Thought leadership for housing associations: A changing credit rating landscape

Introduction

As housing associations make greater use of the capital markets, the impact of credit ratings on the price and availability of debt has increased across the sector. Ratings agencies now rank among the most important financial stakeholders for many housing associations (HAs), influencing relationships with banks, investors, and the Regulator of Social Housing (RSH).

Once the preserve of larger HAs in the sector, Chatham now sees credit ratings as an increasingly important tool for smaller borrowers to prove their credit strength to lenders and improve terms on new funding from a variety of sources.

While COVID-19 has placed significant strain on the sector, credit outcomes have been better than expected. Ratings agencies’ “worst case” scenarios of arrears exceeding 10, 15, or even 20% have not come to pass. There have been several stress points around areas such as market sales. The property market has been in a state of suspended animation for a portion of the financial year, but a rebound in the last six months has helped to make up lost ground. Other areas such as non-essential repairs and discretionary spend have also helped to offset revenue weakness elsewhere. In some cases, net income has even exceeded budget.

However, the market does not stand still, and while HAs have performed better than expected over the last 12 months, the credit rating environment has changed over the same period, too. Chatham believes there are several areas that will become increasingly relevant to rated HAs over the next 12 to 24 months, which will benefit some but disadvantage others:

• Updates to S&P’s methodology
• A subtle change in the approach from Moody’s

To borrowers considering a rating for the first time, these changes will impact the choice of agency.

For borrowers that already have a rating, care must be taken in assessing the impact on the business plan of potential credit rating outcomes, and actions implemented to manage this. It should be noted that forecasts in the business plan for the next three to five years may actually have greater influence on ratings than historic performance or outperformance.

Challenges currently facing the sector include:

• Higher indebtedness – driven by increased development
• Pressure on operating margins – arising from catch up repairs, Fire Safety, and Zero Carbon
• Pressure on operating ratios and interest cover ratios – where lower interest rates may not be enough to offset the impact of higher debt burdens

Changes in ratings methodology and increasing operating pressures raise the risk of downgrades to BBB+/Baa1. This translates to higher credit margins for housing associations. This contrasts to the Utility sector, for example, where equivalent credit downgrades appear to have a negligible impact on pricing.

How should HAs manage their business plans to accommodate this? Should they remain passive and take the risk that the market adjusts to lower credit ratings with the assumption that there would be no impact on credit spreads?

Updated methodology from S&P and a changing approach from Moody's

In December 2020, Standard & Poor’s (S&P) launched a consultation on their credit rating methodology for UK housing associations. Since 2014, their Methodology For Rating Public And Nonprofit Social Housing Providers is the primary framework used for their 40+ public and private ratings in the sector.

The proposed methodology update is intended to:

• Clarify the scope of the criteria; when they will apply the standard HA methodology and when this will be mixed with the approaches taken in other sectors (for example, housebuilders);
• Alter the enterprise risk profile (ERP) and financial risk profile (FRP) to better account for development risk;
• Provide more detail on regulatory and systemic support, replacing the previous country risk assessment cap;
• Introduce slight changes in the ERP and FRP assessments, both in terms of the assessments themselves and the weightings of the baskets within each; for example, the importance of industry assessment is down and liquidity is up; management and governance is also now assessed separately in the ERP and has brought in elements on financial policies that used to sit under the FRP assessment;
• Widen the possible ratings outcome for each Stand Alone Credit Profile (SACP); prior to this change, a score corresponded to a single rating; we now expect to see a choice of two, giving S&P more flexibility to apply a lower rating for the same score; for example, the best SACP available is now aaa/a+, where it was before aaa;
• Cap the SACP based on a number of holistic assessments (e.g., management and governance) and liquidity risk assessments; and
• Introduce a more granular assessment of debt and liquidity profiles

S&P believes that these proposed changes will have a broadly neutral impact on its rated portfolio, with c. 10% of the HA sector ratings affected, and there are expected to be more winners (upgrades) than losers (downgrades) as a result.

While most of the proposed edits are minor and will not impact the way that HAs run the business plan and funding portfolio, Chatham believes there are three areas of concern:

• Liquidity
  1. Liquidity counts for 33% of S&P’s assessment of an entity’s financial risk profile under the proposed methodology
  2. For those with worse liquidity outcomes, (i.e., sources/uses < 1.25x over the next 12 months), this can become problematic

Impact: HAs running tight liquidity coverage (of less than 1.25x sources/uses over the next 12 months) will need to bolster their cash positions or reduce committed spend. Greater focus from S&P in this area may lead to penalties on ratings outcomes.

