Impact of Summer Budget rent cuts on housing asset valuations
INTRODUCTION
A 1% nominal cut in rents each year for four years will be materially below principal projections in association business plans. The change effect will be cumulative and will set a lower starting rent for modelling beyond 2019. We are working with our clients to reset their business plan. Much will depend on the ability to make mitigating operating costs savings.
I set out our view on the scope of the change, then comment on impact on valuations covenants, and finally on security provided to a mortgagee-in-possession. There are conflicting responses in the press from sector valuers – we set out our position below. Please note we still need further details of the new regulations to hold a definitive opinion of the impact of Rent Cuts. This note is based on what we know to date.
STOCK IMPACTED
The Welfare and Work Bill 2015 refers to all social housing except:
Low Cost Home Ownership and Shared Ownership
Here we see the lease with the occupier being the binding contact. Most have rent on retained equity reviewed each year at up to RPI+0.5%. For the moment there is no change and, as any reduction has no Housing Benefit/UC saving[1], there is unlikely to be any fiscal pressure, but there may be “moral” or “consistency” pressure to come.
Affordable Rent
Was included in the draft bill for rent cuts but DCLG have announced that regulation, or guidance, or Statutory Instrument, will allow conversion of existing Low Rent Social Rent to Affordable Rent on relet within the limits set by individual programme agreements. This product shift will enable some income growth for those associations.
But no mention yet of the ability of associations to rebase AR rents to the agreed % of market level on relet. This is a critical part of the income stream for AR and of the mark-to-market principle behind the AR model. There is a dilemma here for Government as the HB/UC impact is high. You should not assume that rebasing will be permitted in the four year “cut” period, and it would be wise to graduate return to rebasing thereafter in BP modelling for say a further three years.
Wales
DCLG have clarified that Rent Cuts (Section 19 in the Bill) will not apply to Wales. We believe that this is not primarily because of the recently announced rent regime (CPI plus 1.5% to 2018/19) but because of the HRA surplus settlement between Local Authorities which took place in April 2015. A revised rent profile would have a material effect on additional debt calculated for each authority.
Local Authorities (retained stock councils)
A similar effect will occur for English retained stock authorities although to a less marked extent because the HRA settlement date was April 2012. But added to this has been the impact on the LA business plan of the revitalised RTB discounts soon after. The combination of the Rent Cut and the enhanced Right to Buy may well lead to Councils calling for a revision to the HRA settlement.
Dates and thereafter
The cut applies to rent reviews in the years starting from 1st April 2016 to 1st April 2019 inclusive.
Apparently there has been Treasury comment that the Rent Standard will revert to CPI+1% maximum on annual review. We advise treating this apparent comment with caution – there are obviously no guarantees here. Remember that if there is some mechanism for rent increase restraint thereafter, of whatever form, that it will take many years from 2020 to “get back” to the future Target Rent, or % of market rent. The size of this wedge in present value terms is likely to impact on existing use investment values more than the next 4 years of cumulative Rent Cuts.
Target Rents
The Rent Cut, as we understand it, suspends any move to Target Rents. Annual uplifts for exiting tenants towards Target Rent were prohibited as part of last year’s RPI+0.5% to CPI+1% based settlement, but the opportunity to move to Target Rents on relet remained a small but helpful part of some association’s business plans. The wording of the draft bill will stop this, even, apparently, if a rent revision is justified by improvement works uplifting the 1991 open market value base of the Target Rent formula.
Grant bids
A material change in income streams will affect project appraisals for new supply and reinvestment. Bids in the making or allocated but not committed will probably require a recalculation and reassessment of scheme viability.
Section 106 planning obligations
Similarly the Rent Cut will reduce the amount that associations can pay the developer for affordable housing rent products. The Price Paid is likely to have to reduce if not already contractually committed. Developers will of course resist this. One option might be to agree with the Local Planning Authority, on a revised financial viability assessment, that a smaller number of dwellings but with a total similar “obligation value” are transferred to the association.
Exceptions
The Secretary of State may apply exceptions to the Rent Cut for a number of reasons, e.g. type of property or location, but the wording of the Bill focusses on making an exception for an association or local authority in financial difficulties. The hurdle will be high. We predict that social landlords will have to show maximum effort in reducing costs to mitigate the income reduction, and perhaps even had imposed special managers or consultants to try to achieve this, before a waiver or amended rent regime is approved for that landlord.
