Page 69. Sutton Living Business Plan and Loan Agreement. Mary Morrissey, Strategic Director of Environment, Housing and Regeneration

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1 Page 69 Agenda Item 5b Report to: Opportunity Sutton Limited Sub- Committee Date: 4 August 2015 Report title: Report from: Ward/Areas affected: Chair of Committee/Lead Member: Author(s)/Contact Number(s): Corporate Plan Priorities: Open/Exempt: Sutton Living Business Plan and Loan Agreement Mary Morrissey, Strategic Director of Environment, Housing and Regeneration Borough Wide Councillor Simon Wales / Councillor Jayne McCoy Mark Baigent, Interim Director, Sutton Living An Open Council A Green Council A Fair Council A Smart Council Open Signed: Date: 27/07/ Summary 1.1 This report presents for approval the business plan and loan agreement for Sutton Living (formerly known as the DevCo, highlighting key commercial drivers and sensitivities to be considered. 2. Recommendations 2.1 That the Sub-Committee approves the Sutton Living business plan as attached in Appendix A, so that, once established, the Company can commence operations in line with this plan. 2.2 That the Sub-Committee agrees in principle the terms of the proposed loan facility as set out in the report, delegating final negotiation and sign-off of the detailed loan agreement between the London Borough of Sutton and Sutton Living to the Strategic Director (Resources). 2.3 That the Sub-Committee delegates a reserved matter; in year sign off on changes to the core assumptions and thresholds within the Financial Model (shown in Sections 7-12, Appendix A) to the Strategic Director (Resources), subject to annual review by the Sub-Committee. 2.4 That the Sub-Committee delegates authority to agree financing arrangements (and specifically the proportion of council equity to borrowing) to the Strategic Director (Finance) for those investments and contracts that are below the reserved matters threshold and therefore not subject to agreement by the Sub-Committee (i.e. below 5m in investment and below 3m in contract).

2 Agenda Item 5b Page Background 3.1 Following the Council s decision in July 2014 to establish a housing development company, detailed proposals have been worked up to demonstrate the commercial viability of the proposed company, to be called Sutton Living. The Sutton Living Business Plan is appended to this report. A dynamic financial model sits behind this document and will provide the basis for future adjustments to the business plan as the company commences operations. This report highlights the key features of the business plan, the assumptions made, the risks that arise and the sensitivities to changes that may occur within the business and the trading environment. The report also sets out the terms of the loan to be made between the Council and the Company. Finally the report sets out the financial monitoring measures and indicators to be used to track the performance of the business. 4. Business Plan and financial performance measurements 4.1 Sutton Living will be a property development company, focused on providing residential accommodation, both acquiring homes built by others and building homes itself on land the company acquires. The homes will be mixed tenure, including homes for market sale, market rent, subsidised sale (shared ownership) and subsidised rent (where relevant, meeting Planning requirements for affordable housing). 4.2 The company will be wholly owned by Opportunity Sutton Limited (and hence ultimately by Sutton Council). The company will be funded by a mix of equity (invested by the Council via Opportunity Sutton Ltd) and debt (borrowed either from Sutton Council or private sector lenders). The proportion of borrowing / equity will be determined on a case by case basis. Where investments meet the threshold for shareholder reserved matters (i.e. exceed 5m) the financing arrangement will form part of the proposal presented to the Sub-Committee. For investments below 5m it is recommended that the financing arrangement be agreed with the Strategic Director (Resources) as part of arranging the appropriate funds. 4.3 There is an option in future to register the company with the Greater London Authority as a development partner, enabling the receipt of grant funding for the provision of shared ownership and affordable rented homes. At this stage, there is no proposal to register the company in this way; this will be kept under review. 4.4 The company will invest a mix of debt and equity in acquiring homes and development land, securing Planning consents, and then constructing homes. Homes will be sold and rented for a commercial return. It is anticipated that the council will provide equity input to the company in the initial development period to cover running costs and development costs. Over time, debts and interest will be repaid as rent income and sale receipts are secured. Where the company s management and maintenance costs, as well as debt charges, are exceeded by the rent and sales income, then profits can be used to repay further debts and/or pay dividends to Opportunity Sutton Ltd and hence the Council. 4.5 The key drivers of commercial success for Sutton Living will be: Acquiring land and homes at competitive prices Securing Planning consents where needed to deliver higher numbers of homes Procuring competitively to construct homes at economic costs whilst achieving high quality standards of end product