• Debt profile
  1. For the Debt to EBITDA assessment, most of S&P’s published ratings fell in the 10-20x band (all but two in their Global Social Housing Ratings Risk Indicators: July 2020)
     
  2. This grouped all such associations in the same bracket under the methodology and offered little room for differentiation on debt profile outcomes, despite some large differences in performance
     1. For example, an HA with Debt/EBITDA of 19.9x and EBITDA interest cover of 1x would be scored the same as one with 10x and 2.5x, respectively
  3. The proposed methodology adds greater granularity, with larger penalties for those organisations with 15-20x Debt/EBITDA while demanding slightly higher interest coverage ratios
     1. For example, penalizing those with outcomes between 1-1.25x against 1.5-1.75x
  4. Chatham believes these new levels may catch some organisations off guard, particularly if they are at the outer edges of the scale on financial metrics

Impact: HAs operating in the 15-20x Debt/EBITDA band and 1-1.25x EBITDA interest coverage will now be differentiated from others with better debt profiles. Bridging the gap may be difficult in terms of reducing the overall debt burden, but HAs will have several operational levers that can be pulled to increase profitability, as well as options to lower the cost of debt.

• Wider ratings anchors
  1. For the same outcome under the S&P credit scoring, HAs can be rated up to one notch lower
     1. This is the case if nothing else has changed in the credit profile
  2. An HA viewed as “strong” in terms of both financial risk profile and enterprise risk used to be anchored at ‘a’; this has now become ‘a/a-’
  3. Added flexibility is supposed to take account of expected improvement, or deterioration, of the credit picture over time, where they sit in the financial profile or enterprise profile range (before rounding), relative risks, and other strengths and weaknesses
  4. But the flexibility appears, so far, to be only in a downward direction
  5. This may give S&P greater discretion to downgrade, even if the individual assessments or the plan have not changed

Impact: If your S&P ratings assessments sit toward the bottom of the range in terms of enterprise risk, financial risk, and underlying key factors, the credit rating may be at greater risk of a downgrade. This may be the case for any ‘a’ credits with a strong/strong enterprise risk and financial risk profile, but where the scores for each sit towards the top of the 2.50-3.50 range in each case. The new methodology will give S&P greater flexibility to assign a one notch lower SACP. In this example ‘a-‘, which may in turn result in a worse credit rating outcome.

Chatham believes that many of the suggestions in S&P’s proposed update make sense. However, rated HAs are encouraged to review their own ratings outcomes in light of these areas outlined above, particularly when assessing the business plan, or as part of an annual update process.

Ironically, this move toward potential downgrade coincides with a more forgiving approach from Moody’s. This has resulted from the use of metrics which do not penalise housing associations for capitalised expenditure in the way that S&P’s do, thus benefitting organisations at a time of rising Fire Safety or Zero Carbon spend. However, it also reflects the more active use of Moody’s “get out of jail card” in the increased use of two grade upgrades for Government Support to borrowers with weak financial outcomes.

Increased focus in several areas also suggests that certain HAs may now fare better under competing methodologies from Moody’s/Fitch, particularly where they sit at the crossover between ratings bands.

Chatham can help you better understand your business plan and potential ratings outcomes under current and alternative methodologies from all three ratings providers in the sector. If you would like further information, please get in touch with a member of the team.

Higher indebtedness ahead and pressure on interest coverage

Retrofit and fire safety costs will have a significant effect on HA operating performance and interest coverage in the coming years, and will be one of the main risks to ratings.

Most ratings agencies will add back this spend – even if capitalised – impacting on EBITDA MRI measures and interest ratios under their models. While banks may offer to amend covenants and/or provide carve outs, early signs suggest that ratings agencies may not be as forgiving.

Estimates of spend vary significantly, with a November 2020 survey by Inside Housing suggesting spend of anywhere between £2.5K to £50K per home across their sample, with the average closer to £20K per unit. Not all HAs will have fully costed this spend in their latest business plans due to this significant uncertainty and lack of commitments on spend.

This additional spend will need to be financed either by:

• Increasing cross subsidisation from open market sales and other non-social activities; or
• By an increase in borrowing

In practice, it is likely to be a mix of the two, however both are likely to be credit negative.

Some of the pressures from higher debt burdens may be offset by the availability of cheap finance and grant, and certainly many borrowers have taken advantage of record-low interest rates to push down the weighted average cost of capital (WACC) of their debt portfolio. As economic growth picks up and central banks reduce stimulus, we may enter a period where HAs need to borrow to fund this increased spend right at the time when there is increased upside risk in gilt and swap rates. Low borrowing costs may not be enough to offset pressure on the operating side of the business.

