The housing cliff The challenges ahead for affordable housing, and the policy decisions facing government to ensure supply beyond 2015

Transcription

1 The housing cliff The challenges ahead for affordable housing, and the policy decisions facing government to ensure supply beyond 2015

2 The housing cliff The challenges ahead for affordable housing, and the policy decisions facing government to ensure supply beyond 2015 Angelo Sommariva and Minesh Patel This document was produced by Moat s Communications and Public Affairs team. September 2013 Acknowledgements This document has been produced thanks to the contribution of Moat staff and external experts who have given up their time to provide constructive advice and frank criticism. Particular thanks are due to Chris Cobbold, Director at Wessex Economics, Clare Powell, Director of Strategy at Sovereign, Pete Redman, Managing Director of Policy and Research at TradeRisks, and Piers Williamson, Chief Executive of The Housing Finance Corporation. About Moat Moat is a housing association providing affordable homes in thriving communities for people in the South East of England. For over forty years, we have delivered high quality general needs homes for social rent, Affordable Rent, retirement and independent living. We also have a strong low cost home ownership offer. We are one of the Homes and Communities Agency s development partners, and the Governmentappointed local Help to Buy agent in Essex, Kent and Sussex. Moat currently builds approximately 500 new homes per year. As it is our intention to continue this rate of development post-2015, we are keen to highlight the challenges that may prevent us from doing so. It is from this perspective that we offer the analysis that follows.

3 Contents 4 Executive summary 6 Affordable housing the model and the new reality 8 Welfare reform and housing supply 14 Financial considerations and housing supply 17 The future of regulation 20 Alternative funding sources 24 Conclusion and recommendations 26 Glossary 27 References

4 Executive summary 4 The affordable housing sector is experiencing a period of rapid change. A combination of policy settings, led by the shift in approach to subsidy and vast welfare changes, have created a climate of uncertainty and heightened risk. As housing associations prepare their post development plans, many will be forced to significantly curb development volumes to manage those risks. As a consequence, despite Spending Review announcements on rent policy and the future of the Affordable Homes Programme, housing supply remains uncertain beyond This paper seeks to raise the understanding of the unprecedented pressures on our build capacity, the likely stress points that could lead to a collapse in development, and the policy decisions facing government to avoid a housing cliff in Under the Affordable Homes Programme, the shift away from capital and towards revenue subsidy has created a heavy reliance on Housing Benefit to make the development of new homes viable. This, in itself, should not be a concern; it is a controlled increase resulting from a change to the social housing funding model. What is concerning is that Housing Benefit has been under the constant threat of further cuts, and current rhetoric implies that it will continue to be targeted in future budgets. This shines a spotlight on the growing tension between DWP s objective of reducing welfare spending vs DCLG s objective of increasing housing supply through the Affordable Rent model. We remain convinced that further tightening of Housing Benefit, either directly or indirectly such as through overall caps, would lead to a significant loss of new homes post A further pressure point created by the reduction to capital subsidy is that it forces more funding to be sourced privately. This means that many providers will find their borrowing increasingly constrained by gearing the longer the current model remains in place. Some housing associations are closer to reaching their borrowing limits than others, but eventually all will become constrained and will have to slow or halt their development programmes. To prevent a housing cliff and an acute housing shortage post-2015, an increase in capital subsidy will need to be considered under any future programme. Another significant challenge is welfare reform, which continues to unnerve investors. This is undermining attempts by the sector (and the Government) to boost private capital, and will continue to do so unless concerns are addressed. Welfare changes that affect housing associations ability to collect rents, and their capacity to inflate rents have a major bearing on the viability of development. The social sector size criteria and direct payments under Universal Credit will each increase arrears and affect the sector s ability to collect rents. The household benefits cap and the recently announced overall cap on welfare spending will prevent housing associations from escalating rents at the government-set rate of RPI+0.5% (to be lowered to CPI+1% in 2015). This inflation-based approach is critical to the viability of the model, as it forms the basis on which housing associations can borrow at attractive rates from the financial sector. The cap on the country s overall welfare spending will also act as a significant future risk if housing associations are pressured to convert more social homes into Affordable

