We forecast that the U.K. social housing sector will build up debt over the next two years and faces a balancing act between investment in existing stock and development of new homes. Due to currently favorable market conditions, we project that interest coverage will remain broadly flat over the next two years despite the rising debt burden.

Keeping up with the U.K.'s continued demand for affordable housing requires increasing investment in development. S&P Global Ratings forecasts that the U.K.'s social housing providers (SHPs) will build 130,000 new affordable homes over the next two years, and raise £20 billion in the process, both for capital expenditure (capex) and refinancing. At the same time, we think that many SHPs will scale back their development of homes for sale because of narrowing margins. This will reduce the cross subsidies from such sales for the development of rental properties. At the same time, enhanced building and fire safety standards and a government agenda to increase the number of energy-efficient homes in the U.K. necessitate greater investment in the existing housing stock.

The SHPs will cover some of their capex with grant funding and, we assume, existing cash. However, we don't think that internally generated cash flow, including the proceeds from asset sales, will be enough to cover the capex, and therefore foresee SHPs' debt steadily increasing through to the end of the financial year (FY) ending March 31, 2023. The increase will be greatest in England, where grant funding is significantly lower than in Scotland, Wales, and Northern Ireland, and therefore the need for debt greater.

We expect the capital markets to remain SHPs' primary source of funding. Investor demand for issuance by SHPs, given their social purpose and low interest rates, make capital market financing attractive to SHPs. Moreover, we consider that the investor base has become more diverse in recent years, supporting funding activities across the sector, with an increasing number of international investors, a greater amount of unsecured debt issuance, and the introduction of sustainability-linked bonds and bank funding.

Increasing Affordable Housing Development Will Cause Debt To Spike

We estimate that SHPs will build 130,000 new affordable homes over FY2022 and FY2023, having added around 60,000 homes in FY2021 by our estimates. SHPs need to provide these new homes while increasing investments in their existing housing stock. While we anticipate that SHPs will balance the two needs, we forecast that their capex on new and existing assets will increase (see chart 1 for the English SHPs). Borrowing across the sector will rise accordingly, exceeding £20 billion in FY2022-FY2023, including the refinancing of more than £7 billion of maturing debt. This will take the sector's total debt at the end of FY2023 to over £107 billion.

Factors contributing to SHPs' need to invest increasingly in their existing asset base are enhanced fire and building safety standards; a focus on customer satisfaction and asset quality, as outlined in the Government's Social Housing White Paper published in late November 2020; and the need to make homes energy efficient in order to meet the U.K. government's target of carbon neutrality by 2050.

Rent Arrears Could Briefly Offset Allowed Rental Increases

SHPs' revenues through FY2022-FY2023 will get a boost from the steady rise in the number of homes across the sector, and in England, the rent regime that will allow SHPs to increase the rent for general tenures by the consumer prices index (CPI) plus 1% for a minimum of five years from FY2021. The SHPs in the devolved regions, Northern Ireland, Scotland, and Wales have more flexibility in setting rents on social housing.

However, the COVID-19 pandemic and related lockdowns imposed across the U.K. since March 2020 have caused uncertainty over the near-term rental income across the social housing sector. The central government's fiscal response to the pandemic, such as the job retention scheme, has prevented a large peak in unemployment so far. Yet we expect that rent arrears will increase incrementally across the sector when the scheme ends, and this could result in a rise in bad debt and a loss of rental income for the SHPs.

The national lockdowns and related uncertainty also slowed real estate sales compared with previous years, and we project that sales revenues will continue to fall in FY2022 and FY2023. At the same time, the lockdowns lowered SHPs' maintenance and repair spending on existing homes due to restrictions on accessing the homes. We think that the sector will be able to resume some of these repairs in the second half of FY2021 such that maintenance capex will increase from the prior year and continue to increase thereafter.

Over time, however, we forecast that the SHPs' internally generated operating cash flow after interest payments will remain relatively stable, with the decline in FY2022 due to a potential increase in arrears and rent losses followed by a recovery in FY2023 (see chart 1).

Chart 1

The borrowing needs mainly come from the English SHPs, which hold about 90% of the debt (see chart 2). We estimate that the English SHPs will need to raise debt to complete their housing development programs and make planned investments in their existing housing stock due to the low amount of government grants.

Chart 2

SHPs Are Well Funded Despite Falling House Sales

We think that grants to English SHPs will remain relatively low, at less than 15% of their capex, despite various grant programs available through Homes England and the Greater London Authority. Proceeds from the sales of existing assets will therefore remain an important source of funding, but we forecast that such sales will decrease over FY2022 and FY2023. Many SHPs are reviewing their property portfolios and divesting properties, either to concentrate on their respective core regions or areas of operation, or because investments to improve the energy efficiency of the properties would be too costly.

