With slowing new home development, U.K.'s social housing providers (SHPs) will not be taking on as much debt as expected. S&P Global Ratings forecasts that the SHPs will need to raise about £16 billion in new debt to cover capital expenditure (capex) and refinance maturing debt over the next two years, compared with our previous forecast of £21 billion in the two years to March 31, 2024. We estimate that the sector will hold close to £116 billion of debt by March 31, 2025, up from about £104 billion that we estimate for March 31, 2023, but slower than our previous forecast of £116 billion by March 31, 2024.

In our view, the slowing funding needs is mainly from SHPs scaling back new home development over the next two years to mitigate negative regulatory and economic factors. We project that the sector is likely to deliver close to 110,000 new affordable homes over fiscal years 2024 and 2025, compared with close to 120,000 homes over fiscal years 2022 and 2023. We estimate that growth in new building will decline to about 1.5% annually and remain below pre-pandemic levels of approximately 3.5%.

We understand that the sector is scaling back its development of new homes because resources are being diverted into existing homes, given the focus on asset quality, building standards, and the green agenda across the U.K. In addition, supply constraints on labor and material have affected the pace of delivery of new homes.

We think that borrowing will continue to cover the still-substantial new home development, so we expect that debt will continue rising, albeit more slowly. In our view, the increase in debt will remain greatest in England, where grant funding is significantly lower so the need for borrowing is higher than in Scotland, Wales, and Northern Ireland. Combined with increasing interest rates, we forecast that the sector's debt metrics will remain weak in the next couple of years.

Most SHPs have increased the use of their cash and short-term revolving credit facilities for financing in recent months. We think refinancing loans with long-term public bonds and private placements will likely resume after being interrupted in the past year due to adverse market conditions and rising interest rates. In our view, once the markets start to stabilize, the SHPs will likely turn back to long-term capital funding to match the duration of their assets.

Issuers With Operational Flexibility Should Maintain Credit Metrics

We think that management decisions, strategies, and financial policies are particularly important as issuers respond to the regulatory and economic stress. And SHPs are responding differently. Our financial forecast see a clear differentiation between those with strong operational flexibility and risk-averse management policies and those with inconsistent or less prudent planning. The former typically entered this period in a relatively strong position, and in our view, they appear able to maintain relatively strong credit metrics even if headroom is diminishing. Conversely, we expect the latter's credit metrics to significantly deteriorate.

Growth In Debt Funding Slows In Tandem With New Home Development

We expect that issuers will continue to raise debt to fund their capital programs, although the buildup would be slower than we anticipated due to the lower debt funding of new home development. Although we see a steady increase in the sector's nominal debt through fiscal 2025, we estimate borrowing in real terms (adjusted for inflation) to remain relatively stable.

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In our view, development grants to English providers will remain lower than in the devolved regions, making them rely heavily on debt funding. Also, cost inflation might have made many ongoing schemes less viable such that--without an increase in grants--fewer units may be delivered under the grant funding program, or delivery might take longer. We expect that English SHPs will continue to account for about 90% of the U.K social housing sector's debt. Although increasing through financial year 2025, grants to English SHPs will cover less than 20% of their capex compared with Northern Ireland, Scotland, and Wales, at about 50%.

We think that proceeds from asset sales will remain a prominent source of capex funding. In addition, we think SHPs will continue to use cash built up since the uncertainty around the Brexit referendum in 2016, which triggered a more conservative liquidity approach across the sector. In our view, the accumulated cash will provide a buffer and flexibility for SHPs in their capex funding. We understand that the sector held more than £5.8 billion on Dec. 31, 2022, as per the Regulator for Social Housing's Quarterly Survey, which is based on regulatory returns from 203 SHPs owning more than 1,000 homes each.

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Debt Metrics Will Remain Under Pressure

We project adjusted EBITDA and nonsales-adjusted EBITDA to be marginally lower than expected. Combined with the ongoing need to fund new homes amid increasing interest rates, we anticipate SHP debt metrics will remain under pressure. Although we expect debt to adjusted nonsales EBITDA to gradually improve after a significant weakening in financial year 2023, it would remain above 20x through financial year 2025. Equally, we think that the adjusted nonsales EBITDA interest coverage may marginally strengthen through fiscal 2025, but remain below 1.5x.

