Covenant waivers continue to rise, as RPs prioritise investment in existing homes

The reasons behind the trend

The growing trend was put down to housing associations requiring support to invest more in their existing stock, as seen in the RSH’s last quarterly survey.

In the survey for the three months to December, the regulator said that a number of providers had obtained loan covenant waivers in response to increasing investment in existing stock.

Providers spent £1.7bn in total on repairs and maintenance in the quarter, eight per cent higher than the previous three months.

Twenty-six social landlords reported having agreed a waiver to exclude the exceptional costs of building safety works from loan covenant calculations, while 22 waivers were reported in respect of energy efficiency or decarbonisation works.

Lucy Grimwood, partner at Winckworth Sherwood, told Social Housing that the growing trend of waivers being agreed was driven by “significant pressures on the sector at present”.

“The sector as a whole is very much in a holding pattern when it comes to large-scale retrofit while they assess their retrofit strategies and what level of funding is likely to be available”

She said that in particular these include disrepairs, decarbonisation and building safety, which have all increased in volume. This is partly due to a post-pandemic build-up, and partly as the drive to net zero gathers pace on top of legislative and regulatory changes. Another pressure is that the costs of meeting those commitments are increasing due to inflation, labour costs and supply chain issues, Ms Grimwood said.

“So, it’s not surprising that we’ve seen an increase in the number of carve-outs being sought and granted. It’s not new – these challenges have been mounting for the last few years. For example, we started to see carve-outs for fire safety works from the end of 2021, following legislative changes, including the Fire Safety Act, earlier that year. But it’s certainly increased.”

Naomi Roper, partner at Trowers & Hamlins, said there is “clearly both increased demand and a willingness on the part of funders to be flexible and accommodating when it comes to financial covenants”.

She said: “Most of the requests centre around the need to exclude spend related to building safety works from the covenants for a year or two. We are not yet seeing much in terms of changes to financial covenants in order to accommodate retrofit works, but that is to be expected.

“The sector as a whole is very much in a holding pattern when it comes to large-scale retrofit while they assess their retrofit strategies and what level of funding is likely to be available.”

Lawyers highlighted that lenders are willing to negotiate covenants if presented with sufficient information.

Ms Grimwood said that lenders have, in her firm’s experience, been receptive and proactive to these requests, working quickly with registered provider borrowers to agree a workable carve-out in the required timeframe.

She said: “Lenders are usually very collaborative in this sector – most registered provider borrowers have a strong working relationship with their main funders – so whilst they have not necessarily had to become more receptive to carve-outs than they have been previously, the need for such carve-outs has perhaps increased given the external big-picture pressures.

“As with all negotiations, it’s about finding a solution that works for all parties.”

Michael Nutman, associate at Anthony Collins Solicitors, said the willingness of a lender to consider and approve a covenant variation request will “depend entirely on the borrower itself”.

He said it depends on the borrower’s financial health, liquidity, credit rating, business plan and forecasts as well as the type of facility in place and the terms of the loan.

Mr Nutman said: “Nevertheless, provided that the borrower in question is being operated in a prudent manner and is ‘financially sound’, we have seen evidence that lenders are open to, at the very least, discussing financial covenant variations, provided of course that there is a clear rationale for such a request which can be supported by appropriate data/evidence.”

The regulator’s take

Will Perry, director of strategy at the RSH, said that the primary reason behind the rise in covenant waivers being agreed is that providers are having to compress more expenditure than they had anticipated when those covenants were set, in a shorter period of time.

Most of what the regulator has been told about on this relates to building safety works, given they are going to require a “short, intense period of expenditure”, he said.

Discussions are also taking place for covenant waivers to accommodate decarbonisation works but this will require longer-term adjustment as these works are likely to take place over the longer term.

Mr Perry said: “You need to have a kind of covenant structure that can accommodate that sustained investment. So, I think decarbonisation will be something that involves larger-scale adjustment, rather than temporarily waiving a covenant for a short period.

“So, I think we will see a hump in stock investment expenditure with the current building safety works. But then when it settles down to a steady level that will be higher than it was five or six years ago.”

Mr Perry hinted that negotiations around covenants could become a permanent trend as the level of expenditure on existing homes in the sector continues to rise.