5 Rent as indicated by the Housing Minister. Depending on the nominal amount of the cap (to be announced in the 2014 Budget), the upward impact of conversions to the Housing Benefit bill would, in all likelihood, lead to a breach of that cap. This would have a severe impact on build capacity post-2015 as it would dramatically increase the risk of arrears, bad debt, and the cost of borrowing. A further challenge is the sector s ability to access alternative funding sources. The reduction in capital subsidy has forced more finance to be secured privately, therefore, access to alternative sources are increasingly crucial to maintaining supply. Some approaches, such as raising money in the bond markets, have been successful for many housing associations. Other options, such as real estate investment trusts, short-term bank finance, and special purpose finance, contain sizable risks that remain largely untested in the sector. Changes to government policy, especially those that do not explicitly commit to inflation uprating, make these types of investments riskier and less likely, with the consequence of limiting the options available for new development funding. Compounding this issue is the Chancellor s recent announcement that social rents will escalate in line with CPI+1% from 2015, marking a shift away from the RPI+0.5% formula. This represents a reduction on current levels, which depending on the accuracy of forecasts, may affect both the underlying viability of existing properties, and the business case for new properties. Under current official estimates, the shortfall could be of the magnitude of 720 million lost to the sector per year. 1 The final challenge discussed in this paper is the sector s uncertain regulatory climate. Build capacity is greatly dependent on the quality of the sector s regulation as it functions to provide assurances that risk is being properly managed. The bottom line is that there is a direct link between risk and the cost of building homes; increased risk unavoidably leads to a reduction in build capacity. The near collapse of Cosmopolitan Housing Group has unquestionably played a part in unsettling confidence. But so too has the regulatory system s inability to balance the necessity of effective oversight with the need to enable sensible innovation. Reforming this complex area will be critical if a collapse of affordable housing development is to be prevented post All of these challenges cannot be seen or dealt with in isolation. It is not possible to understand the impact of welfare reform without seeing it in the context of reduced capital funding; issues accessing finance cannot be separated from diminishing confidence caused by the present regulatory system. The Government is right to encourage more private investment, and like many housing associations, Moat is enthusiastic about tackling the challenges of a balanced portfolio. But investors must be confident of returns based on certainty, clarity, and assurances that risks are being properly managed; policy decisions that weaken confidence also diminish the attractiveness of the investment. The fundamental theme borne out in this analysis is that recent Spending Review announcements will not be enough to guarantee development post The affordable housing sector is responsive to change which can be illustrated by its willingness to manage additional risks and look to alternative sources of funding. But funding gaps cannot continue to appear, and the viability of alternative approaches cannot be repeatedly undermined without the consequence of a collapse in development. 5

6 Affordable housing - the model and the new reality Approach to subsidy In order to achieve significant new supply within public spending constraints, the Government introduced the Affordable Homes Programme (AHP) in The centrepiece of this programme is the Affordable Rent tenure, which consists of lower levels of capital subsidy, and higher levels of rent set at up to 80% of market rent. In the 2013 Spending Review, the Chancellor announced that the AHP will be extended for three years up to 2017/18, signifying a continuation of the current model. Social housing (pre-2011) was typically funded through a capital grant of 60,000 per unit 2 a figure substantially higher than under Affordable Rent. To cover the remaining cost of the home, finance was raised against the future rental income. Affordable Rent homes are typically funded from three sources: Homes and Communities Agency (HCA) capital grant of approximately 20,000 per home (although this figure can fluctuate depending on the agreement negotiated between the HCA and the housing association). 3 Some housing associations such as Moat also use large quantities of recycled capital grant, which most commonly derives from shared ownership sales. Conversion subsidy, supported by the increased rental stream coming from converting an existing dwelling to Affordable Rent. Borrowing or funding from alternative sources such as the bond market, supported by the asset base and the future rental stream of the property. The Affordable Rent model marks a shift in the approach to subsidy away from high levels of capital subsidy to one of high levels of revenue subsidy provided through Housing Benefit. Under this model, the level of future inflation-linked increases to the rent are crucial to the amount of borrowing that can be supported, and therefore, to the level of capital subsidy required in order to build each home. Housing association rent policy is regulated by government. Rents for new homes are set at up to 80% of market levels and inflated each year by RPI+0.5%, although this will change to CPI+1% from This inflation-based approach is critical to the viability of the model, as it forms the basis on which housing associations can borrow at attractive rates from the financial sector. The effect of the model is to create a sub-market rental sector, with rents which are more affordable to people who could not generally afford to rent privately. This approach can only function if tenants who cannot afford to pay these rents from their own income receive assistance from the state. Typically, this means that Housing Benefit accounts for 50% of the rental stream on new Affordable Rent properties, and more than 50% of the increased rent on existing properties converted from social rent. Nationally, the Housing Benefit bill is expected to rise by 1.4 billion over 30 years to pay for the shift in approach to subsidy. 4 The following graph broadly illustrates how the balance has changed in moving from the social rent model to the Affordable Rent model. 6