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The Sector's Fixed Long-Term Debt Mitigates The Higher Cost-Of-Funding Risk

We think that SHPs are somewhat protected from rising interest rates in that they typically hold a significant proportion of long-term fixed-rate debt. The risk mainly arises for SHPs that either have a large maturity coming up, requiring imminent refinancing, or SHPs that rely mainly on variable bank debt.

The Bank of England has steadily increased its bank rate since the end of 2021, setting at 4.25% on March 22, 2023, up from 0.1% in December 2021, and this is affecting the cost of funding in the market. For instance, GreenSquare Accord issued a £250 million 25-year bond at 5.25% in December 2022, while Peabody Trust's £350 million 22-year bond was issued at 2.75% 10 months earlier and Clarion's £300 million 30-year bond at 1.875% in September 2021.

We estimate the sector's average cost of debt is about 4%, which is below the prevailing market rates, supporting our view of the sector's general resilience to increasing interest rates. Some of the fixed-rate debt was issued before 2009 at rates above 6%, and they are gradually amortizing downward or being redeemed early. Also, the early repayment or exits from derivatives positions has become less costly in terms of breakage fees. In our view, this, along with the significant amount of refinancing completed when the debt market was much more favorable, will help mitigate the impact on interest expense.

We Project The Sector's Adjusted EBITDA Margins To Remain Subdued

While we project that SHPs adjusted EBITDA will be marginally below our previous forecasts, so will the sector's adjusted operating revenue such that our forecast adjusted EBITDA margins remain largely in line with our previous forecast.

We expect earnings to gradually recover after what we estimate to have been a weak fiscal 2023, in which we expect inflation to have led to a significant gap between cost and revenue increases. We do not anticipate that SHPs will receive full compensation for the rental income they lose because of the cap to social and affordable rents for fiscal 2024. Furthermore, it remains uncertain whether SHPs will be allowed to increase rents by the consumer price index plus 1% from April 1, 2024, if inflation remains high in September 2023.

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In our view, investment in existing stock would continue to increase as costs to address fire and building safety standards are gradually replaced by investments to reach a minimum of Energy Performance Certificate rating of C by 2030 and achieving a net zero carbon by 2050. Therefore, while we expect inflation to tail off and revenue to gradually increase through financial year 2025, we think the steadily increasing investment in existing stock will continue to contain improvement in SHPs' adjusted EBITDA margins.

We project that capitalized repairs will continue to account for more of the sector's total operating costs, including investment in existing homes. We estimate capitalized repairs will account for 19% of operating expenditure by 2025, up from 11% in fiscal 2021. The sector is phasing out investments in existing homes, so the total amount of capitalized repairs is somewhat below the levels we estimated last year. We also project that the sector's capex for new homes development will reduce more as investment in existing homes continue to grow.

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Borrowing From Capital Markets Is Taking A Breather So Far In 2023

We believe that investor demand for issuance from SHPs has remained high, supported by the sector's social purpose and focus on sustainability, but higher interest rates have led to the sector seeing limited bond issuances and private placements in fiscal 2023. We estimate that capital market funding increased by about £3 billion in fiscal 2023, compared with more than £6 billion the previous year.

The bond aggregators providing funding in smaller tranches to the social housing sector have also seen more subdued issuance and on-lending. The Housing Finance Corp. Ltd. (THFC), which managed the first Affordable Homes Guarantee Scheme, and its wholly owned subsidiary bLEND Funding PLC, as well as GB Social Housing PLC and MORhomes PLC, remain active in lending to SHPs. ARA Venn, in addition to its private rented sector guarantee scheme, issued its first bond in November 2021 to fund the new Affordable Homes Guarantee Scheme. While THFC's loan portfolio is largely unchanged, bLEND raised and on-lent £125 million (down from £260 million the previous year), while MORhomes and GB Social Housing issued £20 million (down from £65 million) and £4 million (£49 million). ARA Venn has issued two £100 million taps so far in 2023.

We estimate that the 43 U.K. SHPs we rate will continue to account for more than half of the sector's total drawn debt. Fifteen are among the top 20 borrowers for financial year 2022, unchanged from a year earlier. Large SHPs with material development programs typically require debt funding, which often comes from the capital markets, as the long-term bond would match the asset's life. Often, debt capital market issuance is tied to a rating, so we've seen the number of ratings on issuers and issues in the sector steadily increase, almost doubling over the past five years.