Is Affordable Housing the star of the real estate investment landscape now?

Speaker A: Hi, I'm Anna Clare Harper and you're listening to the Return, the podcast that gives you the inside edge on key residential market trends straight from industry leaders so that you can grow your property, career, business or portfolio faster. £39 billion worth of government money is entering the affordable housing market. This is the largest affordable housing program in a generation and it sounds like a lot, but the estimated need is 145,000 affordable homes a year. The program will deliver around 30,000 each year. Who fills the gap and how do you make money? By delivering what the market needs. That is exactly what we're going to get into today. I'm, um, Anna Clare Harper. I'm a director at residential investment manager Pinnacle Investments and the author of three residential investing books. And I am joined by my co host, John German.

Speaker B: Hi, I'm John German. I'm, um, head of living investments at Invesco Real Estate Europe and we're global investment managers. With about 2 trillion of assets under management globally and over 500 billion of living investments across Europe.

Speaker A: It's great to have you back. There is an awful lot of terminology in this sector that can put investors off before they even get started. So can you clear some of that up for us?

Speaker B: Let's start with perhaps the easiest one and also the beginning of the Alphabet, affordable housing. What is affordable housing? It's basically a regulated category in the UK housing market where homes are let to occupiers at, uh, between 50 and 80% of the open market rent. The open market rent being 100. Therefore your rent that you're charging your occupiers is either 50 or 20, and that is run by something called a registered provider. The next definition that's important to understand is three types of rental class that you have within the affordable housing space. Social rent is set by a government formula, typically about 50% of open market rent. Affordable rent is a more constrained element where the discount can be up to 80%. And then finally the discounted market rent sector. This is really an open market rental sector where you don't need to be a registered provider to own or operate it. And that's typically round about 60% of open market rents. Then you have something called shared ownership. Shared ownership is a scenario where your occupier part owns and part rents the property and part of the rent that they're paying to the landlord is going down to buy out further stakes within that property and you're effectively trying as the tenant to pay enough money to ultimately buy out the landlords and own the property. Outright. So it's a way of trying to get people from the social housing area into home ownership. In the uk, the next definition would be housing associations who are the traditional providers of affordable housing stock, which could include discounted market rent, but typically doesn't. So really just affordable and social rented stock and shared ownership. And they, uh, are typically not for profit organizations. So their whole ethos is about providing affordable housing for people who have that need and that's under constraint. You also have for profit rented providers, which typically are the more modern renter providers that have been set up where actually you're allowed to take out some of your profit and redeploy it elsewhere, so you're not having to just reinvest it into the social housing sector. And that's typically where we're seeing institutions coming into the market. And then finally, section 106 of the Town and Country Planning Act 1990. This is a piece of legislation that sets out requirements for every planning permission in the uk, which in part will incorporate a requirement for affordable housing within any new housing development. It also will incorporate certain other potential requirements on the landowner. Uh, but the key one for the topic today is the requirement for affordable housing, and that will need to be run by a registered provider.

Speaker A: Now we know what we're talking about and here's the thing. Affordable housing is not a charity project. It's arguably one of the most structurally sound and compelling investment opportunities in the UK real estate sector right now. The government has also just committed 39 billion to the sector and launched a new institution, the National Housing bank, to crowd in private capital alongside it. One of the UK's biggest insurers has just announced a major deal in this sector and yet most investors are not in this sector. So we're going to discuss what's going on and, um, whether this is maybe the moment to pay attention to this space. But first things first, when we speak with investors about affordable housing, the first topic that tends to come up is the need story.

Speaker B: The scale of the need is what really underpins everything in this space. We're not talking about a cyclical housing dip. There's a supply demand imbalance in affordable housing that's structural and has been building for decades. We've not been building enough affordable housing in the uk, full stop for investors. That's really important because there's a persistent inelastic demand and that's the foundation of, uh, the long term stable income that this asset class can generate. You also have very low void rates, typically 1.5% and demand doesn't fall in recessions, it actually rises because less people can afford to pay the rents in recessions. It's really, really a key thing.

Speaker A: Okay, and how big is the problem at the moment?