7 Type of subsidy used 5 100% 80% 60% 40% 20% 0% Social rent Managing the risks As previously mentioned, the Affordable Rent model presents a strong basis on which housing associations can borrow at attractive rates from the financial sector. Despite the challenges, we expect that this will continue to be the case a point echoed by Moody s, despite recent downgrades. 6 However, this will not happen by chance, and will require action from both government and housing associations. Providers have traditionally focused on housing people identified as high priority by their local authority partners. As these households are often reliant on welfare benefits, increasingly including those in low paid work, the continuing success of the model and the sector s capacity to build more homes depends on inflation-linked rent and Housing Benefit for its solidity. Affordable Rent Rent/revenue subsidy - for which DWP is primarily responsible Capital subsidy - for which DCLG is primarily responsible Careful management of the link between meeting housing need and achieving stable rental income is therefore fundamental. When housing associations ability to manage rental income is brought into question by changes to the benefits system in particular if rent arrears increase or if rents cannot rise with the escalator because of those changes the model is undermined as the cash available to support borrowing is reduced. The value of the homes used as loan security is also depressed. Equally, if funders and ratings agencies re-evaluate the sector s risk profile as a consequence of welfare reform as has already occurred the model is again undermined as the increase in the cost of borrowing further erodes the sector s capacity. In its announcement, Moody s emphasised that structural loss of income from weak rent collection could exert further downward pressure on ratings. 7 Without the underpinning of reliable welfare support to residents, housing associations will have to implement new risk management strategies. This will be felt especially hard in 2015, which is the year that new development programmes are due to commence. The suite of risk management strategies could include: Significantly curbing development volumes. Restricting rents to levels that will be covered by Housing Benefit (Universal Credit in the future). This, too, would lead to a reduction in build capacity. Restricting the proportion of lettings to priority households to the regulatory minimum. This would necessitate an extensive re-think about the types of households helped by housing associations. We must therefore conclude that in the new reality, some of the key elements of risk, and therefore build capacity, are no longer under the control of DCLG (who created the Affordable Rent model and are responsible for social housing policy), but instead are with DWP (who administer Housing Benefit and are responsible for welfare policy). The tension between DWP s objective of reducing welfare spending vs DCLG s objective of increasing housing supply through the Affordable Rent model must be urgently addressed. 7

8 Welfare reform and housing supply The social sector size criteria (under-occupation rules) Since April 2013, the Housing Benefit payable to social housing tenants has been restricted according to the number of bedrooms in each property. Moat supports the principle of making more efficient use of the UK s housing stock. We have been involved both in downsizing incentive schemes and in the development of attractive schemes for older people, which have been effective in addressing under-occupation. But the rules that came into effect in April are inflexible, and promote cost saving over and above efficiency. The main issue preventing people from downsizing is that smaller properties are simply not available. The National Housing Federation (NHF) estimates that 180,000 households are under-occupying two bedroom homes, but would be competing for only 85,000 one bedroom properties across the entire sector if they all opted to move. 8 The Consortium of Associations in the South East (CASE), also found that in order to re-house all residents correctly under the new rules, CASE members would need to rebuild the equivalent of 7.5% of their total rented stock as one bedroom properties. 9 This disparity becomes even more pronounced in the context that local authority lists have a further million people waiting for one bedroom properties. 10 Paradoxically, one bedroom homes are an inefficient type of property. They neither provide space for young families to grow, or for care needs that may develop in later years. We therefore cannot support the increased construction of one bedroom homes as a way of addressing the structural deficit caused by the new under-occupation rules. This does mean that at least in the short-term many residents who want to move will be unable to do so. This has already started leading to increased arrears and debt as a result of the policy s introduction in April The early impact A widespread picture is emerging of residents struggling to meet the shortfall in their housing costs, leading to a spike in arrears. The NHF s early findings revealed that within the first two months of the new rules, 65% of housing associations nationally reported an increase in arrears. 11 A detailed piece of research looking at Merseyside, estimated that the total financial cost of the size criteria could reach almost 1.1 million per housing association over the 12 months between April 2013 and March North of the border, the Convention of Scottish Local Authorities found that, of the rent due to be collected from affected tenants, 80% of councils received 50% or less at the end of May. 13 As expected, Discretionary Housing Payments have also been overwhelmed by the volume of applicants experiencing a 338% increase in April Personal circumstances that make downsizing impractical, combined with a shortage of housing stock, means that the size criteria is already proving to be a burdensome policy. Despite the best efforts of housing providers to improve economic mobility among residents, arrears and debt are increasing. 8

9 The increased reliance of Affordable Rent on revenue subsidy means that the stability of Housing Benefit is paramount. The social sector size criteria is testing this stability by undermining the capacity of tenants to pay their rent, without adequate measures in place for those who cannot move due to a shortage of smaller homes. Our inability to collect the full amount of rent owed will have a flow-on impact to our development programmes post Household benefits cap The household benefits cap commenced in April 2013 in four London councils and will be rolled out nationally by 30 September It limits total welfare benefits paid to a couple or single parent to 500 per week, or single adults to 350 per week. Increases to the cap will be determined by the Secretary of State but there is, as yet, no confirmation of how the appropriate increase will be calculated. Yearly rent increases are stipulated by the Government s social rent policy, and the ability of residents to pay this rent is fundamental to the Affordable Rent model as: It minimises the capital subsidy requirement for new homes. It determines the future income capacity for new affordable homes. The predictability and security of the inflated rental income directly affects lender/investor confidence in the sector and consequently the rate at which money can be borrowed. also increases. This reduces the value of each additional pound of rent. A failure to index the benefits cap each year will compromise housing associations ability to escalate rents. Despite the announcement in the Spending Review that rents will rise at CPI+1% for 10 years from 2015/16 to 2024/25, there is no mechanism in place to ensure that the benefits cap can keep pace with those increases. This affects both the underlying viability of existing properties, and the business case for new properties. This irregularity also presents the risk that ratings agencies and those lending against future development will continue to downgrade the sector s outlook. Clearly, that would have a further impact on the cost of borrowing, and therefore, build capacity. Moat has sought to limit rents to keep them within affordability limits, which has made us consider how we approach larger properties. For instance, the capping of Affordable Rent at a figure between 180pw and 200pw, or the relevant Local Housing Allowance (LHA) level, reflects the approximate level of rent at which a family with three children would have their other living expenses affected by the 500pw benefit cap. 15 Moat and many other housing associations have either ceased or considerably slowed development of four bedroom properties for Affordable Rent, as they are largely unaffordable under the cap. With the overall benefits cap in place, as rents increase, the risk of default by households affected by the cap 9