VALUATIONS AND LENDERS’ COVENANTS
There are several variants to the Existing Use Value Social Housing valuation methodology. But all are based on net rental income discounted cash flows. If the operating costs are not reduced to mitigate the rent cuts then the present value of the net rental income streams will reduce. The exact amount of EUVSH reduction will depend on each association’s willingness and ability to review all income and expenditure elements of its business plan. It is unwise to “cry wolf” by just calculating the reduced top line income stream effect. So the amount of EUVSH value reduction is not yet determined but it is almost certain that there will be an aggregate reduction across the sector.
The wordings of asset cover requirements and the RICS Red Book definition for EUVSH, are unlikely to change. Buffers that currently exist for Debt to EUVSH cover ratios will be reduced. This of course reduces future borrowing capacity supported by existing stock, and in a few cases may lead to a breach.
EUV-SH VALUATIONS WILL CHANGE
Lender in possession
Here we believe there is no change in the recovery capacity of a lender-in-possession. The key wording is, firstly, that of the Rent Standard, which is the practical interpretation of the subordination of Grant and the consequent Capital Funding Guide rules, and in the case of LSVTs or dwellings built on land that was a part of a EUVSH priced transfer from a local authority, the practical interpretation of S133:
Para 2.7
In a situation (such as an insolvency) where there is a mortgagee in possession or receiver in place or where the registered provider’s stock is sold to a non-registered landlord following intervention by the regulator, neither the mortgagee in possession, nor the receiver, nor the landlord to whom the stock is sold will be bound by the Rent Standard. That would be the case in relation to all social housing to which the regulatory framework had previously applied, including those properties let on social and Affordable Rent terms. If the stock was transferred to another registered provider, the regulator would discuss compliance with regulatory standards, including the Rent Standard, as part of the transfer arrangements.
where, in our view, the HCA will seek to minimise the extent of consent to write off Grant, or S133 waiver, to just what, and no more than, is necessary to clear the outstanding debt and related costs.
And secondly that most secure and assured tenancy agreements do not specify a future rent or the amount or method for rent reviews, other than the statutory obligations not to increase rents more than once a year, and to recognise that a rent may be reduced by a Tribunal to the market rent. In a very few cases there may be a contractual agreement about rent increases, for example immediately following a stock transfer or as part of a regeneration project, but these usually become void on a lender taking possession.
Consequently the ability to move some or all dwellings to market rent on review, or over the medium term, or market sale on vacancy, remains and is unchanged by the Rent Cut.
The problem here is that some valuation methodologies have attempted to calculate this market value subject to tenancies. It is a special case, and the degree to which a lender-in-possession or their successors in title could move to market prices will vary in each case (particularly for those bound by S133), but rules of thumb have been used for the last 15 years in the sector known as MVSTT. Sometimes these are approximate % discount to market, or a discounted cash flow based on rate of change from low rent social rents[2]. None of these are “real” valuations – they are a special case, and do not reflect the value of the social housing business.
MVSTT VALUATIONS ARE UNLIKELY TO CHANGE
In conclusion the Rent Cut is a significant change for the sector. It has highlighted the difference between a covenant, which in essence is tool for lenders and borrowers to manage the performance of the asset/liability, and the potential recovery amount in default. And it seems to highlight a difference of view within the valuation profession. In short-hand we concur with the JLL view but have doubts about the Savills view.
Finally, you will appreciate that this is our assessment to the current state of play, it will change and become clearer. I have shared this with you to help thinking and business plan modelling, and for debate. Please do not make decisions based in this information alone, and please let me know if you have alternative views.
Pete Redman
Managing Director Policy and Research
TradeRisks Ltd, 21 Great Winchester Street, London EC2N 2JA
Tel: 020 7382 0908 Mobile: 07540 914 672
[1] In a very few cases like complete downward staircasing there may be an HB eligibility and in a small number of cases there is eligibility for income support mortgage interest.
[2] It is possible that a valuer might say that the discount to market that the Rent Cut has increased might increase the time it would take to get all rents up to market rents or reduce the rate of vacancies that can be sold, without too much aggravation for the lender in possession, thus reducing MVSTT a small amount.