Speaker B: There are 1.34 million households on local authority waiting lists at the end of March last year. That's people who are waiting to get into affordable housing and can't. And that's growing by about 40,000 every year since 2020. There are 134,000 people in temporary accommodation and 4.2 million households have some form of unmet housing need. And really of those, about a third is people who would qualify for social rent as their most appropriate form of tenure. So there's your demand. Massive, massive demand. What about the supply? Well, we're building about 60,000 new affordable homes every year, but unfortunately we're also losing about 28,000 a year through right to buy and demolition. Things just become obsolete. So you really only have a NET increase of 30,000 a year against a total need, as you mentioned earlier, of 145,000 a year. Just by simple maths, the number and the undersupply is going to continue to grow even with substantial development. So the demand and the requirements and the potential investment returns are very, very strong.

Speaker A: And as you said, netgaap has been building for years and it will persist for decades. It's not a short term problem and it's not a short term fix. But this is an investment podcast. So I think it's okay to say this is a social problem, but it's also an investment opportunity. To understand why we need to look at, uh, what's happened to traditional providers of affordable housing, we get into what I would like to call the funding story. Housing associations or registered providers own 62% of affordable housing stock, but they are under serious financial strain. We've got Post Grenfell, higher fire safety costs, rising health and safety standards, decarbonisation requirements. All of that means that a huge amount is needed to pay for repairs to existing buildings. Estimated up to about 100 billion of investment sector wide in upgrading existing homes. Repairs costs have been driven up significantly in recent years. And as a pointer, uh, the cladding safety scheme provides some funding to support with some of the fire safety costs associated with that. 5.1 billion has been allocated by the government alongside a £3 billion building safety levy. So there's £8 billion there to fund 100 billion of need.

Speaker B: That's just 100 billion in the affordable housing space for getting the open market space as well so it's a drop in the ocean.

Speaker A: It is a drop in the ocean. Repairs costs have increased. At the same time, the traditional funding model has broken down under higher borrowing costs. Previously, housing associations funded their growth through a combination of government grant and also very low cost debt. So they would issue bonds and that would help them to fund growth. They could do that based on their credit ratings. But with higher repairs costs and also higher finance costs, the result is a squeeze on their interest cover ratios. So a particularly important one is called EBITDA mri. That's basically a metric that is watched by the regulator of social housing and also by rating agencies. And it measures what, what is the income after repairs costs and how does that relate to the amount of interest that needs to be paid each year. And many housing associations are now failing by that test. This is a bit of concern both for the regulator and the rating agencies, and it makes it a problem for the housing associations themselves. The result is that many housing associations are pulling back from new development in order to focus on their existing stock. In 2018, 34% of housing associations were prioritizing existing stock over new development. By 2023, that figure was 95%. So they're really kind of reining it in on the new stock and stepping back. Precisely when demand is reaching its peak. That creates the first signal, I would say, of the opportunity. Could institutional capital help plug the gap? Institutional ownership was around about 1% of the sector, which is worth about 500 billion. So the market is huge, but the incumbents are constrained and there are entry barriers there to protect those who have got in or are getting it. So that's the setup. Next we should look, uh, at what the government is doing about it.

Speaker B: You've already mentioned some of the initiatives, but just to highlight them a bit more, there's the 39 billion social and affordable housing program. That's a 10 year program, 3.9 billion a year. If you do simple math. And in theory that should produce 300,000 homes over 10 years, 30,000 a year, maybe that doubles your 30,000 net to 60,000, but still well below the 145,000 target. Just to bring that up 60% of that programme. That 39 billion also needs to be in the social rent space. So very important because that's one of the largest demand spaces that is required by the market. And that is also the most grant intensive area of the affordable housing space as well. It's important to try and make the money that you have in that stretch as far as possible. The National Housing Bank. It was launched on 1st April this year. 16 billion of equity guarantee and debt. The idea being it frees up and helps facilitate investment opportunities alongside other areas of capital sources. And then perhaps also most Importantly, there's a 10 year rental settlement that was announced in April of this year as well, which is at CPI +1. One of the things you're thinking about as an investor and coming into a market is what is the resilience of my rental income and how much will it grow by? We now know that in the UK affordable housing space rents will grow at uh, CPI plus 1 for the next 10 years. So that's very easy to underwrite and so to that extent that's really helpful and um, should encourage investors to come into the space.