10 How quickly Affordable Rent catches up with constant 500pw cap Merton Kingston Bromley Brighton Croydon Epping Welwyn Hatfield Horsham Crawley Bexley Greenwich Chelmsford Harlow Tunbridge Wells Tonbridge & Malling Sevenoaks Dartford Stevenage Thurrock Maidstone Uttlesford Basildon Wealden Gravesham Swale Southend Maldon Ashford Medway Dover Hastings Years 2 bedroom 3 bedroom 6

11 Using actual Moat data as a sample, we have conducted an analysis of how quickly Affordable Rent becomes unviable if the cap is held constant. Based on a 2% CPI increase + 1% each year, the graph (opposite) shows how many years of cost of living and rent increases it would take for the total to catch up with the benefits cap. 16 The findings shown on the graph are concerning. Should the 500pw benefit cap be held constant each year, once the number of years indicated have elapsed, housing associations will no longer be able to increase the level of Affordable Rent in that area without a substantial proportion of residents becoming unable to afford their rental payments. At the upper end of the scale, within the first year, two bedroom homes in the boroughs of Kingston and Merton will become unaffordable. But even at the lower end, two bedroom homes in Dover and Hastings will become unaffordable in under seven years. For a majority of local authority areas across the South East, it is the speed at which this situation is likely to unfold that is of greatest concern. What the table shows in relation to three bedroom properties is that: In 65% of local authorities, homes will become unaffordable within two years. 77% will become unaffordable within three years. 100% will become unaffordable in slightly over five years. In relation to two bedroom properties, it shows that: 68% will become unaffordable within four years. 90% will become unaffordable within five years. The impact of being unable to inflate rents annually An inherent assumption in longterm financial planning for housing associations is the increase in rental income with the escalator. It is this inflation that makes an individual scheme viable and, as a consequence, generates capacity for new homes in the future. The impact of reducing rent inflation has been tested against the detailed business model used for Moat s long-term financial planning. Under a scenario of a 1% reduction, in order to maintain the same level of interest cover, development volumes would have to be reduced by 40%. This illustrates the extreme sensitivity of new house building to decisions taken on welfare policy particularly those which might directly affect the ability of housing associations to inflate rents, or our practical capability to collect rents. It is worth noting that the modelling assumptions used for this analysis are optimistic. This is because they neither: take account of the increased cost of borrowing that would result from lenders perceived loss of confidence resulting from housing associations inability to inflate rents, nor; take account of the more conservative approach that would be taken to the long-term financial cases for new homes should it become practically impossible to rely on inflation uplifts. 11

