Housing associations and the covenant cage

Britain needs more affordable housing, obviously. In the last quarter century, the number of households in Britain grew by roughly 13% from 25 million to just under 29 million. This growth far outpaced the delivery of new affordable rental housing. Worse, during this period, the number of families languishing on local council waiting lists oscillated stubbornly between one million and two million but did not change materially overall. This article examines how families on the waiting list may be housed, going forward. As ever, doing so requires a little perspective from the recent past.

It will come as no surprise that the change in tenure has not been uniformly distributed. Some sixty percent of the growth can be attributed to the rising number of households that rent. Private landlords account for ninety percent of these new renters but private landlords are not best placed to build new homes and would be most unlikely to build new affordable homes.

A mere ten percent of the new households since 1990 found a berth within the social housing sector. Hence the statement of the obvious in the beginning of this article bears repeating. Say it with me. Britain needs more affordable housing. This dearth is part of a long-standing failure to grasp the nettle. Half a million fewer families rent from their local councils today, compared to 1990 when Margret Thatcher left office. Councils are strapped for cash. Many are technically insolvent. They can’t raise council taxes at will, can't raise the rent on the houses they own at will either, and their ability to borrow is mired in a tangle of red tape. In these straitened times, those waiting lists are not going away any time soon. Given the shape of the curve below, is it hyperbolic to ask: has social housing hit rock bottom?

Not all doom and gloom: Fortunately, disparities exist within the social housing sector. Recently, declining occupancy within council homes has been more than offset by rising occupancy within homes provided by housing associations. That's why the vertiginous plunge in the chart above appears to plateau. Can these intrepid associations house those on local council waiting lists?

In 2023, English housing associations built fewer than sixty thousand new affordable housing units. At that rate, it might take twenty years to eliminate the waiting lists – longer if the population keeps rising. And building homes is not cheap. In 2023, English housing associations invested roughly two hundred thousand pounds per new housing unit. Check my maths. We're talking a cool quarter trillion to solve the waiting list problem, right? There or thereabouts. At this scale, accuracy is not your friend. For a sense of perspective, days ago the Chancellor detailed a twenty billion pound hole in the nation's finances, hinting that she may have to raise taxes to fill it.

A hundred billion here, a hundred billion there. Pretty soon we're talking about real money

Chipping away at the problem is laudable but Britain is a big place. The waiting lists are comparable to half the stock of council houses extant today. For non-profit housing providers to make a big splash they need to dive into a very deep pool of funds.

Where will that real money come from? Reinvestment of the aggregate annual housing association surplus won't cut it. These surpluses barely cover the need to service existing debt. The housing associations need other options. The following chart lays out the ways the associations have funded the acquisition and development of new homes recently. The blue part of the circle refers to new money from banks and bond investors, which I examine in more detail below. The red components are other sources of funds. The red gets darker as those sources become harder to access at short notice.

Asset sales: To a large degree, housing associations fund new houses by building and selling houses for profit. To state the obvious, selling homes is not a reliable way to substantially increase the stock of new homes.

Cash reserves: Most housing associations have cash on their balance sheets. On the other hand, using existing cash to build new homes is not sustainable either. It's prudent to keep some in the kitty for a rainy day. As the saying goes: hope for the best. Prepare for the worst.

Cash grants. With two big internal sources proving insufficient to address the challenge at scale, this leaves housing associations somewhat dependent on the kindness of strangers. The first port of call is often the government but not this time. Despite making the delivery of new housing a top priority, last week the Chancellor assured us the taxpayer spigot is running dry.

Private sector investment. Most companies that want to build new homes need to raise money project by project. Non-profit registered providers are no different in that respect but they are different in other ways. They lack shareholders and can’t announce an emergency rights issue at a moment’s notice. Many of the larger associations can access the bond markets. Some two hundred associations manage a thousand units or more (accounting for roughly 95% of the sector) but only seventy or so have investment grade credit ratings.

The rest make do with bank debt. These banks are strangers, to repeat the analogy, but not always kind. Banks expect to be repaid on the knocker at regular intervals in fair weather and foul but are not all that keen on lending when it's raining.