He said: “I think it’s certainly true that the sector as a whole and the performance of individual providers is going to change.

“There will be more expenditure, and depending on what happens to rents, providers will potentially bring in lower income than perhaps they’d been anticipating, and the sector will have to adjust to that.

“It doesn’t mean that everyone is going to seek to change their covenants or get specific waivers, because a lot of providers have quite a lot of headroom under their covenants, and so they don’t need to adjust. But I do think that the sector as a whole will report lower levels of interest cover and higher levels of investment expenditure.”

According to the latest quarterly survey for the third quarter, the regulator has “sought additional assurance from providers where investment in stock appears to be insufficient” and “will continue to engage where appropriate”.

Asked about this, Mr Perry said that the regulator is looking for assurance that providers have a fully worked-through investment plan, that they know the investment needs of their stock and that they can fund those works that are needed.

“It’s saying, ‘Do you know your stock, have you got an investment plan, do you maintain homes at an appropriate standard and do you know how you are going to fund the investment?’,” Mr Perry said.

“So, it’s using the funding plan as an indicator of the provider’s stock management. If we see outliers, we may need to find some more assurance, so we can be confident that the provider has a robust investment plan.”

Mr Perry advised housing associations to manage their risks and to be open with their lenders with regard to covenant waivers, to inform them of the need to make changes in advance.

He said: “Our messages are what they’ve always been – understand your risk, understand your stock, manage it effectively, communicate well with your lenders about what’s going on in your business and take informed, strong decisions.

“As the range of pressures on the sector grows, as cost drives up, that need for a really strong understanding of the business, really strong investment decision-making, really strong risk management, has never been more important.”

Moving away from EBITDA MRI

The main covenant that providers are looking to amend or avoid in future is the EBITDA MRI interest cover ratio, which stands for Earnings Before Interest, Tax, Depreciation, Amortisation, Major Repairs Included.

It is a key indicator for liquidity and investment capacity and seeks to measure the level of surplus that a provider generates compared to interest payable.

Louise Leaver, partner at Bevan Brittan, said she has “definitely” seen an increase in the number of borrowers asking for amendments to their EBITDA covenant. She said generally lenders are more willing to agree to the change and providers should start the conversations with lenders early.

Ms Leaver said: “The more information that borrowers can provide about the likely costs, the easier it is to have that conversation with lenders and that is where the issue tends to lie, because it can be hard to be specific about the likely costs.”

At Trowers & Hamlins, Ms Roper said that EBITDA MRI is proving to be an “unpopular financial covenant” and for new funding RPs seem to be “shying away” from including an EBITDA MRI covenant as part of the covenant package.

“Funders generally seem to be accommodating in relation to agreeing financial covenant packages without EBITDA MRI, including for some clients where they receive requests to update historic covenants, though often this requires an increase to the ratio percentage,” she said.

“The more information that borrowers can provide about the likely costs, the easier it is to have that conversation with lenders and that is where the issue tends to lie, because it can be hard to be specific about the likely costs”

Signs of this trend have been seen in the wider sector, with for example the provider of the government-backed Affordable Homes Guarantee Scheme twice relaxing its covenant ask last year, in response to borrower demand.

Julian Barker, partner at Devonshires, told Social Housing that where borrowers are seeking new facilities from funders, they are “pushing very hard” for EBITDA-only covenants and are usually successful.

He said that most lenders are now prepared to give new facilities based on this covenant, but in the case of amendments to existing covenants, lenders still appear reluctant to switch to EBITDA-only covenants.

Where there is concern about meeting a covenant, lenders generally agree time-and-amount-limited carve-outs, Mr Barker said. However, he is talking to a number of borrowers who are planning to push the banks for a straight switch to an EBITDA-only covenant that is not limited in this way.

“I suspect that lenders will, over the next few months, agree to this switch. The question will be whether they insist on an increase in the ratio as a result.”

He believes “all sides are reaching the conclusion that EBITDA MRI covenants are no longer fit for purpose in today’s RP funding market”.

There is an acceptance by lenders that there is a legal and political obligation on borrowers to incur the costs around decarbonisation and fire safety spend, Mr Barker added, and a desire from both parties to ensure borrowers do not default on their loans.

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