UK: RP Issues A Briefing For Registered Providers

Last Updated: 5 November 2008

The credit crunch has taken a firm hold on the property market and RPs look set to suffer as a result of the economic downturn. We look at the specific problems being faced and how RPs can work to overcome them.

RPs SUFFERING IN THE PROPERTY MARKET CRASH

We look at the effect the downturn in the housing market is having on RPs' accounts

As property sales plummet, what measures can RPs take to minimise the impact?

The global credit crunch has hit the UK property market hard, with Nationwide and Halifax stating that house prices have fallen nearly 11% in the past year. Lack of mortgage availability and a fall in consumer confidence has led to a downturn in the housing market, the effects of which could be far worse than those encountered in the 1990s. The demise of Lehman Brothers, HBOS and Bradford & Bingley has also added to the misery.

Many larger registered providers (RPs) are increasingly financially dependent on the sale of property (via outright sale or shared-ownership) to make their business models work, and until recently, few RPs had assumed that there would be any downturn in their anticipated revenue from property sales.

Predicted effect on RP accounts

Property sales

The sector's reliance on property sales is clearly illustrated in the global accounts published by the Housing Corporation, which show an increasing deficit before tax and property sales for the years 2005 to 2007. In 2007 the surplus generated from the sale of properties was £542m, compared to the overall surplus before tax, £270m.

The balance sheet

RPs have been developing to a greater extent over the last few years and are likely to be holding properties on the balance sheet that have experienced impairment.

In addition, RPs trying to sell properties, either through shared-ownership, HomeBuy or outright sale, will be holding significant amounts of property on the balance sheet as current assets. These assets are valued in the accounts at the lower of cost and net realisable value, and RPs may need to make significant write-downs to these assets to reflect the reduction in the achievable selling price. Also, contractors are increasingly facing financial difficulties and taking longer than planned to complete developments – making matters worse in a market where prices are continuing to drop.

The global accounts in 2008 and 2009

The 2008 global accounts are yet to be published, so we have made some simplistic assumptions to show how the 2008 and 2009 global accounts might appear when taking into account the effects of the slowdown, impairment of housing stock and increased interest rates.

The assumptions we have used for 2008 are:

  • an increase in rental income of retail price index (RPI) of 0.5% plus 3% for growth
  • an increase in operating costs of RPI of 2% plus 3% for growth
  • RPI at 3%
  • an increase in interest payable of 0.5% to reflect rises in the London interbank offered rate (LIBOR) plus 6% for growth
  • impairment of housing properties of 0.1% of assumed 2008 net book values
  • growth of 20% in surplus on fixed asset sales
  • all other items in the income and expenditure account remain the same.

Fig 1: Predictions for the 2008 and 2009 global accounts

The assumptions for 2009 are as follows:

  • an increase in rental income of RPI of 0.5% plus 1% for growth
  • an increase in operating costs of RPI of 2% plus 1% for growth
  • RPI at 5%
  • an increase in interest payable of 1% to reflect interest rate rises plus 6% for growth
  • impairment of housing properties of 5% of net book values at 2007 plus 10% of net additions for 2008 and 2009
  • no surplus on disposal of fixed assets
  • all other items in the income and expenditure remain the same.

The housing property additions for 2008 and 2009 have been assumed to be the same as in 2007, based on the movement in the global accounts.

These assumptions are highly speculative. However, the results in figure 1 are highly alarming and would be likely to result in a number of RPs breaching covenants.

The ability to meet cashflow requirements will become even more critical in the future, particularly as significant levels of cash are likely to be already committed to ongoing developments.

Mitigating the risk

For existing shared-ownership and outright sale schemes, the first step is to assess whether the asking price for properties is reasonable given the current market conditions. For some schemes a small downward adjustment will secure property sales; for others, it is possible that despite discounts and strong marketing strategies, the properties will still not sell. In these circumstances, it is likely that the best option will be a change of use to rental rather than sale, taking advantage of the recent Housing Corporation dispensation on these areas. However, this may well crystallise an impairment (since value for rental properties is usually much lower than for sale), and is likely to have adverse VAT consequences (please refer to our article 'VAT adjustments for temporary lettings').

For schemes in progress, careful monitoring should ensure developments are completed to timescale. Perform regular reviews of contractors' financial viability, and prepare contingency plans in the event of insolvency. Properties should be marketed as soon as possible and preferably prior to completion.

Planned shared-ownership and outright sale schemes may now not be viable in current market conditions. Development appraisals should be re-worked on revised assumptions in relation to property sales.