Once upon a time... housing associations would take out long term loans at regular intervals to roll over maturing loans as they came due. When possible, they spread the redemption dates out over time. These practices stabilise borrowing costs across the economic cycle and reduce future refinancing risk. So far, so sensible. But times, they are a-changing. There is no need to challenge conventional funding practices when the interest rate environment is benign or improving. And for most young treasury professionals benign or improving is considered normal. Indeed, rates trended towards historic lows between the global financial crisis sixteen years ago and the global health crisis four years ago, making it easy to believe low interest rates would persist forever. They did not. Those days appear to be over.

Peter, Paul and Mary. In the short run, borrowing from the bank to roll over maturing debt makes sense but in this environment, new strategies are required. You can rob Peter to pay Paul but eventually, reality bites. Notwithstanding last week's quarter point cut in the Bank of England's base rate, at the margin, the cost of raising new bank debt today exceeds the effective cost of servicing low cost debt locked in years ago. As long as this funding cost disparity remains, the Peter to Paul heist makes things worse. The music stops when neither Peter nor Paul will refinance the debt.

This chart is one way of illustrating the challenge. For as long as that nice yellow line remains above the white bar, there will be upward pressure on the effective cost of funds the housing associations face, even if rates stop rising. That rise in the cost of funds shows up as one part of the battle one must have with your bank manager. Call that the eastern front.

All is not quiet on the western front. To fulfill their social mission the associations must pay staff and keep their existing portfolio in good order. In recent years, salaries and wages have risen during a (hopefully) once-in-a-generation spike in the cost of living. Scheduled and reactive maintenance costs have risen too. Cladding needs to be replaced lest buildings go up in flames. Damp and mouldy properties won't fix themselves. And don't forget the environment. Clean energy commitments need to be funded upfront. Meanwhile, regulated rent increases lag inflation as they are pegged to the change in the consumer price index in the prior year. When all these challenges collide, something has to give. Deferring uncommitted development seems prudent but is antithetical to the goal of delivering more affordable housing.

The covenant conundrum: Since commercial banking is not particularly competitive, banks hold the whip hand. They need not move quickly at the best of times and are prone to slow walk these negotiations during the worst of times. Moreover, bank facilities can be complex. Each is unique and laden with covenants intended to ensure that the borrower maintains a healthy financial position throughout the term of the loan.

Corporate finance, not rocket science. What is a financial covenant when it's at home? There are gearing restrictions to make sure that long-term assets are not financed entirely with debt. There are negative pledges – a commitment by the borrower to refrain from securing new loans with assets that underpin the bank loan but which rank senior in the event of liquidation. However, the most important covenants are interest coverage ratios.

For most companies, the ratio between operating profits (in the numerator) and debt service obligations (in the denominator) should be maintained between 150% and 200%. This ratio goes by the ungainly acronym EBITDA, meaning Earnings Before Interest, Tax, Depreciation, and Amortisation. Pay attention to the letter "B." The standard ratio for housing associations is different. Their so-called cash interest cover starts with operating surplus and then strips out the cost of repairs and maintenance required to maintain the viability of the assets that generate revenues. This measure is excessively conservative.

If the cage is too small, these covenants can have the opposite effect to that intended. If breached, banks can threaten immediate repayment. According to the Regulator of Social Housing in the March 2024 Quarterly Report:

It is evident that levels of interest cover have deteriorated and are set to remain depressed in the short-term

In aggregate, housing associations in England owe the bank about fifty billion pounds. When the debt is small you really need the banks. When the debt is large enough, the balance of power starts to shift. The Regulator observed in their most recent report that several associations are negotiating waivers and exemptions to these covenants and some are in discussions with their banks to use a more conventional definition of cashflow coverage, such as EBITDA.

So much for the nerdy stuff in the numerator. In later articles, we will dive into the number below the vinculum. There are ways to bring the effective interest burden down, way down. It won't be easy but, as President Obama was wont to say, you need to stop admiring the problem and start tackling the issues.*

Corporate borrowers do not include the presumption (as opposed to obligation) that they will pay dividends on their equity as part of the cash interest they must cover. How can housing associations use "synthetic equity" to radically (and sustainably) reduce their requirement to pay cash interest? Doing new things, at scale, will inevitably take the housing associations outside their comfort zone. This is necessary because the societal need is great and grasping nettles can be uncomfortable. Those solutions deserve more space than we can devote to the subject here but stay tuned.

*Correction. Obama used to say: "Stop admiring the problem and get [stuff] done," but why let a quibble ruin a good rant?

Institutions affected by these issues, feel free to get in touch.

#socialinclusion begins at home.

Ike Udechuku | Cofounder | CEO | The Pathway Club