12 Direct payment of Universal Credit The Government will begin rolling out Universal Credit nationally from October 2013, which will be paid directly to tenants. The current system pays Housing Benefit automatically to landlords. The proposed change in approach to payment of housing costs threatens to significantly increase management costs for housing associations, and has been a key concern for our lenders as it affects our practical capability to collect rents. Reflecting on the impact of direct payments, the Government s November 2011 Housing Strategy recognised the importance of stable rental incomes for social landlords, as they allow access to the affordable credit used to develop new homes. 17 The most comprehensive study undertaken in this area to date previous to the DWP Demonstration Projects was the Tenant Direct pilot, undertaken by L&Q between 2002 and It involved a total of 700 households and consisted of two strands, each within a specific pilot area. The first strand focused on introducing new tenants to direct payments within L&Q s South West region. The second transferred all Housing Benefit payments directly to existing residents across its Croydon stock. Under the first strand (new residents), rent arrears rose to 6% by the end of the final period which compared to an average for the region of 3.8%. Under the second strand (existing residents), arrears ballooned to just over 9% after 12 weeks, before settling at 7% after 12 months. This compared to an overall average of just 3% arrears within the control area. 18 Typically, housing associations have 50% or more of total rent revenues paid through Housing Benefit. 21 Therefore, with the introduction of direct payments, a significant element of risk will be added to half of our rental income. Substantial additional costs will also be incurred in managing tenant payments. As the department responsible for this policy, the DWP will ultimately determine how this proceeds. The concern for Moat is that the DCLG is an observer on this issue, despite the seriousness of it in terms of determining future build capacity. We have consistently argued that neither landlords nor tenants would be supported by an increase in arrears. Attempts to ease the transition to employment by paying benefits in a similar manner to wages are commendable, but they distort the reality that welfare benefits are intended as a safety net. The creation of safeguards and trigger points aimed at protecting social landlords income streams may help to lower arrears. 22 But wherever possible, arrears should be prevented rather than mitigated. With this in mind, it is encouraging that in October 2012, a concession was granted to the Northern Ireland Executive on this issue. Unlike the rest of the UK, tenants in Northern Ireland will still be able to have the housing element of Universal Credit paid directly to their landlords. 23 We welcome evidence that the Minister is willing to concede flexibilities where necessary, and that the IT system can be modified to accommodate these flexibilities. 24 The Minister for Social Development (Northern Ireland) made the point that unique circumstances exist in Northern Ireland which warrant special treatment. We must take the Government s decision to grant this concession as verification that a uniform system is not the right approach. The South East of England also shoulders unique conditions, particularly in relation to its housing market. As rent levels are higher on average, the policy will deliver greater levels of debt in the South East than any other part of the country. This will translate into a greater impact on build capacity in an area where the housing crisis is also most acute. Arrears - L&Q Tenant Direct and DWP Demonstration Projects L&Q Tenant Direct DWP Demonstration Projects Arrears during pilot Arrears during projects 19 Usual arrears levels within control area 1 st strand (new tenants) 6% 3.8% 2 nd strand (existing tenants) - after 12 weeks 9% 3% 2 nd strand (exisiting tenants) - after 12 months 7% 3% Sector average for arrears (2013) 20 After 4 months 8% 4.8% After 12 months 6% 4.8% 12

13 Finally, it is important to note that even if it were possible to manage the transition to Universal Credit without any increase in tenants rent arrears, there would still be significant extra costs associated with the new payment methods. Over many years, housing associations and their colleagues in local authorities have evolved an efficient, cost effective approach to transactions. This has made automatic payment of Housing Benefit the cheapest option for most housing associations; the introduction of direct payments will add substantial transaction costs, regardless of the level of rent arrears. Overall cap on welfare spending In addition to the household benefits cap, from 2015/16, the Government will introduce a cap on the UK s total welfare spending. 25 It will apply to over 100 billion of welfare spending and will include social security and tax credits expenditure such as Housing Benefit. The details of the cap, such as whether it is to be indexed, are not yet known. The nominal amount will be set at Budget 2014 alongside the Office for Budget Responsibility (OBR) fiscal forecast. consider increasing the conversion of stock from social rent into Affordable Rent. We await the full details of the plan, but it is important to consider that any attempt to pressurise the conversion of social rent to Affordable Rent will have a further upward impact on Housing Benefit. This impact makes the cap on welfare spending a significant future risk. Indeed, the compounding impact of the various welfare reforms are forcing housing associations to manage their risks in different ways. This will be felt especially strongly in 2015 as new development programmes commence. In some cases, development volumes will have to be significantly reduced. In other cases, the proportion of lettings to priority households will need to be reduced to the regulatory minimum. This has already been seen in the buy-to-let market, where the proportion of landlords with tenants who receive LHA has fallen significantly from 34% in March to 27% in June As discussed previously, the Affordable Rent model works on the basis that landlords can charge higher rents up to 80% of market rent levels. This, in turn, reduces the amount of capital subsidy required for each new home, but has a controlled, upward impact on Housing Benefit. Following the announcement of the extension of the AHP, the Housing Minister, Mark Prisk, also announced that landlords taking part in the new programme would have to enter into efficiency deals. A component of these would be a commitment to 13

