In the emerging new world where commercially minded ‘for-profit’ registered providers (RPs) backed by institutional equity are now bidding directly for developers’ Section 106 affordable housing quotas, many RPs will wish to revisit their investment appraisal methodologies and assumptions to ensure they are suitably positioned to participate in more competitive Section 106 bidding processes.
This article revisits the technical aspects of investment appraisal and common financial modelling challenges, and explores some of the common misconceptions around interpreting measures of value and return.
Investment appraisal principles revisited
The recent large-scale entry of for-profit RPs into the Section 106 market has caused some angst in the not-for-profit RP community, a few of which fear being ‘outbid’ on Section 106 deals by their for-profit counterparts.
Of course, competition is by no means a new feature of the Section 106 market. As noted by Simon Dow, interim chair of the Regulator of Social Housing’s Regulation Committee, at the recent Social Housing Finance Conference, not-for-profit RPs have seemed happy to bid against each other on Section 106 deals for years.
Enhanced competition for Section 106 assets may not be an entirely bad thing if it contributes to driving greater efficiencies in the sector, as not-for-profit RPs will necessarily be required to take a more commercial approach and manage their operating cost base more carefully.
A more competitive environment is likely to encourage RPs to revisit their investment appraisal methodologies and assumptions, in particular to ensure these are both up to date and fit for purpose.
From a purely financial perspective, RPs bidding for Section 106 assets will calculate a cash price that they are prepared to pay to receive a future cashflow stream.
This is no different in principle to an investor calculating its bid price for a financial asset, such as a bond. Both involve present valuation of a future cashflow stream, but with a different cashflow profile and a different associated set of risks.
In order to derive their Section 106 bid price, RPs need to formulate both an investment appraisal methodology and an appropriate set of quantitative assumptions.
Any developing RP’s investment appraisal methodology and assumptions are key organisational value drivers (and this applies whether or not the RP is ‘for profit’).
Both should be reviewed and approved regularly by the board (or a specialist finance subcommittee of the board) to ensure they remain appropriate to use in the context of changing financial, economic and operating conditions.
A robust investment appraisal methodology is ordinarily founded upon having a carefully structured financial model which can correctly capture the cashflow characteristics of the assets within the Section 106 portfolio.
However, differing modelling approaches can produce starkly different results. The present value of a long-term cashflow stream is highly sensitive to the discount rate used to derive it. Discount rates (or corresponding internal rate of return hurdle rates) often vary considerably between RPs.
Furthermore, RPs often use different discount rates to appraise different tenures, taking into account each tenure’s specific risk profile.
The term of an appraisal, and in particular whether or not a terminal value (or exit value) is incorporated, can also greatly affect appraisal results.
RPs need to be cautious around using off-the-shelf appraisal software tools, which can be ‘black boxes’ and are sometimes not able to handle important structural nuances. It is always critical for investment professionals to appreciate the limitations of their models.
While an investment appraisal model is typically constructed very scientifically, the determination of model assumptions could reasonably be viewed as far more of an art than a science.
Certain appraisal assumptions are not only highly subjective but are necessarily required to be forecast a very long way into the future, well beyond any visible planning horizon.
Assumptions for house prices and cost indexation, interest rates, first tranche sales prices and staircasing, and costs per unit, could all reasonably sit within a significant range of values.
|(1) NIY||(2) Base IRR (no TV)||(3) Base IRR (with TV)||(4) Scenario 1 IRR||(5) Scenario 2 IRR||(6) Scenario 3 IRR|
Notes: (1) NIY is calculated on apportioned cost of the Section 106 package; (2) and (3) illustrate base case IRR with and without terminal value; (4) shows IRR with reduced operating costs and voids; (5) shows IRR with accelerated sales at higher prices; (6) shows combined effect of (4) and (5) on IRR
It is important for bidding RPs to maintain a keen awareness of the assumptions embedded in their Section 106 bid pricing and the risks attached to those assumptions, recognising that actual future cashflows may turn out to be quite different from those assumed at the outset.
Appraisal risks can be made visible to decision-makers through providing sensitivity analysis to illustrate the possible range of future outcomes, and explaining how these outcomes translate into different present values of the Section 106 assets (and therefore bid pricing) now.
Affordable housing market participants need to be careful around interpreting different measures of financial return. The concept of a running yield and an internal rate of return (or IRR, which is also commonly referred to as ‘yield’, in the bond market for example) are quite different but are frequently confused. The former measures return over a single time period (most often a year) and the latter (in theory, at least) measures the annualised return from all relevant cash flows over the full life of an investment.
By way of an illustration, it could be perfectly reasonable for a particular Section 106 portfolio to have a net initial yield (ie year one yield on cost) of a little over three per cent, but a nominal IRR in excess of six per cent (for example, a portfolio with a high proportion of shared ownership units, with some leverage assumed).
In contrast a Section 106 opportunity with a NIY of six per cent would be almost certainly unachievable, and an IRR of three per cent may suggest that a scheme doesn’t stack up without additional subsidy (three per cent being below a typical RP’s risk-adjusted long-term cost of funds assumption).
To complicate matters further, running yields are often quoted relative to both cost and value (and often without it being made clear which) and calculated IRRs may encapsulate incomplete sets of cashflows and can be calculated over quite different time periods.
In the new environment, RP investment teams will need to have (i) a comprehensive understanding of both investment principles and the characteristics of the assets they are bidding for, (ii) a sophisticated appraisal modelling approach and (iii) suitably skilled and qualified investment professionals overseeing investment activity.
Nathan Pickles is founder of corporate finance consultancy and recruitment services business Wharfedale Associates