Business plans should also be adjusted, for at least the short term, to ascertain what effects the slowdown will have on an RP's financial position, and to work through arising potential problems.

Most crucially, RPs should check carefully that all loan covenants will be complied with even under pessimistic assumptions. If there is any doubt, urgent discussion should take place with lenders. As a general principle, lenders will now be more demanding of information. Nearly all RPs are now more reliant on gaining the trust of lenders, so it will be essential to support their needs.

Do not assume that impairment provisions can be added back in the same way that depreciation changes can. This should be checked, and if in any doubt, confirmed with the lender.

It's not all bad news

We cannot predict when the property market will start to pick up, although our expectations are that prices will continue to fall through 2009. However, others have predicted that by 2012 house prices will be worth 15% more than their peaks in 2007. We can only hope that the events of the past 12 months may soon be a distant memory. However, our view is that the market will take a long time to recover and sentiment will remain cautious for a number of years. We hope we are wrong.

A NEED FOR IMPAIRMENT PROVISIONS

In light of the troubled UK property market, we look at the conditions which must apply to constitute an impairment.

With the current devastation in the UK housing market, one of the key questions is whether, and to what degree, falls in property values will need to be reflected in impairment provisions within the 2009 financial statements.

First, is the asset really impaired? A drop in prices from a previous estimate, or from the most recent appraisal, does not necessarily lead to an impairment. An impairment arises only when there is a reduction in the recoverable amount from a fixed asset below its carrying amount. However, the recoverable amount is not quite what it might seem at first.

There are two different ways to look at the recoverable amount. When considering impairment, there is no need for a provision if either the market value (after deducting the costs of sale and any grant that would need to be repaid or recycled), or the value in use (the present value of the cash you should be able to get from using the asset as intended) is higher than the carrying value.

In the past, the positive housing market provided considerable protection from impairment. While this will still be the case for some RPs, an increasing proportion of properties, particularly new ones, are 'under water' based on current market value. This leaves 'value in use' defined more specifically as existing use value for social housing (EUV-SH) in the RP sector.

Unfortunately, since most RPs plan on the basis that the early years of a housing scheme will make a loss, and provide some subsidy to the scheme out of its own resources, it will often be the case that, initially, EUV-SH is below cost after deducting grant. Does this mean, therefore, that an impairment should be recorded immediately?

Fortunately, the answer will often be 'no'. FRS 11 (paragraph 20) deals with impairments of fixed assets and allows charitable organisations to use service potential as a gauge for assessing impairment, rather than purely cash flows. This is developed in more detail in the 2005 and 2008 Statement of Recommended Practice (SORP), where reference is made to void levels. This is interpreted by some as meaning that if you plan to make a loss on a scheme, you don't have an impairment; whereas if you don't plan to make a loss but you make one anyway, you might well have one. Perhaps the solution is to plan to make a loss.

None of the above applies to properties developed for sale or shared-ownership, although with properties funded by grant any loss would be mitigated by grant abatement and no impairment might arise.

There are likely to be numerous debates about whether impairments should be recorded, which criteria should be used and the judgements made. However, the lack of clarity on how to account for impairment will mean each RP can provide a coherent argument on why its particular treatment is reasonable under the circumstances, even if it is different from a neighbouring RP in a similar situation.

VAT ADJUSTMENTS FOR TEMPORARY LETTINGS

Before letting dwellings which are failing to sell in the current climate, careful consideration should be given to the VAT implications which may apply.

Many housebuilders may be considering letting new properties they have built or converted (from non-residential to residential properties), where it is not yet possible to achieve a suitable sale. However, by opting to let, rather than sell new or converted dwellings, the VAT application will be different.

The sale or grant of a long lease (over 21 years) in new or certain converted dwellings is zero-rated, giving rise to full VAT recovery for the builder. However, the letting of a residential property is VAT exempt. Input VAT is not normally reclaimable on expenditure attributable to exempt business activities. So, the shortterm exempt letting of an unsold dwelling may affect the housebuilder's ability to recover input tax on construction and other costs. A VAT exempt temporary letting may require the housebuilder to do one or more of the following:

  • restrict input VAT recovery on current and future VAT returns
  • repay input VAT previously reclaimed on returns already submitted (a one-off clawback adjustment)
  • agree a special method with HM Revenue & Customs (HMRC) for recovering future input VAT.

