Gearing cuts against the grain

Gary Grigor discusses the gearing covenant constraints and the impact on housing supply.

In light of recent initiatives in the 2017 Budget to stimulate housing supply, there is an ever-growing argument that gearing covenants constrain Registered Providers (RPs) and Registered Social Landlords (collectively, Associations) from reaching their true potential.

Most mature Associations on corporate covenants are expected to demonstrate their perceived financial health via annual interest cover compliance (sometimes on a three-year rolling basis) and gearing compliance at all times. Net rental income tests are also infrequently requested by some funders in the sector.

Gearing covenant frustrations
Whilst no Association would take issue with demonstrating its ability to generate enough income to satisfy interest cover over a rolling periodic basis, it is the gearing covenant, in its various subtle iterations, that continues to cause frustration.

In essence gearing assesses the amount of debt in an Association as a proportion or percentage of that Association’s underlying assets. The greater amount of debt to the cost/value/number of those assets (however the test happens to be prescribed), the more turbulent the financial health of that Association is perceived to be.

But in a sector where the debt capital markets (private and public) have successfully funded without a gearing covenant, why does it continue to persist in new and restated legacy bank funding documentation and some private placements that go to market?

Banks will point to compliance of the gearing covenant as a demonstration of stability and financial health within predefined parameters, all with the aim of ensuring that the Association is not financially overstretching itself over the short-medium term.

Hindering supply
In the debt capital markets, there is recognition that by the very nature of the long-term funding of those particular deals, the relevant Association needs to put its cash to work in order to realise the long term financial gains to which it aspires.

So, at a time when the Chancellor is calling all Associations to arms and to equip themselves with every possible trowel and spade within sight to deliver the extra capacity, do the constraints of a gearing covenant cut against the grain of the call to increase supply?

In short, yes. With an already limited supply of housing available to be acquired, Associations are naturally looking to development activities to try and meet demand. Such development activities require large up-front cash commitments, but this results an intrinsic lag between that upfront cash investment and when the tangible assets emerge that can readily be identified for covenant testing purposes. There is therefore limited scope for Associations to be able to increase debt and show immediate equivalent assets gains.

With £15.3bn of new financial measures announced by the Chancellor, it is too early to say if those financial initiatives will ultimately disseminate down to the pockets of the Associations. If they do, then that raises the question if such funds will constitute component parts of “debt” for the purposes of gearing?

Conventional wisdom would say that the Government will require its money back in some form and for that reason the financial assistance will constitute “debt”, therefore scuppering the intention of those Associations constrained by gearing covenants. Irrespective of whether the debt is accrued from government or private finance arrangements the Associations will still be constrained from putting that money to work because of the lag of achieving tangible housing properties by which to counter-balance the debt ratio for gearing purposes.

This often has the added complication that the treatment of an Association’s assets for calculating gearing is not uniform. It is not untypical for gearing covenants to attribute a lower value to shared equity assets such as shared ownership properties and right to buy properties. This places an additional hardship on Associations to meet prescribed gearing thresholds where their asset base is diverse.

So whilst the Chancellor will continue to call on Associations to do as much as they can for the greater social purpose upon which they are founded, just don’t expect too much because it will be to their ultimate peril if they do!

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