HAs approach lenders for retrofit carve-outs
A number of housing associations (HAs) are in early discussions with their lenders over potential carve-outs to interest cover covenants in relation to the impact of building decarbonisation spend.
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One of the key covenants concerned in discussions is the EBITDA-MRI interest cover ratio. The ratio measures the level of surplus generated (excluding sales of existing assets) against interest payments, but HAs must also take off capitalised investment in works on existing buildings. The covenant is therefore sensitive to higher repairs spend during a particular accounting period, as opposed to incremental build-up over time.
Not all HA loans use the covenant, with a range of others in use – some of which may also be impacted by increased retrofit spend.
Legal professionals in the sector with whom Social Housing has spoken have observed an increase in conversations with lenders about covenants in relation to decarbonisation spend, with one noting a “particular focus on it over the past six months”.
Meanwhile, housing leads at major lender NatWest told Social Housing that it is having “lots of conversations with organisations at the moment, specifically around retrofit”.
Separately, some HAs have also approached lenders for carve-outs for building safety spend, with some agreed, Social Housing understands.
HAs are beginning to scope out the cost of decarbonising their stock by 2050, with a range of estimates on the potential costs of doing so. Consultancy Savills has estimated that £3.5bn will need to be invested annually by the sector. Meanwhile in Wales, one estimate places the total cost of decarbonising the sector’s current stock at £4.8bn.
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Jonathan Walters, deputy chief executive at the Regulator of Social Housing, said: “At a broad level the sector is going to have to spend more money keeping the existing stock in the right condition. Unlike building a new home, the spend on zero carbon work is unlikely to generate additional income, so all other things being equal, that puts more pressure on the business plan.”
“The spend on zero carbon work is unlikely to generate additional income, so… that puts more pressure on the business plan”
Marcos Navarro, director and ESG lead at NatWest, told Social Housing: “NatWest is open to having conversations with housing associations around adjusting covenants – and fire safety work is a classic example of where the bank has been willing to adjust its covenants to allow for additional expenditure that might not have been expected. [Retrofitting] is similar to that, but it becomes a bit more difficult [in determining] what is genuinely one-off expenditure versus the normal course of business.”
Mr Navarro added: “One of the big challenges that we have to take into account isn’t necessarily just the covenants that we’ve got in place but also the covenants in place with other funders.”
Figures from the regulator’s latest Statistical Data Return, published in February, lay bare the challenge facing the sector over decarbonisation.
More than half of social units owned by registered providers were built between 1919 and 1980, the data shows.
Mr Walters said that for most of the sector, no numbers on retrofitting spend have yet been built into business plans.
Tom Paul, director of treasury and commercial at 45,000-home Optivo, told Social Housing that the extent to which interest cover covenants could hinder housing associations’ decarbonisation spend will depend on the speed at which boards wish to reach ‘carbon zero’.
For Optivo, the path to Energy Performance Certificate (EPC) Band C in 2030 is already mapped out and costed, but Mr Paul sees a bigger price tag attached to the route beyond that, to 2050.
“We could do that in a straight line, divide the cost by 20, do a bit every year. But if we thought the right thing was to do it sooner, then we would need to be more careful about taking big cost hits in any one year,” he said.
“The interest cover covenants are there to make sure that the business is able to and will be able to pay its interest bills, and as things stand, the cost of net zero will drag on these metrics. The increased energy efficiency benefits, to the extent they exist, go to the resident, so from our perspective it looks like cost. Whether that’s capitalised or revenue, it still looks like cost.
“So, if in time our board looks to target achieving net zero sooner than 2050, the effect would be to push decarbonisation costs through fewer years, increasing the cost the business carries in those years.
“Ultimately the constraint on when net zero is achieved could, as things stand, be in the hands of lenders and interest cover covenants.”
Although some comparison has been made between the financial challenge posed by both the building safety and carbon zero agendas, and whether the former might provide some precedent where covenant flexibility is concerned, the profile of spend will differ.
