The last twelve months has seen the real estate investment trust (REIT) become a feasible source of alternative financing for housing associations. Three social housing REITs have now listed on the London Stock Exchange.
The appetite for REIT promoters to invest in residential tenures including shared ownership, shared equity, supported housing and build-to-rent is insatiable so it looks like the availability of hybrid alternative financing models from this sector will become a more common source of finance.
What is a REIT?
REITs are UK public companies listed on a recognised stock exchange such as the London Stock Exchange. REITs are subject to a special tax regime so generally they are exempt from corporation tax on their profits derived from their property rental businesses. The key draw for REIT shareholders is that, unlike some other property investment vehicles, REIT dividends are distributed without tax having been first deducted at source before the dividend is paid to shareholders. This mitigates double tax.
The appeal of REITs to housing associations is understandable as a source of alternative financing. In return for transferring housing stock to the REIT, the housing association receives cash, shares or a combination of both. Inflation-linked rent is then payable by the housing association to the REIT under the lease. This may only be partially offset by the inflation-linked management fees payable by the REIT to the housing association. Matching these liabilities is key to the success of this alternative financing product.
REITs find investment in social housing assets attractive as they are seeking an inflation-linked income stream. Social housing assets are viewed by the REIT as a stable financial risk as housing associations are government regulated. For supported housing, the housing benefit which supports the inflation-linked rent payable under the lease to the REIT is not currently subject to any cap. There is a political risk that this may change in the future.
The REIT way?
Last week, the HCA highlighted to housing associations that the REIT alternative finance model is not risk-free.
One of the regulatory risks for housing associations is that, whereas under previous alternative financing products the financial risk was crystallised at the time of the transaction, the Regulatory Judgment regime now requires an in-depth governance and financial viability assessment every three years or so. This means the performance and financial risk with this type of alternative financing will generally be revisited on an ongoing three to four-year cycle against the prevailing economic conditions on each occasion.
Boards of housing associations need to take into account the inflation risk in these newer alternative models and compare them with the relative cost and risk of traditional bank debt finance where a long-term interest rate swap has been made.
The risk that boards of housing associations need to understand is that any underperforming long-term finance where you are taking all or part of the inflation risk may result in an unexpected G3/V3 HCA regulatory judgment in circumstances not contemplated at the time. This could have a domino effect leading to debt/bond covenant breach on other debt and repricing or enforcement action by the bank.
Managing risk is a challenge for housing associations considering alternative finance models and balancing cheaper finance solutions today against future inflation risk. Supported housing (unlike general needs housing) is exempt from the four-year social housing rent cut. This does not apply to other social housing tenures and the long-term nature of management lease/lease backs means housing association boards need to undertake or procure expert financial comparative studies as well as ring-fencing, as far as possible, the regulated assets of the housing association.
To some extent, housing associations or a non-HCA regulated group finance entity may be able to manage future inflationary risk by taking some of the consideration for the transfer of housing stock in shares in the REIT which may mitigate inflationary risk.
This article first appeared in Inside Housing on 23 August 2017