It didn’t take too long for the shine to come off the great boom in private sector funding for social housing. Hundreds of millions of pounds have been raised by a number of closed end funds focused on this space, with Civitas very much being the market leader. Usually, it takes a good year or so for an alternative asset class to fall from grace, but I reckon we could be heading for trouble in this sector much quicker than expected. As evidence, I cite the news today that a housing association which works with Civitas is in trouble – more on that below. In sum, Civitis was forced to respond to news that one of its partners First Priority has a variety of operational issues which have caught the eye of the sector guardian, the office of the Regulator of Social Housing. I’ve pasted in the short version of the Numis report below – this says that Civitas has noted that it is “in active dialogue with the management team at First Priority, to assist them with their current situation”. The fund leases 45 properties (out of a total of 403) to First Priority, and at 31 January 2018, all rents had been received in full.

For the record I’ve long been skittish about this sector not because I’m hostile to private sector involvement – quite the opposite in fact. I’m as keen as the next politician to work out how to spend more money on social housing and get private investors involved. My worry has always been that the devil is in the detail – it’s all about execution, unrealistic expectations and financial engineering.  To be specific I worry about the following issues, only some of which are directly related to the gaggle of investment trusts in this space.

1. Many housing associations are pushing the boundaries of commercial activity, possibly opening themselves up to financial risk. As government funding for housing associations has been curtailed – and rents forced down by the central government – we’ve seen housing associations become much more creative. Many of the big players such as Peoples for Places now have large commercial arms involved in everything from leisure centres through to straight commercial resi developments. There’s nothing intrinsically wrong with this and I admire the entrepreneurial zeal of many of these outfits. It’s also true that these commercial developments are usually ring-fenced from the boring core activities. But nevertheless, one has to accept that there is an obvious potential for management overreach and a real question mark about the commercial acumen of these supposedly third sector organisations. I’m also worried about the blurring of lines between the explicit promise of government support (traditional ring-fenced activities – see below) and the more implicit backing for commercial and affordable housing projects.
2. Too much housing association activity has been focused on properties with rents closer to the market average (80%) not the category most in need of assistance i.e real social rent housing which is usually priced closer to 50% of market rents. Somehow, we need to jump-start investment in traditional council style rentals where the rents really are affordable. Unfortunately, the returns are also likely to be much, much lower in this latter category, for the simple reason that many of the clients simply can’t afford to pay more. If returns are much lower, then why not accept the inevitable and have explicit government funding for this activity, with the accompanying low cost of state capital?
3. Within the assisted living sector competition has been intense and I worry that too much money has been funnelled into too few genuine opportunities – with execution a real risk. Many of the housing associations in this space are smaller, and there have already been many scandals involving the quality of care in these supported facilities, many of which have clients with learning difficulties.
4. Complex financial engineering has been encouraged by a government desperate to get in private investment. Again, this is not necessarily a problem as such but I worry that weaker housing associations might be tempted to use financial backing from private capital, with the promise of higher returns through complex structures. Many conservatively managed housing associations, by contrast, seem happy to tap up outfits such as the Works Board where the cost of capital is much lower. At a push, some housing associations and charities have also focused on the retail bonds space where yields are much more reasonable – at around 4%.  As I have said many times before, anything in this space yielding well over 5% has to answer to real concerns about complex financing and execution risk.

According to Numis, Civitas’ share price has traded on an average premium to NAV of 6.5% in the past 12 months, “reflecting the strong NAV growth it has reported in its unique “portfolio NAV”.

If past examples are anything to go by, the fall from premium grace is usually abrupt and painful. I’d expect that premium of more than 5% to crumble into a 5 to 10% discount if bad news continues to come out of this sector. In a sense that turn around would only be fair – I can think of a number of mainstream commercial property REITs currently trading at a 5 to 10% DISCOUNT, where the financial structure is much clearer and the upside opportunity much greater (Schroders European Real Estate for example).

More from that Numis note this morning….

“In autumn 2017 First Priority Housing Association Limited (FPHA) advised the regulator that it had terminated its contract with its managing agents and had appointed a new Chief Executive. A regulatory notice this week stated that First Priority “does not have sufficient working capital or the financial capacity to meet its debts as they fall due”. In addition, it “was not compliant with the Governance and Financial Viability Standard”, the “Board has failed to ensure that it operates an appropriate strategic planning and control framework” and the housing association had still not submitted their annual accounts to 28 February 2017.

Numis Views: While Civitas has received all rents due from First Priority up to 31 January, the regulatory notice states that it is trading on the “goodwill of its creditors”, and so we would question its ability to keep up with rental payments going forward. At 30 September, First Priority accounted for 14% of Civitas’ rent roll, although we expect this to have fallen to high single-digits following acquisitions. Clearly, the governance failures at the Housing Association (HA) are disappointing and highlight that tenant covenants in the social housing sector are not risk-free. However, private funders have never suffered a credit loss, according to Triple Point, and in the past, struggling HAs have been rescued by other more financially stable HAs. We believe this was one of the key attractions to investors at IPO, along with the message that rental streams were effectively government-backed. The outcome of First Priority situation will be a significant test of the security of the revenue streams for the social housing funds. We understand that neither Triple Point Social Housing nor LXi REIT have any exposure to First Priority.”