France Telecom: lessons for UK employers following 'institutional harassment' ruling
Out-Law Guide | 08 May 2010 | 5:14 pm | 11 min. read
There is increasing demand for social housing, but the Government is seeking to reduce its financial commitment to social housing and is looking to find alternative sources of private finance for social housing.
One means the Government has of achieving these objects is the use of real estate investment trusts (REITs). These are tax efficient property investment companies. They were first developed in the US but were introduced in the UK in 2007.
There have already been changes to the REITs regime since its introduction in 2007, because it has not taken off in the way intended by Government. As well as changing the REIT qualification requirements, the Finance Act 2012 will permit REITs to be floated on the Alternative Investment Market, the junior London stock market for growing companies.
The Treasury has recently published a Consultation Document (35-page / 354KB PDF) specifically on ways of encouraging private sector participation through social housing REITs. This article looks at the current investment landscape, and the issues that will need to be considered to encourage social housing REITs in the UK.
What would a social housing REIT look like?
In order to establish a social housing REIT with a social housing rental business from the outset, it is likely that one or more housing associations (registered provider(s)) or local authorities would transfer a batch of properties into a newly incorporated REIT vehicle (a Newco). This Newco would be floated on the stock exchange, either the London Stock Exchange (LSE) Main Market or AIM. Acquiring empty properties for rent is a possible approach, but this would involve a time lag in establishing the social housing rental business.
The assets would be contributed in exchange for either cash, equity shares in the Newco or a combination of both. REIT rules permit only one class of ordinary equity shares. The contribution could take the form of either the transfer of freeholds into the Newco, and/or the grant or transfer of long leaseholds. A long leasehold of 75+ years would likely be acceptable to investors.
Valuation of the stock contributed (undertaken on a discounted cash flow basis) would be critical, as it is for property-backed IPOs generally. The valuation report would appear in the IPO document.
A REIT would be able to refinance existing housing association loans and/or provide additional 'equity' finance as part of an 'equitisation' of the registered provider. However, any cost of refinancing the loans and/or the requirement for consent to transfer the secured assets would need to be addressed early on.
There is also a question over how the social housing grant will be treated within a REIT. A social housing grant is technically unsecured debt on a registered provider's balance sheet. This will either need to transfer onto the REIT's balance sheet as unsecured debt, or be converted to equity in Newco, or be written off (treated as a true grant) by the social housing regulator, the Homes & Communities Agency (HCA).
The investment landscape
According to the Treasury consultation, the HCA estimates that £4-5bn in private finance funding is required for social housing over the next 12 months. One of the Government objectives is for social housing REITs to provide additional private finance for social housing.
There is, however, a well established path to finance for registered providers. They can take on long term debt via traditional bank lending, or they can issue bonds on the capital markets ('own name' issues, or aggregators such as The Housing Finance Corporation). Bond finance has become the registered provider's preferred source of finance; it is a relatively simple structure for the lender (particularly where the registered provider has an investment grade credit rating), and of course is backed by security for the debt.
Any equity REIT structure would therefore need to 'compete' against such debt structures, which typically offer an overall cost of borrowing of 5-6% per year.
Long term debt at attractive rates has become more difficult to obtain during the economic downturn following the banking crisis of 2008. This has impacted on the ability of the Government to achieve its social housing targets and has added impetus to the Treasury consultation. However, while the income return on a REIT would be stable and 'Government backed', since the REIT would be a registered provider, it must be attractive enough to attract City investors who might otherwise invest in debt.
Institutions and pension funds looking for longer term guaranteed returns will measure any prospective REIT investment against other investment opportunities. These will include bonds and 'real estate-backed' equity securities generally, such as other publicly traded REITs, diversified property funds and listed supermarket groups.
Scale is important
The returns on a given social housing project are Government-regulated and relatively modest. Social housing rents are fixed for both registered providers and local authorities and are significantly below market rents. However, in order to 'stretch' grant funding, the Government has allowed registered providers to provide homes at so called 'affordable rents', meaning at 80% of market rents.
Therefore, to make a social housing REIT work, a significant portfolio will be required. Any proposed REIT raising less than, say, £200-250m might be of insufficient interest to investors. Investors at such a scale may want a full listing with the additional investor protections that this affords, rather than an AIM listing with 'lighter touch' regulation. This will involve additional costs of set up.
The new Affordable Rent Product allows for rents of up to 80% of market rent. Government policy also permits an RPI +0.5% increase in social rents per year, but only for the lifetime of the 2010 Parliament, and the facility to charge higher rents for a proportion of re-lets. Even at this level, this may not be enough to encourage social housing REITs.
The Consultation Document pointedly confirms that no purely residential REIT has been set up to date, even for commercial residential portfolios charging full market rents. Once the affordable rents cap of 80% of market rent applies, the situation is made worse.
There are possible economies of scale in maintenance of a large portfolio, and typically lower void periods for social housing, because of waiting lists. The Consultation Document asks whether these economies of scale and longer tenures are "sufficient to offset a decrease in rental income and thereby make social housing sufficiently attractive for investors". The answer may well be that the basic discounted rental premise will be likely to outweigh these advantages by some margin. There is also the related question of whether the 90% distribution requirement will allow enough reinvestment of income into the portfolio to give capital growth.
If so, the public capital grants regime will need to remain in place (and perhaps be increased) to incentivise the establishment of social housing REITs; arms' length investors would typically look for an overall 8%+ return in an equity proposition.