Speaker A: So we talked a bit about the 30,000 homes a year versus an estimated need of 145,000. The program therefore covers about a fifth of the supply gap. That then means that the crowding in mechanism is quite a critical variable. The National Housing Bank's ambition is to lever uh, 53 billion of private capital. And that only works if institutional investors do actually co invest at scale. So that's the bet and it's also the opportunity. Rather than the old model of grant plus cheap debt, the new model is built around this blend of grant plus debt, debt plus institutional equity. How does that work in practice?

Speaker B: For a registered provider, you can access grants depending on where it's located, between 50 and 130,000 pounds per rented home and for between 40 and 60,000 pounds per shared ownership home. The higher levels are in London and higher value areas. Those are subsidies that help make returns work. But it's not the complete story they're partway through. But with this additional certainty around the 39 billion access to the National Housing bank sums the certainty on where rents are going to go. That should help the government's desire to bring in private capital, which has a framework which you can clearly underwrite to deliver long term stable returns. Saville's hope have forecasted that they will be delivering 840,000 homes over the next five years, still well short of the government's target of 370,000 homes per annum per year, but a meaningful change from where we are at the moment. So this crowding in mechanism is one that really will be crucial in making this work.

Speaker A: If the return profile is so compelling and the need is so acute, why isn't there more capital in the sector already? And what does the answer tell us about the nature of this opportunity?

Speaker B: The first Thing is, you're looking at a more core style of investment, looking at long term recurring income streams to drive your returns. And that typically lends itself to a domestic investor who's also tax efficient in terms of how their investments are treated. And also institutional capital as well. There are some dedicated affordable housing funds already in play, to name a few, legal and general M&G, CBRE Global Investors, Octopus Cheney Capital Man Group resonance and Columbia third needle. And they've raised something in the region of 3 billion into the space already. It is an investable sector already. But what is being offered here? What is a profile of the investment returns that these types of investments can generate? Net operating income of really between geographics will be dictating where this will end up between 4 and 5.5%. So your income of your 100 you invest, you'll be getting between 4 and 5.5% every year and total return. So the combination of income and rental growth. If you assume the CPI plus one, which we can for the next 10 years because that's what the government award is, and say long term inflation running at 2.5%, you're getting a blended total return of between somewhere between 7.5% and 9%. So if you look at that on a relative basis, if you're saying 10 year gilts are running at 4.5% plus or minus at the moment, then your pickup is somewhere between 300 and 450 basis points above 10 year gilts. Potentially quite attractive. Other key things to remember about this is you have very, very low void rates. People who are in affordable housing don't want to leave because they have nowhere else to go to and their rents are also helpfully paid by the government. So actually your void rates are incredibly low. Your bad debt levels are incredibly low because 85% of your rents are actually paid for by the government. And finally looking at economic shocks, people will continue to pay their rents in affordable housing because it's backed by the government and because they have nowhere else to go to. So it's very smooth income streams and typically is uncorrelated to other asset classes within real estate.

Speaker A: What kind of investors is this for then, John?

Speaker B: It's really more core long term capital. You're looking at a index linked low volatile investment. I see this as being very popular for UK pension fund capital. UK domiciled doesn't have to be local government pension schemes. It could be anything that's UK domiciled and also potentially insurance companies who like that long dated income stream M&G LNG and also pensions Insurance Corporation have all invested into the affordable housing space over the years. So it matches their uh, long term liabilities and it has very good downside protection against inflation. ESG is another important credential and with the S component being very well ticked with affordable housing, you're also saying if you can create new stock or improve old stock, you can add to uh, that ESG component. There are potentially multiple tenure strategies. So you've got the social rent, the affordable rent and the shared ownership. So you could have a blend of those which change your income, your overall investment profiles. With the shared ownership you're getting some of your capital investment back just through the natural course of time. That can be very interesting and really what local authorities are looking to do with the section 106s house builders need to sell and get built the affordable housing components of their scheme to build the other stuff, which also helps the underlying housing problem in the uk. This will help unlock private sector housing as well as the affordable housing components. So the two are uh, inextricably linked and go hand in hand.

