In recent years it has become the convention for defined benefit pension schemes to assign different asset classes to one of two categories: growth/return seeking or liability matching. However, this framework may inadvertently deny consideration of other potentially very attractive assets that do not fit neatly into either category. Such assets offer relatively high risk-adjusted returns, but at the same time possess liability-matching properties. This combination can help a pension scheme achieve full funding while minimising the level of risk.
The pension industry is beginning to wake up to these opportunities and, increasingly, pension schemes are expressing interest in non-traditional investments such as ground rents, renewable energy projects or social housing. However, the pioneering investors are facing a number of challenges.
Two of the biggest ones are that pension scheme trustees are unfamiliar with the new opportunities and that the accessibility is poor. Nevertheless, new products are being developed and it is likely that in the future pension schemes will significantly increase their allocation to these assets. In order to provide an example of such an asset, we provide a brief overview of social housing, presenting its attractive characteristics and ways of accessing it for pension schemes.
Social housing refers to provision of affordable accommodation to people on low incomes. This is done mainly by registered social landlords (housing associations) and local councils. The Government supports the programme via grants and housing allowances. Housing associations are subject to relatively strict regulation. They need to comply with the Tenant Services Authority rules, are under scrutiny of the Audit Commission, and their boards have to comply with standards of corporate governance set out in the Companies Act.
Currently, there are 1,700 housing associations in England covering about
2.5 million homes. Regular expenditure on buildings’ maintenance or regeneration is financed via rents on existing properties. Since 2005, the government has set the rent increases to be RPI + 0.5% and, via this mechanism, rental income is linked to inflation. In order to ensure that the affordability is maintained, a 0% floor and 5% cap is applied to the RPI changes.
The investment opportunity consists of providing long-dated, inflation-linked debt funding to the housing associations. In the past, this funding was traditionally obtained either from government grants — via the Homes and Communities Agency — or through long-term (over 25 years) bank loans.
The former has suffered from recent austerity measures and was cut from £8.4bn over the previous three-year period to £4.4bn over the next four years at the Comprehensive Spending Review last year. The latter is no longer easily available because banks are reluctant to lend cheaply and long-term. At the same time, significant falls in house prices have reduced the income obtained by the housing associations from house sales.
It is estimated that housing associations will need to borrow about £15bn to be able to fund their planned development and regeneration projects until 2015. Consequently, housing associations are starting to turn to other forms of financing. For example, in 2010, they issued over £1bn worth of public bonds. Thanks to robust cash flows and tight regulation, publicly traded bonds issued by the major housing associations carry relatively high ratings (A1-Aa2). Smaller associations can access public funding via The Housing Finance Corporation (THFC) that also holds a high rating (A+).
There is an excellent and mutually beneficial opportunity for the funding gap experienced by the housing associations to be filled — to some extent — by pension schemes, who could benefit as they gain access to index-linked cash flows, which are attractive from a liability-hedging perspective.
At the same time, social housing currently offers much higher yields than gilts, while remaining relatively secure. Pension funds can aim for borrowers with strong credit ratings and also benefit from the high level of security of their investment.
Firstly, the houses themselves serve as collateral. Secondly, c.60% of the rental income comes from local government agencies. In addition, rent collection track records are good, and bad debts only account for 1%. This is a result of limited supply and strong demand, as demonstrated by the c.1.75 million household waiting list as at 31 December 2010.
Social housing investment models
There are three main models of investment in social housing. The most popular one, long-dated index-linked debt, has been discussed above. One other option is the development partnership. This carries more risk but is also associated with higher returns. In terms of asset class characteristics, this is very similar to an unlevered infrastructure investment.
Usually, a Special Purpose Vehicle (SPV) is set up in order to ring-fence the project and to limit the liabilities on both sides. Equity involvement of the association would depend on the particular agreement — however, given the reduction in the HCA grants, they are unlikely to contribute to a large extent. If required, the resulting investment can be decomposed into an equity-like investment and a debt component as described above, and allocated into the relevant part of the pension scheme’s asset allocation.
The third option is a sale and leaseback agreement. This consists of buying a number of existing properties and leasing them back to the housing association for 30 to 50 years.
Depending on the agreement, the property ownership might revert to the association, in which case the pension scheme receives amortisation of the capital value over the term of the lease. However, this model, like the long-dated index-linked debt, has a certain limitation — housing associations that are already heavily geared might not be able to afford another liability item on their balance sheets.
The benefits of investing in social housing, apart from the ones already outlined, include participation in socially responsible investment (SRI). Although there is currently no obligation by pension schemes to consider SRI, according to the amendment to the UK Pensions Act 2000, trustees are required to disclose the policy concerning their scheme’s involvement in SRI in their Statement of Investment Principles.
The main drawbacks are the relative complexity and poor accessibility of this investment opportunity. However, as more pension schemes express interest in this asset class, more research is being conducted and new investment products are being created to address these problems. One other important feature is the relative lack of liquidity. Investors are rewarded for this in the form of an illiquidity premium.
A further consequence of illiquidity is that the valuation of the assets will require thought as there are unlikely to be readily observable prices available. And although we can say that, barring default, the social housing asset cash flows will be a good match for the pension scheme’s liability cash flow, the mark-to-market value of the assets may not exactly match the mark-to-market value of the liabilities.
In this scenario, there should be some mitigation from the fact that the expected return of the asset should increase relative to the discount rate used to value the liabilities. However, this benefit will depend on the judgment of the scheme actuary.
Regulatory risk should also be considered — currently, social housing rents are linked to inflation at RPI + 0.5%. However, there is no guarantee that this policy will be maintained forever. In case the rules change, housing associations might find that there is a major mismatch between the rental income they receive and the payments they need to make in the sale and leaseback model. In the development partnership agreement, there are also project-specific risks that need to be considered. However, usually the investor is rewarded for that in the form of a higher yield.
In summary, housing associations and pension schemes seem to be a perfect match. Pension schemes can fill the need for necessary funding and, in return, they receive long-dated, index-linked cash flows and also benefit from the illiquidity premium. Moreover, social housing is a relatively safe asset, because of high-quality borrowers, typically rated at least single A, and the underlying collateral.
At present, social housing as an asset class is still evolving and not many fund managers offer this as an investment opportunity. However, considering the combination of the size and importance of the social housing sector, the significant financing and refinancing needs, the attractive investment opportunities that exist primarily due to the withdrawal of the banks from the financing market, the elevated illiquidity premium as well as the security offered, social housing as an asset class is expected to gain significant traction within the pension community over the next year or two.
Pension schemes could be well rewarded for the allocation of time and effort necessary to gain the insights and expertise needed to allocate to this asset class.
This article originally appeared in The Actuary magazine.