Registered provider participation
Non-profit registered providers transferring properties into a REIT could also become investors in the REIT. It is highly likely that a registered provider will continue to manage the housing stock post transfer to the REIT. Registered provider or local authority equity participation, or the lack thereof, could have an impact upon investor appetite.
It has been suggested that registered providers may seek some kind of capital upside sharing arrangement with the REIT, akin to a 'preferred return' that would come out before equity. However, given that an 80% rental cap applies to social housing REITs, any proposals that further reduce investor returns are likely to materially impact the viability of a REIT. To the extent registered providers wish to participate in the upside of a REIT, many will feel this should be only by way of equity participation ranking on an equal footing with other investors. Indeed, this is implicit in the Government policy decision that REITs should have only one class of ordinary share.
Given the need for scale, it is more likely that the REIT will involve a 'pooling' of properties from several non-profit registered providers or local authorities. As such, before any IPO there will be a preliminary stage (which may take some time to navigate) of negotiations between these parties. Consents will also be required. As this is critical to any formation of the REIT, the registered providers and local authorities will be key drivers in the process. Early engagement with private sector REIT 'sponsors' will be important. This will involve an additional layer of complexity and cost to the launch of a REIT.
Housing Regulatory considerations
Consent of the Homes and Communities Association (HCA) will be required for the transfer of social housing stock into the REIT. Also, for local authorities a positive tenant ballot will be required. The REIT will also need to be registered as a 'for-profit' registered provider under the Housing and Regeneration Act 2008. Transfers of tenanted social housing stock (regulated assets) to a for- profit registered provider such as a REIT is not covered by The General Consents 2005 and 2010, so a bespoke consent for the REIT would be required. Unregulated assets such as market rent properties can be transferred into a REIT without consent.
These regulatory requirements would need to be conditions precedent to any REIT launch and the IPO timetable for it. It would be helpful for investors, in terms of encouraging REITs, for the Government to provide more detailed criteria for the grant of consent for social housing REITs, and a pre-application process for informal confirmation of consent in principle.
The Treasury consultation document also mentions the ongoing review of the regulation of for-profit providers by the HCA, which would include REITs. The ultimate level of regulation will be critical in terms of whether new REITs will come through. Again, bondholders, as opposed to equity shareholders, are one step removed from the regulatory framework.
Keeping things simple
Given the need for scale, prospective REITs may need to operate on a nationwide basis. However, there are currently four separate regulatory and incentive regimes for social housing in England, Wales, Scotland and Northern Ireland, based on devolved powers. These are summarised in Appendix A of the Treasury consultation document.
Having to analyse four different regulatory regimes (in terms of financial modelling) and summarising them in an IPO document will involve complexity. The REIT structure would be competing with more established debt structures and equity investors may generally be less familiar with pure residential equity investment propositions. As such there may be a need to simplify this framework in order to encourage new REITs.
Management of the REIT
Key to any listed company is the strength of the management team. The management team is likely to be made up of those with prior experience of running listed companies.
The REIT management structure would need to be put in place at an early pre-IPO stage. However, there may be a shortage of candidates. Many property funds are managed by non-executive boards offshore, coupled with an onshore external manager appointed under a management agreement. However, a REIT must be tax resident in the UK, meaning that its central management and control must be in the UK, which will limit the pool of potential candidates.
So, the choices for a REIT would appear to be a traditional single board within Newco (with no external management team), or a non-executive board for Newco coupled with an external manager appointed under a management agreement. In either case, the majority of the board would be onshore. As the REIT is a listed vehicle, it will need operational and governance freedom in the future. Any residual 'control rights' for the registered providers are unlikely to be possible.
Under a bond structure (with which a REIT would compete), the risks remain with the borrower. Furthermore, it would be rare for any property investment fund to take on historic contingent liabilities. This is not specific to REITs but is a general principle. Therefore, investors in a social housing REIT will likely seek:
Clearly, the registered providers would be paid to take on these risks and undertake the management services, which they could in turn subcontract. This may indeed open up opportunities for support services (facilities management) companies to provide long term maintenance services to the social housing sector, coupled perhaps with an (up to 10%) equity participation in the REIT.
Key to the Government's strategic thinking is the use of REITs to provide more social housing stock. However, institutional investors may not wish a REIT to take on development projects and risk. They may prefer to invest in an existing property portfolio already generating rental income.
Development of housing for rental will be permitted under the REIT conditions, so long as it is undertaken with a view to generating future rental income and the properties are retained for at least 3 years post development. However, this is more a question of investor appetite and comes back to the risk point above.
Development could of course be financed by traditional development finance, with the dwellings purchased by the REIT. The non-profit registered provider (or a representative/special purpose vehicle if there is more than one non-profit registered provider) could undertake the development on an agency basis. However, consistent with the REIT not taking risk, would formal comfort be required as to 'expected' rentals even if for any reason the development was not completed?
Prospective investors will conduct a risk/reward analysis when looking at social REIT opportunities compared to established debt structures already in use. At present, the factors considered in this note may deter investors from considering social housing REIT opportunities. Therefore, the consultation is to be welcomed.
The grant regime will likely continue to be necessary in encouraging private sector involvement. Ultimately, in terms of REITs generally, it may be the case that in order really to kick start REITs in the UK (social housing or otherwise) a private unlisted REIT alternative is required.
Pinsent Masons will be submitting a response to the consultation before the deadline of 27 June, but would welcome views on the above from industry participants. Please feel free to submit comments to the contacts listed on this page.
France Telecom: lessons for UK employers following 'institutional harassment' ruling