3 Page 71 Agenda Item 5b Securing the best possible sales values and rental incomes from market homes Keeping down the management and maintenance costs for rented homes whilst achieving quality standards Keeping rental void periods to a minimum through effective marketing, letting and property turnaround Keeping rent loss to a minimum by taking appropriate debt recovery action, including property repossession if needed Ensuring cashflow is sufficient to cover debt interest charges and repayments 4.6 The business plan makes assumptions about land and property acquisition values, housing for sale values, market rental values, subsidised rental values, construction costs, management and maintenance costs, etc. 4.7 Sensitivity analysis has been undertaken to look at how vulnerable the business model is to changes in the key assumptions, for example if interest rates change, cost inflation changes or property market values increase or decrease. The most sensitive area is general inflation in the economy, with low inflation leading to reduced surpluses / dividends. 4.8 Whilst the plan assumes that Sutton Living retains ownership of the majority of homes to achieve long term rental revenue income, it is worthwhile considering the likely long term asset value uplift, which will underpin the company s balance sheet and may provide security for further debt and pipeline development beyond the initial period of development set out in the business plan. Asset value growth would also provide the option of additional sales to reduce debt if there were any difficulties in future repayment schedules. 4.9 The key measure of performance previously agreed by the Strategy and Resources Committee is the Internal Rate of Return (IRR). This measures the rate of growth within a project (or the business as a whole) and can be used to compare competing projects and choose which to invest in. Calculated through a discounted cash flow analysis, with the net present value at zero (i.e. the project breaks even over time). For Sutton Living, the cumulative IRR achieved by the development and acquisition portfolio of Sutton Living should be 4% and this will be used to assess the impact of any individual site upon the portfolio before proceeding further The business plan will also be monitored against a range of standard financial performance measures used across the housing development and management sectors, as follows Profit On Cost (POC) - the ratio between the scheme profit and the total development cost of the scheme (land price plus building costs and fees). Profit On Value (POV) - the ratio between the scheme profit and the total market value of the scheme. Return On Equity (ROE) - this measure looks at profit against the equity capital invested in the scheme/company. Calculated as follows: Net earnings (income-expenses) / Equity Return On Capital Employed (ROCE) - this measure looks at profit against the combined equity and debt capital invested in the scheme/company. This is a better measure than ROE because it also looks at how effectively debt is being used. Calculated as follows: Earnings before interest and tax (EBIT) / (Assets - Liabilities)

4 Agenda Item 5b Page 72 Rental Yield - there are two typical measures of yield: gross and net. The latter takes out expenses (management and maintenance costs, debt charges). Net yield is calculated as follows: (Rent - Expenses) / House Price Price to Earnings (PE) ratio - a commonly used measure in commercial finance in relation to share value, which in relation to rented housing is calculated as the inverse of the yield calculation, as follows: House Price / (Rent - Expenses) Rent Collection Rate - the % of total rent collectable on the portfolio that is actually collected. This may relate to the level of void properties but also the level of arrears / bad debt. Occupancy Rate - the opposite of a void rate, basically the % of the portfolio that is let over a given period. It is possible to have a very high occupancy rate but a poor rent collection rate, if a lot of tenants are in arrears and repossession action is delayed. Operating Profit - there are various versions of this measure: gross profit would be income less direct running costs (management and maintenance); EBIT operating profit is income less running costs and overheads before debt interest and tax charges; EBITDA margin is calculated after paying debt, tax, depreciation, and amortisation. Net profit would be after all other company costs have been paid. For Sutton Living the most useful ratios will probably be gross profit and net profit. Net Debt - this is calculated as long term debt + short term debt - cash and cash equivalents. Debt / Equity ratio - sometimes called "leverage" or "gearing" ratio, this shows how the company is levering its shareholder equity. Calculated as total liabilities / shareholder equity. Interest Cover Ratio (ICR) - this ratio is typically used by lenders to monitor how easily the borrower can afford to keep paying debt charges; housing providers usually enter covenants with funders to keep ICR above a certain minimum level (say 1.25 or 1.5). Calculated as follows: Earnings before interest and tax (EBIT) / interest expenses in the period Land Bank Efficiency - % of land holdings (by site numbers or by land area) not yet under development. This shows how rapidly the company gets newly acquired sites through Planning and into production It is recommended that all the above measures are used as appropriate for at least the first year and then future monitoring arrangements reviewed. 5. Loan facility 5.1 Strategy and Resources Committee has approved the principle of Sutton Council making a loan facility available to Sutton Living to finance its development activities. The Sub-Committee is recommended to agree the outline terms set out below and delegate to the Strategic Director (Resources) to negotiate and approve the final detailed terms on behalf of the Council.