14 Financial considerations and housing supply 14 Social rent policy On 26 June 2013, the Chancellor announced that social rents will escalate by CPI+1% from 2015 until This announcement was intended to deliver certainty to the sector on future rent increases. The housing association business model is calculated over a long period, generally 25 years or longer. Moat uses a model of up to 60 years. It is expected that the management and interest costs will exceed the rental income of a new home in the early years, but that over time, inflation will bring the net rent above the cost of servicing the debt. Moat considers a new home to be viable if it breaks even over the set period, on the basis of rent increasing each year with the escalator. Because of the way this model works, the rate at which the rent increases over time is critical. The initial reaction to the Chancellor s announcement appeared to be generally positive. Much of the optimism was stimulated by the statistic that between 1989 and 2011, RPI inflation was only around 0.7% higher than CPI inflation on average per year. 27 Under a repeat scenario through to 2025, where the 0.7% average remained steady, the gap between RPI+0.5% and CPI+1% would be around 0.2% per year. A difference of this size would be absorbed by the moderate assumptions built into most business plans, and would therefore pose little concern. However, subsequent analysis has shed a different light on the impact of the change. Within days of the announcement, TradeRisks published advice that the switch could result in a fall in annual rent increases of between 0.8% to 1% based on OBR projections. 28 Analysis featured in Social Housing magazine also suggested that the impact of the shift may have been initially underestimated. Again, based on OBR figures, Savills predicted a significant annual shortfall, accruing to around 9% by 2024/25. A shortfall of this magnitude would roughly translate into 720 million lost per year to the sector. 29 The workings for this projection, which assume that the CPI would meet the Bank of England target of 2% after 2016/17, and that the long-run difference between CPI and RPI would hold steady at 1.4% are shown in the table opposite. It is clear that there is a large difference between RPI and CPI projections based on whether one chooses to look at the historical gap referred to as the wedge or whether one accepts the OBR forecast. But it is important to note that the 1989 to 2011 figures ignore the downward effect that the housing component had on the wedge in 2009 as a result of the financial crisis. 31 To exemplify this by looking back at the last 10 years, the cumulative gap between RPI and CPI between June 2003 and June 2013 was 5.9%. If 2009 is taken out of the equation, the gap shoots up to 9.3% over the remaining 9 years. 32 This clearly represents a substantial difference, and is broadly in line with the OBR s projection for Finally, we are aware that there remain uncertainties with the measurement methods used in the OBR s estimates; indeed, the composition of CPI is currently under review with a final report due in summer This naturally places a question mark over any long run prediction. But the bottom line is that if the OBR forecast turns out to

15 Projected gap from change to social rent policy 30 CPI RPI CPI + 1% RPI + 0.5% Cumulative gap 2015/16 2.3% 2.8% 3.3% 3.3% /17 2.1% 3.2% 3.1% 3.7% /18 2.0% 3.6% 2.1% 4.1% /19 2.0% 3.4% 3.0% 3.9% /20 2.0% 3.4% 3.0% 3.9% /21 2.0% 3.4% 3.0% 3.9% /22 2.0% 3.4% 3.0% 3.9% /23 2.0% 3.4% 3.0% 3.9% /24 2.0% 3.4% 3.0% 3.9% /25 2.0% 3.4% 3.0% 3.9% 8.9 be relatively accurate, the impact of the switch would be substantial, and would lead to a significant fall of the sector s build capacity. Borrowing limits There is a perception in some quarters that any amount of capital funding provided for new homes will automatically lead to an increase in development. Whilst this is generally the case, it is important to consider the borrowing limits that may prevent this from occurring over time. As discussed earlier, the AHP has changed the funding environment by relying more heavily on revenue subsidy in contrast to the social rent model which provided higher levels of capital subsidy per home. A consequence of this shift is that it forces housing associations to source more funding privately in order to build new homes. So, if capital subsidy now only makes up circa 20% of the cost of building a new home, the remaining 80% must be found elsewhere. Therefore, with higher levels of borrowing per unit, housing association gearing has increased over the course of the AHP. In effect, this means that whilst the programme has been successful in driving development over the period, it is unsustainable in the long run as borrowing becomes increasingly constrained by gearing. The Government s decision to extend the AHP for a further three years signifies a continuation of the current model, and will continue to place pressure on gearing levels up to at least The majority of housing associations will have gearing covenants with their banks and possibly with some bondholders. Whilst some housing associations are closer than others to hitting their gearing covenants, in the long run, we would expect the majority of housing associations to eventually reach their borrowing limits. We estimate that a number of housing associations will not be in a position to develop as many homes in the extended round as in the current round of the AHP. A number of associations may not be in a position to develop at all between owing to their borrowing limits. If the AHP is extended beyond 2018, progressively fewer associations will be in a position to bid. Alternatively, if existing finances were restructured to allow for higher gearing, we would expect an increase in the cost of borrowing. This too would lead to a reduced build capacity. The use of government guarantees One way in which the Government is seeking to reduce the cost of borrowing for housing associations is through the use of guarantees. Following the announcement of the AHP extension to 2018, the Government also announced its plan to use around 3 billion of guarantees to make the programme more attractive. 33 We welcome the use of guarantees, and are encouraged by analysis that shows a significant potential saving for providers. The Housing Finance Corporation has tested a number of scenarios which suggest a potential saving of between 0.55% and 1.05%. On a guaranteed loan amount of 10 million, the present value of the saving over 30 years could therefore be between 1 million and 1.9 million. 34 Certainly this would seem like positive news which could ultimately translate into extra capacity. However, with uncertainty remaining about other government policy actions, it is 15

