Pearls and Irritations

Many well-intentioned solutions have been proposed to address Australia’s housing affordability problem, yet fail to gain traction because the challenges faced by key stakeholder groups aren’t being addressed simultaneously. We believe success on a material scale will be more likely when this occurs.

We propose a model that potentially meets the needs of government, capital markets, and community housing providers in a simultaneous fashion, via the intermediation of a nationally owned, centralised property clearing house. 

Guiding principle

First State Super invests its members’ retirement savings to achieve risk adjusted, long term capital growth above inflation, following a guiding principle of “Universal Ownership”. This principle reflects a recognition by large pension funds that they do not sit outside of markets or the broader economic system – they are an integral part of the system architecture and, have significant impact on: asset pricing; system stability; the environment; the governance of companies they own, and the communities in which they operate. In this sense, all our investments are impact investments – they all have socio-economic impacts, direct and indirect, positive and negative.

The Universal Ownership principle becomes a relevant consideration when giving thought to potential solutions to Australia’s housing affordability challenge. Large pension funds have significant capital which must be prudently invested to generate returns for the owners of that capital, being fund members.

Contemporaneously, the housing market is short of funding in a number of respects – particularly in addressing the shortfall in existing housing needs, let alone the additional strains caused by future population growth and longevity. Prima facie, it would appear logical and straightforward to bring the suppliers and users of capital together, agree commercial terms, and then get on with addressing the housing challenge. Unfortunately, history shows, that the issues are much more intractable than a simple alignment of intentions can resolve.

Challenges facing key stakeholders

Pension funds have several operating constraints that govern the way they invest; the housing market (particularly the community housing sector) is diverse and fragmented in its needs; and the most important player, government, is faced with the difficult task of meeting strong demand with limited resources. The needs of each of these sectors must be addressed together if progress is to be made towards increasing the supply of affordable housing.

Working together, these three groups (Government, Capital Markets, and Community Housing Providers) have the potential to ease the current strain on the affordable housing sector, providing their individual challenges are overcome. We see their challenges as follows:

Government

• Demand for community housing is increasing, whilst in the face of budgetary pressures housing investment by governments has fallen
• Social housing tenants receive significant rental subsidies and the existing social housing stock requires significant ongoing maintenance spending.
• Waiting lists are growing, due to chronic undersupply and the increasing tenure of tenants.
• There is a growing discrepancy between operating costs and rental collections, placing further pressure on government finances and reducing the ability to invest in new housing stock.
• Governments are also being asked to transfer large-scale housing stock to the community sector, despite its ageing and deteriorating status, which is a difficult choice as public housing is a significant asset on government balance sheets.

Community Housing Providers (CHPs)

• The community housing sector is a critical component of the framework, however is challenged with regards to scale, both in aggregate terms and as individual providers
• The sector is somewhat fragmented, with the largest providers representing only a small fraction of total stock (around 5,000 dwellings compared to a total of around 72,000 dwellings).
• Due to a lack of scale, CHPs are required to engage in non-core activities (such as obtaining finance, undertaking in-house development, and project management) in addition to their fundamental task of providing tenancy services and delivering social services.
• State governments are, therefore, somewhat sceptical of the ability of CHPs to absorb large scale stock transfers and/or develop large volumes of stock themselves.

Capital Markets (especially superannuation fund) challenges

• Superannuation funds are required by the Australian Prudential Regulation Authority (APRA) to hold high levels of liquid investments which can be redeemed at short notice by fund members
• Unlisted property investment constitutes an illiquid investment
• The current low real yields being generated by traditional defensive assets has meant that funds need to maximise returns from their illiquid portfolios
• Affordable or social housing provides a lower rental yield than alternative property sectors (e.g. retail, office, industrial). At the same time, capital appreciation (more heavily relied on by private individual investors) is relatively less attractive.
• Institutional investors are unable to access the taxation benefits of housing investment that are available to individuals (who ultimately set the market price);
• The level of existing bank lending to CHPs is constrained and insufficient to enable meaningful increases in supply of this type of housing. Capital markets financing would require an alternative mechanism, such as traded debt issuance.

Bridging the “return gap”

It is necessary to further clarify the role of government in any solution seeking to increase the supply of affordable housing. Providing affordable housing by discounting market rental rates is unlikely to generate the returns, in isolation, that professional investors will require. These investors have a fiduciary obligation to act in the best interests of their members, and are simply unable to accept rental payments of, say, 80% of market rent, when they could accept 100% of market rent elsewhere (all other things being equal). Thus, there exists a ‘return gap’ which is the difference between the required return demanded from investors and the return yielded by discounted market rental properties.

