For UK social housing REITs to grow, government must reduce up-front costs and promote shared ownership, says Rosalind Rowe
There is no doubt that the UK has a housing crisis with demand far outstripping supply. While the social housing sector does not hold the solution to the country's housing needs, it can make a useful contribution; however, in the current economic climate, with fewer grants and restricted bank lending, the sector needs alternative sources of funding. Some social housing providers can access finance through the issue of bonds to the private sector. Forward-thinking registered housing providers are planning for a time when accessing the bond market may prove to be difficult. They also want to access equity, given any loans - bank or bond - are likely to be restricted by loan-to-value (LTV) requirements, so there will not be 100% funding.
The government has recognised this need for alternative funding and is exploring whether part of the answer lies with social housing REITs. While the housing sector welcomes the dialogue, some key changes are needed before REITs can deliver a significant increase in the social or key worker housing.
Changes have been introduced this summer in the Finance Act to encourage REITs to invest in market-rented property. For example, there will be no entry charge (previously 2% of gross real estate assets), plus there are initiatives to support new investment by institutional investors and start-ups.
There may be one or two social housing REITs now emerging - if they can deliver a reasonable return to investors taking account of risk. For example, a portfolio with a known track record would be easier than a proposed development where construction has not yet started. However, to achieve increased supply on a large scale, returns must be comparable to commercial property or if not, then, at least, they should equal market-rented residential property.
Government can encourage an increase in returns through flexing the current REIT regime to reduce costs. One step the government could take would be to reduce Stamp Duty Land Tax (SDLT) costs, which are irrecoverable. Currently, a buyer of a portfolio of let residential properties can benefit from a reduction in SDLT to as little as 1% (based on the average value of the portfolio), but similar SDLT relief is not available for buying a cleared site even though detailed planning consent may have been obtained for residential development. Further SDLT savings could be made where - for example, a local authority or a landowner contributes land into a REIT in exchange for shares. The SDLT and gains arising on the sale of land could be deferred until the REIT shares were sold.
Further costs include irrecoverable VAT, which arises because landlords cannot charge VAT on rents yet pay 20% VAT on repair costs which they cannot recover. A reduction in the rate of VAT for repairs would improve returns.
Changes such as permitting a higher level of borrowing and also not requiring REITs to meet the three-year development test would be helpful. REITs are required to have a financing ratio of 1.25 income cover, but this may not always be possible if there is substantial maintenance. The three-year development rule applies where a REIT spends more than 30% of the acquisition price on an asset and sells within three years, which would be difficult to track where there are many small units.
Investors will want an acceptable dividend yield on shares held in a social housing REIT (say 4-5%), which may need to be funded by sales of property at the margin. Such a mechanism should be acceptable to the government, given the intention of any REIT would be to grow, not shrink, and any such distribution to shareholders would be taxed as income. We would expect rents from shared ownership properties (where the tenant buys a portion of a property and pays rent on the balance) to also be acceptable as investment income. Such properties have a number of advantages: they generate long-term income streams and, moreover, a tenant is likely to take care of the property because he has a financial stake in its value.
There are structural issues to address. Where housing benefit is paid direct to tenants, there are fears by some institutions that arrears could become substantial. Given these payment provisions already exist, registered housing providers would be expected to present a track record of low voids.
The government will also need to address how to deal with housing grants. Surely if the intention is to increase the supply of let property, then cash generated from this initiative must be recycled into new housing and not just handed back to repay earlier grant funding.
Social housing REITs may take different forms; they may be registered housing providers, as seen above, or just an intermediary landlord through a sale and leaseback. However, a REIT could become the way for registered housing providers to recycle capital to grow the sector, through developing joint ventures with local authorities and then spinning off the vehicles wholly or partially to a REIT.
The government seems to be in listening mode. For social housing REITs to work on a grand scale, the investment returns have to increase. The upfront costs need to be reduced but the government must also embrace the special models of shared ownership and occasional sales of assets to improve returns. The government's Autumn Statement will make interesting reading.
Rosalind Rowe is head of the real estate practice at PwC