16 difficult to draw firm conclusions about whether the guarantees will deliver extra capacity, or prevent further decreases in new homes delivered. It is also worth considering that the use of guarantees have been found to have two main negative long-term effects. Firstly, speaking in relation to the use of government guarantees on bank bonds, a study published in the OECD journal, Financial Market Trends, found that: borrowing once guarantees are no longer available. This would no doubt lead to a reduction in build capacity unless future governments were either prepared to continue using guarantees, or increase the capital subsidy available per home. The fact that the cost of issuing guaranteed bonds reflected by more than 50 per cent the guarantor s creditworthiness (rather than the issuer s) implies that banks with lower profitability and weaker balance sheet positions but enjoying guarantees from highly rated sovereigns were able to raise funds at a much lower cost than sounder and better rated banks. 35 In other words, lower rated banks were disproportionately favoured by the market distortion created by the guarantees. Translating that to the housing sector, we may find in the long-term that higher risk providers will feel better accommodated by the use of government guarantees. This is an important point to note given the HCA s stated desire to protect social housing assets from high risk ventures. Secondly, the same study found that the guarantee measures could create expectations of further intervention. 36 Although it is difficult to predict the future effect of this distortion on housing, a situation may arise where providers find a significant increase in the cost of 16

17 The future of regulation Build capacity is greatly dependent on the quality and strength of the sector s regulatory system. Sound regulation provides assurances that risk is being properly managed, it generates confidence for investors, and perhaps most significantly, it keeps the cost of borrowing low. Strong regulation is therefore essential for funding future development. The link between regulation, confidence and the cost of borrowing was clearly evident in February 2013 when Moody s took the decision to downgrade almost all English housing associations. In doing so, it cited a weaker regulatory framework as one of its key considerations. 37 Reacting to the downgrade, the Chief Executive of The Housing Finance Corporation referred to the HCA as a stripped-back regulator, reflecting on the evidence that it has seen its resources severely cut back since At the start of the 2009/10 financial year, the Tenant Services Authority (TSA) had 270 staff and a running costs budget of 29.8m. By the end of the 2011/12 financial year it had reduced its staff numbers to 171, and its budget to 19.5m. 39 On 1 April 2012, the TSA transferred its regulatory powers to the HCA. Yet during the 2012/13 financial year, the HCA s underlying staff costs decreased by a further 2.5m even as it absorbed staff transferring from the TSA. 40 These cuts must be seen in the context that the sector s risks are expanding. For-profit providers are entering the sector and not-forprofit landlords have been steadily diversifying into non-social housing activities. All providers have also been increasingly turning to new sources of private finance. 41 At best, a lack of resourcing leads to delays and a struggle to achieve timely decisions. At worst, the regulator could fail to identify problems which could lead to a major collapse. An example of this type of failure, which has played a part in unsettling confidence, was the case of Cosmopolitan Housing Group. It incurred heavy debts on its student housing business, which was secured against its social housing assets. A significant failure was only narrowly prevented in this instance when Sanctuary Group stepped in to rescue Cosmopolitan from insolvency. 42 The HCA referred to this case as a timely illustration of the degree to which the regulator needs to keep pace with the rate of change in the sector. 43 Whether the concerns about a hypothetical failure are justified and the analysis appears to suggest that they are at least to some extent they are having a real impact on confidence. In order to avoid the loss of further confidence, and indeed to allay concerns about the capacity of the HCA to perform its regulatory duties, it is our view that the current system requires reform. Principles for regulation According to research from the University of St Andrews, housing regulation is seen widely as being either passive towards change or as a bureaucracy that actively discourages it. 44 Indeed, there is a general view within the sector that innovation is often stifled by the complex process of regulatory approval for new products. Most often, this causes costly delays, and in some cases, leads to worthwhile and feasible products being abandoned. This decreases the sector s ability to attract 17

18 investment and increase revenue through legitimate business ideas. With increasing pressure to crosssubsidise social housing activities, the issue of effective and appropriate regulation must be dealt with in order to prevent development decline post Given changes to subsidy, the diversification of tenures, and the potential for cross-subsidy from new products, there is a need for intelligent regulation aimed at enabling. With this aim in mind, we recommend shaping the future regulatory system along the guiding principles opposite. Overall, we support a system of regulation based on flexibility, which enables providers to deliver more homes, continue to rehabilitate existing stock, and to support residents. Robust risk management is vital but much of this should be done at executive and board level, with a role for the regulator in overseeing that proper governance is in place. We would like the present balance to shift towards a system that supports housing supply through sound and effective management rather than one which is unduly restrictive. Principle 1 Responsive, enabling regulation An innovative housing association looking for new ways to cross-subsidise social housing activities needs responsive regulation that will encourage new programmes, products, and ideas. Regulation should not stand in the way of innovation, but should actively enable new models which manage risks professionally and effectively. There is also a dichotomy between the rhetoric of latent capacity and asset sweating and a regulatory system which is effectively designed to prevent mistakes rather than enable development. Principle 2 Flexible regulation Most housing associations have relatively simple business models. Within that simplicity, flexibility is needed in order to improve efficiencies and find new funding opportunities. Flexibility must be built into the system to ensure that opportunities for improvement and cross-subsidy are captured appropriately. However, despite the simplicity of the model, housing associations are incredibly diverse in terms of history, size, capacity, risk appetite, product range and geographic spread. Effective reductions in both capital and revenue subsidy mean that providers will look increasingly to diversify into other areas; the private rented market is the most obvious current example. At the same time, there are a number of new for-profit entrants in the sector. It is important to determine how these new entrants, as well as greater involvement in private rented housing, will fit into the established social aims of the sector. The regulator must be flexible enough to assess these movements, and indeed, the organisations involved, according to more appropriate criteria. For this reason, onesize-fits-all regulation is not effective; flexibility is required to bridge the diverse issues that are likely to arise post