5 Page 73 Agenda Item 5b 5.2 Appendix B contains a guidance note from the Council s external legal advisers explaining in more detail the recommended arrangements and typical terms and mechanisms involved in a local authority on-lending to a company of this type. 5.3 The principle terms of the loan agreement include: A loan facility for market housing development this is required to be at a comparable commercial rate in order to comply with State Aid regulations. A loan facility for affordable housing development this is not required to be at a commercial rate because the purpose of the loan is exempt from State Aid rules. Security against the Company s assets in favour of the Council as lender in the form of a debenture (a charge against the Company s assets including land and properties). Requirements on the Company to provide full development scheme details to the lender before the loan facility can be drawn down for specific expenditure on that development scheme. 5.4 The specific interest rate to be applied for each loan facility is considered commercially confidential. The principles for the establishment of the loan rate are set out in the legal advice at Appendix B. 6. Impacts and Implications 6.1 Financial a. Grant Thornton have developed a financial modelling tool to assess the viability of schemes being considered by Sutton Living. b. The model currently assumes that Sutton Living, will need to secure long term funding from the Council of approximately 59m after taking into account sales income from the schemes. The peak debt of during the construction phase is 66m but this will be reduced by the income from sales once completed. c. This funding will be a mixture of loan and equity funding. Under current regulations, any loan made by the Council can only be used for capital expenditure by Sutton Living so there will be a need to fund some of the costs as equity funding. The ratio of loan and equity funding for any given scheme / contract will be agreed on a case by case basis (either through the Sub Committee or the Strategic Director, Resources dependent on whether the size of investment / contract exceeds reserved matter thresholds). d. The Council will receive interest on any loans in addition to the repayment of debt. The interest rate applied to the loan will need to be an equivalent rate to what could be achieved in the private market in order to comply with state aid rules. As the Council is able to borrow at a lower rate than the market rate, there is the potential to generate additional income for the General Fund due to this margin. This will need to be offset against any loss of investment income as a result of providing some of the funding as equity. e. The Shareholders can choose to receive a dividend in respect of the equity funding when a surplus is generated by Sutton Living.

6 Agenda Item 5b Page 74 f. The financial projections included within the business plan are based on a number of illustrative schemes and various funding assumptions. Prior to the agreement of any funding being made a detailed financial appraisal of each scheme will be undertaken and a loan agreement drawn up that will set up how the scheme will be funded to ensure tax liabilities for the company are minimised alongside any costs or loss of income to the Council. g. The financial projections within the business plan demonstrate that Sutton Living will be unlikely to achieve a revenue surplus for a number of years and the level of debt will be considerable. Whilst this is a risk, the model also demonstrates that the capital value of the Housing stock will rise annually which will provide additional security against the debt and the opportunity to sell properties to reduce this debt if necessary. Legal 6.2 The legal implications are set out in the body of the report 7 Appendices and Background Documents Appendix Letter A Sutton Living Business Plan Title B Summary of proposed financing arrangements Background Documents Report of the Strategic Director Resources to the Strategy and Resources Committee dated 29 June 2015 Opportunity Sutton Ltd and subsidiary companies governance arrangements. Report of the Strategic Director Resources to the Strategy and Resources Committee dated 23 March 2015 Opportunity Sutton Ltd and subsidiary companies Member decision making and oversight. Report of the Executive Head of Community Living and Strategic Commissioning dated 7 July 2014 New Build Council Housing Proposals for Future Development. Report of the Strategic Director of Environment and Neighbourhoods dated 8 July 2013 Wholly-owned companies and alternative governance structures to deliver public policy objectives. Audit Trail Version Final Date: 28 July 2015 Consultation with other officers Officer Comments Sought Comments checked by Finance Yes Sue Hogg Legal Yes Paul Evans

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