Joe Griffin: In the three years that I’ve been at Just Group our exposure to the Housing Association (HA) sector has more than doubled – both in terms of the number of issuers that we hold and the total market value of our exposures.
Our interest in the sector is due to several key drivers. Firstly, it's a highly defensive sector. For example, in the early stages of the pandemic, we still had confidence in the sector, even in the spring of 2020 when the HAs stopped building new units. This is mainly because a large proportion of HA revenue comes from core recurring cash flows from social housing letting tenants.
"We think that the defensive nature of the sector and the strong regulator contribute to stable investment grade credit ratings."
Another reason is that the sector benefits from the strong regulator. Because the regulator has strong oversight and regular engagement, they can pick problems up before they become significant – particularly with the weaker HAs.
We do hold some of the lower-rated HAs. But the regulator works alongside management to formalise an action plan to improve their performance, they push through mergers, can remove the board, and can remove management. They have a lot of powers, and we feel it’s a nice safety net. If things do get bad with our issuers, then the regulator can step in and improve that situation.
We think that the defensive nature of the sector and the strong regulator together contribute to stable investment grade credit ratings, which, given our business model, is critical to us.
ESG considerations were present in 2020, but less so than they are now. We feel that these HA investments are making a difference in the lives of others. We're helping providers fund more affordable housing.
This is crucial given the severe housing shortage that we have in the UK. This supply/demand imbalance impacts lower-income families more too. There’s a social drive for our investment in this sector, which includes looking at the new units the HAs are building but also the existing units they have. We’re involved in providing issuers with funding to enable HAs to improve fire safety, decarbonise, and help keep tenants safer within the UK.
"Capex requirements are as high as they’ve been in recent memory,
with the decarbonisation push."
We’re aware that there are headwinds facing the sector currently. Over the last 12 to 18 months, there have been more negative rating actions from the credit rating agencies than positive, as high inflation is increasing the cost of building new units. The costs of maintenance and repairs on existing houses is going up too, yet at the same time, the government has capped the rents at 7% increase per annum.
This is squeezing the operating margin for many providers, whilst at the same time, capex requirements are as high as they’ve been in recent memory, with the decarbonisation push and the required fire safety spending since Grenfell in 2017.
Both of those factors are putting downward pressure on the ratings and investors have to be aware that where – maybe five to 10 years ago – this was an A+/A sector, a lot more of the publicly-rated HAs are rated at A- and a few are starting to push down into BBB.
A weaker UK, as a sovereign, is also a factor. The country was AAA 10 to 15 years ago, but that steadily has come down. It’s rated AA- (negative) by both Fitch and Moody’s currently, and should the sovereign fall to A+, we might see more HA ratings get downgraded.
In terms of more commercial aspects and portfolio management, the HAs and the good benefits I've mentioned – such as being defensive and well-regulated – means it comes with tight spreads.
We know when we're investing in a HA that it's unlikely to be a lucrative deal with very attractive pricing. As well as that low spread it's also a relatively illiquid sector: most HAs, other than the big 50,000+ unit holders, will have maybe one or two bonds and these bonds aren't huge. With that comes illiquidity.
We’re generally comfortable with this though, given that we’re predominantly a buy-and-maintain investor, but if we were trying to sell out from a troubled name, it wouldn't be as easy.
Joe: It’s a more defensive, lower spread sector when compared to the majority of other Commercial Real Estate (CRE) transactions and asset classes in our books. Our CRE loans, for example, tend to be much shorter-dated – often three to 10 years. They're also more volatile in terms of both the property valuations and the rental income, which makes our ratings of these transactions equally turbulent. This isn't ideal for us given our business model, but we are compensated with higher spreads.
HA investments are appropriate for our long-term buy and maintain portfolio. CRE loans require a lot more active management, whereas if we invest in an HA deal, we're getting a certain security pool and we wouldn't expect that security pool to be changing over the life of the deal.
However, with the CRE transactions there are often properties being bought or sold, which requires more active management. That's why we look to our external managers for those services. HAs are more passive, and we can easily manage them in-house, which is great.
"We have the more volatile, higher spread assets with the more stable HAs."
We do look at some longer areas for real estate deals too, which have characteristics more in line with HAs – such as commercial ground leases and income strips. Income strips, in particular, have characteristics that are close to the HA sector. These are often long-dated (around 40 to 60 years) and backed by a government-linked tenant, such as a local authority or university, which means their ratings will often be more stable.
A good balance is key. We have the more volatile, higher spread assets together with the more stable HAs, and we like that balance. It's important for us to have a diversified portfolio in that area.
Joe: Yes, housing – and social housing, in particular – is a sensitive topic. HAs regularly make the news and often for the wrong reasons.
"Reputationally, we don't want the headline that we’ve invested
X amount in “X issuer”."
The quality of an HA’s stock is always scrutinised and any units that fall short of the required standard – whether in terms of fire safety, energy efficiency, or, more recently, dampness and mould – could mean negative headlines.
These are all key considerations for us when investing. Reputationally, we don't want the headline that we’ve invested X amount in “X issuer”. We don't want to be funding providers that aren't keeping their tenants safe.
But at the same time, some HAs that are below standard need to get up to standard quickly. To do that, they often need debt funding. If we know that the proceeds are being used to improve existing stock and tenant safety, then we will happily invest in an HA to fund these works.
Due diligence always means evaluating existing stock. This wouldn't just be the security pool that we're getting for our investment; it would be all units under management. We want to see how they meet the Decent Homes Standard and if there are fire safety or cladding concerns. To this end, we'll speak to management to determine the level of control that they have around their stock inspections and the general importance they place on tenant wellbeing.
Joe: The main way that the government impacts our investments in this sector is through the changes they make to the operating environment – for example, the level of grants offered for building new homes or improving the existing ones around issues like fire safety and decarbonisation.
The level of grant directly impacts the credit profiles of the HAs we hold. The government is responsible for the rent setting and the rent cap, so it has a big impact on the sector.
However, we don't see that many opportunities for public-private partnerships (PPPs) in the sector anymore. We mainly focus on public bonds and private placements from the issuers. We see some PPPs in project-finance-style deals in the student accommodation space, which can be interesting. These opportunities are long-dated and fully amortising, both of which are positives for us, and we would welcome similar opportunities in the HA sector.