Nevertheless, prompted first by Brexit and then by the pandemic, SHPs have strengthened their cash positions significantly and have secured additional revolving credit facilities to cushion them against the concomitant uncertainty. This uncertainty persists amid the pandemic and the related lockdown across the U.K., but we believe that the sector is well placed to face it in the next year, thanks to its strong liquidity (see "Outlook 2021: Strong Liquidity Should Help Social Housing Providers Remain Resilient," published Dec. 8, 2020). According to the latest Quarterly Survey from the Regulator of Social Housing, SHPs' available cash increased by £0.1 billion during the quarter to Dec. 31, 2020, to reach £6.9 billion. We think that the SHPs are likely to employ part of this cash to fund their capex programs (see chart 1).

In Northern Ireland, Scotland, and Wales, development for sale is not as prevalent as in England, as SHPs receive higher government grants, and consequently do not subsidize their social and affordable housing developments through sales receipts to the same extent as in England. Government grants fund more than 50% of the affordable homes built in the devolved regions, compared with less than 15% in England. SHPs in the devolved regions have had more flexibility in setting rents on social housing, although the new rent regime in Wales restricts rent increases to CPI +1% for five years from FY2021. However, we consider that the profitability of the SHPs in the devolved regions is generally weaker than that of their counterparts in England due to generally lower rents.

Debt Servicing Should Remain Resilient

We estimate that the sector's absolute debt will increase by around 6% annually to exceed £107 billion by March 31, 2023, a marginally lower annual increase than the 7% we assumed in our March 2019 borrowing report. Given the increase in debt, we project that the sector's S&P Global Ratings-adjusted leverage will increase steadily, but think that interest coverage will remain fairly solid thanks to a gradual fall in funding costs. We forecast that the sector's adjusted debt-to-EBITDA ratio will edge up to 19x by FY2023, from 15x in FY2019, while adjusted EBITDA interest coverage will edge down to 1.7x from 1.8x. The peak in adjusted debt to EBITDA in FY2022 (see chart 3) reflects our projection of the impact on the sector's earnings when the government's job protection scheme ends.

Significant fundraising at a time when interest rates are low, and the refinancing of expensive legacy debt across the sector over the past two-to-three years will result in lower funding costs than we previously assumed. Although interest expenses and other financing costs should increase through FY2023 with the steady increase in debt, the average cost of this debt will gradually decline.

Chart 3

Capital Markets Will Remain SHPs' Main Funding Source

We assume that the capital markets will remain the main source of SHPs' funding over the next two years, for several reasons. More SHPs are setting up euro medium-term note programs under which they issue debt, including London & Quadrant Housing Trust in October 2020, Aster Group Ltd. in January 2021, and Platform Housing Group Ltd. in February 2021. We believe that the issuance of unsecured debt could increase over time, in tandem with international investors' increasing appetite to invest in the U.K. social housing sector. We don't see as great a need among international investors for having bonds secured by housing assets as U.K. investors, with for instance Places for People Group Ltd.'s issuance of unsecured debt, to investors in Europe, the U.S., Australia and Asia.

We estimate that issuance by the 41 SHPs that we rate in the U.K. social housing sector increased by more than 75% in FY2020 to exceed £3.5 billion, or about one-third of the new finance raised that year. The issuance took the form of public bond issues and private placements, as well as taps or the release of retained tranches of existing bonds. Several of these bonds had links to social purpose. For example, Clarion Housing Group Ltd. earmarked the proceeds of a £350 million bond in January 2020 and a £300 million bond in November 2020 for the development of energy-efficient housing under its sustainable housing finance framework. Aster Group aims to use the proceeds of the £250 million sustainable bond it issued in January 2021 to fund the development of energy-efficient social and affordable homes for rent.

Bond aggregators The Housing Finance Corp. Ltd. (THFC) and its wholly owned subsidiary bLEND Funding PLC, GB Social Housing PLC, and MORhomes PLC remain active in lending to a wide variety of SHPs, often in smaller tranches than a public bond issue. THFC, set up over 30 years ago, has a loan book of over £7 billion, on-lending to more than around 150 SHPs. bLEND Funding was established in 2018 and has built up a loan book exceeding £900 million. MORhomes, also established in 2018, has arranged funding totaling about £430 million to the sector, while GB Social Housing, focusing on smaller transactions than its peers, has a loan book of about £330 million built up over eight years.

The 41 SHPs that we rate account for close to half of the U.K. social housing sector's debt, or about £44 billion of the outstanding debt in FY2020. Two years ago, our rated portfolio accounted for about one-third of the U.K. social housing sector's debt. Since then, we have added five SHPs to our rated portfolio, while the existing SHPs have increased their debt over the past couple of years, a trend that is only set to continue (see table 1).

Table 1