Borrowers would do well to quantify the impact of any future rise in rates, and in some cases contemplate new debt issuance sooner rather than later not to be caught offside should market rates move in the next 12 to 24 months.

Risk of BBB/Baa1

The HA sector has been a comfortable inhabitant of the ‘A’ rating space for some time now. Despite a steady downward drift in ratings across all three ratings agencies over the last six years, in part mirroring that of the sovereign rating, HAs are an asset class that fits in well to the investment grade category.

This has offered a few benefits, particularly around the availability of long-dated finance and lower capital requirements for the pension and insurance industries who have historically been a “good match” for HA borrowers in the capital markets.

Further pressure on key financial metrics and the expansion of ratings bands to incorporate downward flexibility raises the prospect that ‘A-’ borrowers may run greater downgrade risk – through no fault of their own.

Chatham believes that the impact on funding costs are currently in the order of 30-40 bps on a downgrade to BBB. While this may reduce if a significant number of HAs are downgraded to this level, we suggest borrowers should take account of this in future funding plans.

Appendix: detail of main proposed changes to the S&P methodology

SACP:

• Moving financial policies to enterprise risk profile
  • New section under "Management and Governance"
  • Previously under “Economic Fundamentals and Market Dependencies”
• New weights for calculating SACP
• “Industry Risk” assessment goes from 30% to 20%
• “Liquidity” goes from 25% to 33%
• Assessment ranges changed very slightly
• Widening bands to allow for higher/worse scores
  
• Matrix used to determine SACP now accounting for broad ratings drop of one notch
• For example, best outcome now aaa/a+
• Was aaa
• This allows greater flexibility in their “holistic analysis”
• New holistic analysis that can cap the SACP
• Mainly Liquidity Risk or low Management and Governance assessments
• New section under “Management and Governance”

Enterprise risk:

• Industry Risk now clearer in treatment of riskier open market activities
  • <1/3 operating revenues – apply HA industry risk
• If >1/3 but <2/3 operating revenues – assign midpoint of relevant industry risk
• If >2/3 revenues, then assign appropriate industry risk score (e.g., homebuilders if this is open market sales)
• May also use EBITDA or total assets in place of revenue for this
• Industry Risk seems to capture the declining grant levels and substitution of market sale activities in lowering the market position for many UK providers – although unclear
• Market Position changed, based on regulatory framework and systemic support, and market dependencies
  • Previously covered Strategy and Management and Asset Quality and Operational Performance
• Market Dependencies side covers many of the previous factors on asset quality and operational performance (e.g., vacancies and average age of portfolio)
• Regulatory framework and systemic support now more explicit; covers forms of support from regulator, regulatory framework, and public policy mandate
• New Management and Governance section
  • Picks up elements previously in market position (e.g., strategy)
• Combined with financial policies

Financial performance:

• EBITDA measure unchanged
  • Removed negative adjustment for volatility in EBITDA/Revenues ratio
• Debt Profile includes additional detail
  • Debt/EBITDA <15x now scored one notch lower in their assessment – in line with >20x (i.e., penalising greater indebtedness on an EBITDA-based measure)
• Interest cover now measured more explicitly on non-sales EBITDA; excluding earnings from development for sales activities (looks like SO is included under their Appendix which brings in “recurring property sale activities” if social housing related); levels also changed to reflect lower coverage rations in general on this measure; >2.5x now the highest band; greater penalties for lower scores
• EBITDA will exclude divestments as part of its asset management strategy
• Liquidity
  • Uses now includes other cash outflows (e.g., to JVs more explicitly)
• Levels lowered by 0.5x at the higher end in sources/uses table; previously 3x or above was highest band, now 2.5x
• Lower levels still scoring roughly the same
• Can now cap the SACP due to Liquidity Risks, in the case that this ratio falls below 1.0x on their 12mth look forward (which counts only committed capex spend)
• Would not apply cap if they thought that provider has “strong” or “exceptional” access to a government-backed liquidity source; meaning central government, a central government owned bank, or agency
• Negative adjustment for volatility in liquidity, although this is not well-defined
• EBITDA – other notes
  • More explicit adjustment for underfunding of pensions
• Asset quality will also be captured and modelled spend adjusted appropriately if believed to be deteriorating over time
• Debt – other notes
  • More clear negative adjustment if exposed to >40% rate or FX risk