe it’s the expectations which have to move.
We have many discussions with clients about appraisal methods and it appears that over the last year or so – as low long-term interest rates start to look like the ‘new normal’ – some RPs have loosened discount rate requirements (or some functional equivalent), but the majority have not.
The barrage of policy changes has not instilled confidence and people have been more focussed on mitigating the effect of the rent reduction and challenging their cost base. But perhaps we will see changes over time.
Planning the future
Another area of policy change has been town planning.
It doesn’t seem unreasonable that landowners should contribute to the provision of homes which meet the need of all sectors of the community, since land use decisions are communal ones.
It may be that some policy changes are undermining that but we will have to see.
Nonetheless if the question is asked whether RPs could theoretically do more to provide new homes, without having to turn the development function into that of a mixed-use property developer, then the answer must be yes, given the ability to raise funds at low rates and the strong demand for new housing.
It may be that the safety valve should not be so much about restricting output as insisting that landowners, local authorities, or other partners share some of the long-term risks, rather than associations sticking to the simple, historic model of holding assets outright.
This type of thinking seems consistent with the direction of travel around deregulation of the sector.
There are a host of practical reasons complicating decision-making which go beyond the scope of this article. But hopefully it offers some food for thought on what a strategy around growth in a low interest rate environment might look like.24th February 2016