Realistically, the only party able to meet this return gap is government. There are broadly three ways that governments can (and currently do) meet this gap:

• The direct provision of funds/subsidies/grants
• Guarantees of outside investors’ capital
• The provision of land/housing stock for the purposes of development or redevelopment, or the supply of industrial/fringe land for conversion to residential housing lots

Various proposed solutions have advocated the issuance of affordable housing bonds backed by a government guarantee. Briefly, such bonds would provide a lower return than a similar asset in the private market (i.e. the return gap), and would have investment risk reduced by a government guarantee to fund interest and principal payments. This would make the lower return acceptable to investors. Notwithstanding widespread advocacy for such a mechanism, there is little evidence of any government supporting the option. Accordingly, we have not proposed any form of government guarantee in our model.

In conjunction with Per Capita and The Committee for Sydney – Financial Services Knowledge Hub, we have previously proposed a model which relies on the government provision of land and/or housing stock – either currently used for affordable/social housing or additional land – which can be utilised to develop new stock of mixed private, affordable and social housing. The private housing proportion will be sold at market rates. The development profits from these transactions subsidise the affordable/social housing, meeting the return gap.

Proposed new financing and development model (CAHC)

We propose an innovative financing model which addresses the challenges identified in the Simultaneous Housing Equation (as discussed above). At its core is a new Commonwealth Affordable Housing Clearinghouse (CAHC). The objective of the CAHC is to finance and develop housing stock to be transferred to CHP’s and/or state and territory housing authorities. The CAHC will not manage affordable or social housing.

The CAHC would act as a central expert facilitator and clearinghouse for the development of affordable housing nationally. It would partner with state governments, CHP’s and major builders to generate large scale housing construction projects. Governments would provide land for development (greenfield sites) or redevelopment (brownfield sites). Tenders will be issued for the construction of mixed private, affordable and social housing dwellings. New construction will be at higher levels of density than existing housing estates. Upon completion, private dwellings will be sold and the development profits used to subsidise the affordable and social dwellings. CHP’s will submit Expressions of Interest to manage these dwellings upon completion, and ownership will be formally transferred to the CHP’s. Funding for projects will be obtained from capital markets via the issue of debt instruments in the form of Affordable Housing Bonds (AHB’s).

Investment objectives met by proposed model

This proposed model will satisfy several critical investment objectives, necessary to attract capital markets participants:

• A suitable investment mechanism in the shape of Affordable Housing Bonds (AHBs). These provide the necessary liquidity sought by superannuation funds. These structured instruments would emerge from a pooling of debt capital, facilitated by a centralised entity (the CAHC), paying both interest and principal based on the underlying debt pool. Proceeds from the sale of private dwellings would reduce the debt pool and rental returns from affordable and social housing would be used to pay interest and repay principal debt.
• Sufficient scale could be achieved via the establishment of the CAHC to facilitate large, diversified, institutional grade property developments. A meaningful level of debt issuance (sufficient to attract institutional investors) would require projects on a scale approximately ten times bigger than the largest community housing development project so far undertaken in Australia. A centralised, government controlled entity, would be required to achieve this.
• Increased density within housing developments is a necessary component of greater scale. Land with sparsely developed social housing would be re-developed at an increased level of mixed dwelling density (i.e. private, affordable, and social housing). Private dwellings would then be sold upon completion. This is the key element within our proposal by which the return gap is met.
• Pipeline Volume – to achieve long term viability of such a financing model, the development of a liquid market in AHB’s would be necessary. This could be achieved via a pipeline of development projects. Issuances of AHB’s could then be undertaken on a semi-regular basis, improving the breadth and depth of Australia’s asset-backed/secured bond debt market and the capital markets in general.
• Institutional grade counterparties are required to ensure the confidence of capital markets before they invest. The underlying housing development projects funded by the AHBs must be constructed at scale by large credible builders or syndicates. This will help the AHBs achieve the appropriate credit ratings and meet the required risk-return profile for institutional investors. Development projects can be de-risked through large, diversified building programs; secured through transparent competitive tendering processes; undertaken by institutional grade property development companies or syndicates, and overseen by development experts.

In summary, unless the challenges facing the various parties are addressed simultaneously the problem of affordable housing will continue.

Benefits of proposed model

The proposed CAHC model goes in large measure to address those challenges and delivers a range of benefits. The model:

• Provides an innovative financial mechanism to unlock capital markets and facilitates investment in affordable and social housing
• Improves the efficiency of private, affordable and social housing development through large scale development in partnership with institutional grade builders
• Provides a separation of scaled development activities best delivered by large private builders, and bespoke tenancy and management services best delivered by CHPs and state governments. This separation facilitates the growth of CHPs while allowing them to focus on their core competencies of tenancy management and social service provision
• Leverages development land to subsidise affordable and social housing construction, via an increased density of housing development. This allows the return gap to be met without requiring significant monetary contributions or debt guarantees from government.
• Is a holistic solution which increases the supply of private, affordable and social housing nationally at scale, with the added benefit of improving affordability in the private market.

Damien Webb is Head of Income and Real Assets at First State Super, overseeing investment activity in the areas of property, infrastructure, agriculture and credit income. The model referenced in this article was contained in a March 2016 submission to the Affordable Housing Working Group.

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