Speaker A: And you might ask why then there isn't more capital in this space already? I think the honest answer to that is complexity and a lack of familiarity. It's a regulated sector with its own language, its own approval process and its own relationships. Most institutional investors, not the ones that you mentioned earlier, who are already in here, but most, most don't already have the operational infrastructure to participate. And that's what creates this window of opportunity. There's a big barrier there, but these barriers are navigable and for those who have already navigated them, they're actually protective. The closest thing to a template at scale is quite a recent deal. Legal in general, who have over a trillion pounds in assets under management, paired with Hyde Group, who are uh, a registered provider who own and manage 125,000 homes, created a joint venture. This joint venture seeded with over 1000 homes cross social rent and shared ownership and Legal in General. They'd invested 1 billion in affordable housing since 2018. They seeded this joint venture with 1,000 homes across social rent and shared ownership. Now this joint venture, uh, can also invest in green retrofit so it can directly address the decarbonisation burden, um, that is weighing on housing associations and also create additional revenue for capital deployment. Legal in general is really happy with this deal. It describes the model as delivering three things. Stable inflation, linked income for pension savers, measurable social value for residents and reduced pressure on the public. First, and they themselves have invested over A billion pounds in affordable housing since 2018 and they're targeting 10,000 new social and affordable homes by 2030. So it's a great example of what can be done. The income is visible, the capital growth is real and the social impact is measurable. That is exactly the kind of profile that the National Housing bank will was designed to attract. Now that legal and general model requires serious scale. But there are genuine entry points for mid market capital, particularly through section 106. Becoming a uh, registered provider that we talked about earlier. That can take easily 12 to 24 months. Investors already through that process have a real sourcing advantage. And housing associations and house builders increasingly see these well run for profit RPs as credible buyers. One specific conversion opportunity worth flagging is that market housing schemes are being restructured now to include shared ownership. So that's new affordable supply that wasn't previously viable. The house builder is building the homes but they're not able to sell them and they're able to convert them into shared ownership, thus creating additional stock, which is why this is called additionality.

Speaker B: A couple of other things just to bring up as well. The wider housing link is worth noting. Section 106 obligations mean institutional capital that absorbs the housing stock. The affordable housing stock frees up the house builder balance sheets to deliver more market housing. The two things are connected and understanding that connection is a sourcing advantage. The window to establish a registered provider status ahead of the crowd may not stay open indefinitely. The National Housing bank is explicitly designed to bring more private capital in and competition for the best opportunities will increase as it does.

Speaker A: Really good point. So let's bring it together then.

Speaker B: So I think the first one is very clearly the need is structural and will not resolve quickly. That is the foundation of the investment case and that's not going anywhere.

Speaker A: Yeah. Secondly, the government has committed serious capital to this. But private investment is not optional here. The maths simply doesn't work without it. That's both the challenge and the opportunity.

Speaker B: And then finally the third entry barrier is real. But once cleared it does create genuine competitive advantage. Registered provider status, operational credibility and relationship with house builders and housing associations do take time to build. Those who've already built them or are uh, building them are ahead of the game. I think this is therefore the kind of opportunity that could be ideal for UK pension funds. But those investors who are perhaps looking for higher value, more opportunistic returns, this may not be quite the asset class for them.

Speaker A: Thanks John. That's it for this episode of the Return each month we go deep on a sector strategy or shift so that you can spend less time filtering the noise and more time acting on the signal. If it was useful for you, please tell someone. And if you have questions or topics you'd like us to cover, we would love to hear from you. You can send us a text via the link in the show notes or you can find us on LinkedIn. Anna Claire Harper and John Sherman. We'll be back next month with another deep dive. Until then, bye Bye. Thanks for listening to the return. If this episode has sparked an idea or helped you out, I'd really appreciate you recommending it to a friend in residential. Let's connect on LinkedIn or you can text me. The links are in the Show Notes. Get in touch and let me know if there's a guest or topic or challenge you want covered. Until next time, bye for now.