Peter Benz, executive director of finance at Network Homes, said: “The building safety programmes that we are all undertaking, certainly in the G15 but also across the country, are obviously extremely urgent because they directly affect our residents’ safety in the buildings that they occupy.”
In numbers
1919-1980
Period when half of units owned by registered providers were built
2050
Government target year to bring UK to ‘net zero’
£3.5bn
Annual investment in sector required to meet 2050 target, estimated by Savills
Band C
EPC target that Optivo has mapped out to reach by 2030
As a result of building safety spend being concentrated in the immediate term and containing a significant non-capitalised element, the direct effect on the EBITDA-MRI indicator is likely to be greater, whereas carbon spend is likely to be more heavily capital in nature in the years to 2050.
Network, which owns around 21,000 homes, does not have an EBITDA-MRI-linked covenant with its lenders. However Mr Benz said the indicator remains important to the business with regard to its credit profile, and in broader conversations with lenders.
Where longer-term spend on retrofit is concerned, Mr Benz said that the constraint of gearing and gearing covenants may become a factor for the group in its path to 2050 should external funding or alternative funding models not become available.
“We are not constrained by gearing in the short term, and we may well be able to weather sustainability funding requirements from our own resources over the next 29 years, but there will be substantial opportunity costs, so
if we have to fund this all from our own resources, our ability to develop is going to be severely curtailed or at some point potentially completely prevented.”
Social Housing spoke to partners at several major law firms about the perceived willingness of lenders to agree to covenant flexibility, and what carve-outs might look like.
“We want to make sure the carve-out is for a specific purpose that is absolutely sustainability linked”
Lee Shankland, partner at Addleshaw Goddard, said: “I think lenders broadly are happy to carve out expenditure to remediate fire safety issues, provided that the housing association can demonstrate how soon the money will be spent and when. What we’re seeing are some parameters around the period and the maximum spend per year following discussions between borrowers and lenders, with lenders allowing carve-outs for up to two or three years.”
He added: “Some, but fewer, lenders are starting to allow carve-outs for cap-expenditure in relation to retrofitting from a net zero perspective.”
Julian Barker, partner at Devonshires, has observed two kinds of carve-outs around decarbonisation. “The first allows an additional capped spend each year and the second is a total amount over a period of time like four or five years, but with no specific annual cap. Which one a registered provider goes for depends on their decarbonisation programme. If they are going to do a lot in one year they will go for the latter, or if they want to spread the cost over time they will go for the former.”
But he added: “I’m not having clients say that they need this carve-out or they will breach their covenants; it’s more that they are being prudent and seeking headroom on their covenants.”
Covenant flexibility from lenders may form part of a broader two-way street on sustainability, Louise Leaver, partner at law firm Bevan Brittan, suggested. “[We] are increasingly seeing lenders include requirements for EPC ratings of a certain level with loan agreements and there are two sides to that coin. If the EPC ratings across a borrower’s existing stock are to be improved as part of decarbonisation, there will be costs associated with that and those need to be taken into account in financial covenant calculations.”
Neil Waller, partner at Trowers & Hamlins, said he would expect to see a “lot of focus on the detail”. He added: “If I’m a lender, I’m going to have some healthy scepticism about somebody saying, ‘Well I’ve got to spend £5m on this retrofit, it’s all zero carbon anyway, isn’t it.’ I’d say, ‘Well how much of this would you be doing anyway?’”
At NatWest, Stuart Heslop, head of UK housing, said that the bank is likely to focus any agreed flexibilities on “the next two to three years”, rather than a longer period. “We want to make sure the carve-out is for a specific purpose that is absolutely sustainability linked. It’s not a carve-out to allow a very standard repair or ongoing maintenance issue to be dealt with – it is genuinely to improve the quality of the building itself.”
NatWest’s Mr Navarro suggested that the bank may also look to tee up carve-outs with a sustainability-linked loan to capture the retrofit activity.
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