19 Principle 3 Robust and accountable governance Boards have a pivotal role to play in order to satisfy the regulator that the sector is made up of well-managed providers. The role of the board is vital under the system of co-regulation, and there is scope for boards to become even more accountable for scrutinising the risk of their organisations. A sound board will understand the strengths and weaknesses of the individual provider, the executives competence to assess and manage risk, and will have access to detailed information on a regular basis. We believe that it is the board, rather than an external body, that is best placed to dissect and judge the performance of housing associations. Boards should therefore rightly hold pre-eminence in scrutinising the risks associated with business decisions and ventures. In our view, the regulator would be more effective focussing less on the practical elements of the work of a housing association, but with a greater emphasis on ensuring that governance structures are robust and able to deal with the risk taken on. Paying for regulation On 27 June 2013, the Chief Secretary to the Treasury published Investing in Britain s future, outlining the Government s infrastructure commitments for the 2015/16 Spending Round. The paper included a proposal to allow the HCA to charge fees for its regulation services. The rationale for the fee is to strengthen its capacity to regulate an increasingly diverse sector and drive efficiencies in the social housing sector on the basis of a stronger emphasis on regulating value for money. 45 There is very little evidence to suggest that paying for regulation would causally lead to better regulation. We do, however, feel that it could encourage future governments to set aside less funding for regulation which could be particularly dangerous during good economic times, when riskier decisions are more likely to be taken by providers. We believe that a charge for regulation would be likely to end in levy-creep over time, where housing associations gradually end up paying more for the service, without any guarantee over its quality in return. Conversely, if providers were given a substantial influence over the structure of the system, that reduction in independence would make the system less credible, and would significantly erode confidence. Overall, we do not believe that paying for regulation is an appropriate way forward for the sector. At a time when resources are increasingly being used to plug gaps left through changes to subsidy and the welfare system, it is our view that a charge of this nature would add a further burden at exactly the wrong time

20 Alternative funding sources A survey by Baker Tilly in 2012 found that 63% of registered providers who responded are now considering alternative funding other than traditional banking sources, the most popular being corporate bonds. 46 Several providers have issued bonds since August 2010, and rates for recent issues have ranged from 4.3% to 5.5%. Of the 12 billion that will be spent by housing providers on the AHP, the National Audit Office estimates that 4 billion will come from other sources (distinct from grant and conventional borrowing). Although borrowing still accounts for 83% of the sector s existing facilities, 70% of new finance in 2012/13 came from bond activity and private placements. 47 Although these figures appear positive, it is important to consider that pressure is mounting on investment from alternative sources. On the one hand, housing associations have historically operated under a simple business model, which delivers moderate returns on the back of relatively low levels of risk. On the other hand, turbulence is being created by various policy settings, such as welfare reform and changes to subsidy, which are eroding those returns whilst increasing risk. Ratings agencies are reacting to this new situation, and obliging investors to re-evaluate their risk-to-return ratios. Given that conventional bank borrowing is not available to housing associations at levels seen before the financial crisis, the threat to alternative funding sources could see a shortage of finance for post-2015 development. Real estate investment trusts Following the 2012 Budget, the Government consulted on social housing real estate investment trusts (REITs), focusing on the prospect of altering existing rules to favour social housing businesses. The plan was mostly met with scepticism for similar reasons to those outlined below, and this prompted the Government to defer the idea of dedicated support in December Whilst we would welcome social housing REITs as an alternative source of funding for the sector, we remain unconvinced about their attractiveness to investors. Firstly, to be attractive to institutional investors, REITs need scale. Institutional investors seek out longterm, stable, inflation-linked income from their outlay, and would be unlikely to accept the complication of development risk. Therefore, to quickly generate scale, the most likely option for establishing a REIT would be from the transfer of existing social housing stock. Very few housing associations are large enough to have sufficient unfinanced and unsecured stock to transfer in order to create the necessary volume to attract investors. Our advice is that that somewhere in the order of 500 million worth of unfinanced and unsecured stock would be needed to reach the right scale. Another option may be to form a club of housing associations, which may be able to achieve the necessary scale. However, this in itself, would add complexity and cost, thus eroding the eventual return. For instance, the REIT would require an additional management team and administration structure, meaning that costs would need to be built in further eroding the return. 20