HMRC recently issued information on two methods to calculate the one-off clawback adjustment. The calculation must be made as soon as the temporary letting starts and must be based on a realistic expectation of the letting period or eventual sale value. HMRC may also require the housebuilder to provide evidence in support of the estimations used in its calculations.

The first method calculates reclaimable input tax based on the estimated eventual sales value as a percentage of the sum of the estimated sales value, plus estimated exempt rents.

The second method uses the expected letting period as a percentage of the deemed ten-year economic life of the dwelling, but this calculation is strongly discouraged by HMRC and is unlikely to provide housebuilders with a higher VAT recovery rate than the first method.

In addition to repaying VAT reclaimed on direct construction costs, the receipt of exempt rental income may also require businesses to restrict VAT recovery on past and future overhead expenses, particularly if there are VAT return periods where exempt rent is the only income.

However, it is possible that housebuilders may be able to restructure their property ownership prior to granting a temporary letting so that a VAT clawback does not arise.

CONTRACT COMPLIANCE

"How exposed are your maintenance contracts to incompetence and fraud?" asks Just Housing Consultancy director, Keith Simpson.

The economic downturn evidenced by falling property prices and the credit crunch is putting the business plans of many housing associations under severe pressure. Consequently, more associations are being driven to ensure they are obtaining value for money on day-to-day responsive repairs and void contracts.

The national move towards partnering over the last decade has been fraught with problems and has not produced the results anticipated. The three major objectives of reducing costs, improving quality and providing continuous improvement simply cannot be demonstrated nationally, as indicated in the recent Audit Commission report, For better, for worse: Value for money in strategic service-delivery partnerships.

In my opinion, Sir John Egan never, in his wildest dreams, envisaged that partnering could apply to "a man in a van full of ball valves", as can be evidenced in his report, which is focused solely on major construction projects such as Heathrow's fifth terminal.

As a result of this mismatch between strategic partnering and day-to-day repairs, a plethora of consultants have been engaged to create a whole range of models for open-book partnering. Many of these are not fit for purpose, leave the client exposed and are not even fully understood by technically weak and under-qualified clients. This situation is compounded by inadequate IT systems and poor integration that does not allow effective control and monitoring of budgets. Regular overspending on responsive repairs has resulted in planned maintenance programmes frequently being raided to bail the client out, and keep poor client management below the chief executive's radar.

This process has created a serious situation, as the major contractors continue to win long-term partnering contracts where clients are encouraged to transfer more and more clientside responsibility to the contractor, purportedly as a means of cutting costs. A major contributor to this position has been the 60/40, quality/price evaluation model, which lacks credibility. As a result, contractors can employ expensive bid teams in an attempt to sway impressionable residents and clients, without having to demonstrate an agreed quality standard, corrupting the tender process.

Competitive tendering should always adopt a clear quality threshold, which all contractors must achieve in order to move forward to the Invitation to Tender process (ITT). The ITT process is then purely about price, with assurance having already been provided in relation to the quality of service. So, invite six or eight contractors to tender, making it clear that the award will be to the lowest price. It is easy; not only do you achieve the best price, but you dispense with the 'beauty parade' which corrupts so many tendering processes.

Whether the contract is open-book or schedule of rates, the only challenge is to manage the contractor successfully so that they deliver what they have promised. Accepting that many clients are technically weak and unable to confront the major contractors' professional teams with confidence, it is essential to undertake regular independent 'contract audits'. These should not be confused with forensic audits, carried out by accountants. The contract audit is undertaken by suitably qualified surveyors who are familiar with the contract. They take samples of recent work, including photographic evidence, and revalue it against invoiced costs; they then report on over/under claiming.

Our two contract audit teams are currently being overwhelmed by clients who have real concerns about their repairs and maintenance contractors – and rightly so, since we have secured up to six figure repayments for clients following our audits.

However, the story does not end there. How can we deal with the issue of technically weak clients to ensure they develop the skills and understanding to be able to manage the contract? Just Housing's contract auditors conduct workshops with the client team, where the findings of the audit are set out and discussed, enabling robust inspection and verification processes to be established and embedded to ensure further audits are unnecessary.

The current situation requires action from both clients and contractors if value for money is to be evidenced. The confidence that partnering once enjoyed in this part of the sector has evaporated and there needs to be a return to robust contract compliance and quality assurance that can give clients an evidence-based guarantee that they are receiving value for money.

MITIGATING THE IMPACT OF THE CREDIT CRUNCH

Adrian Wild discusses how the credit crunch and the wider economic slowdown might affect RPs, and suggests possible actions to limit the impact.

Over the last decade or so RPs have operated in a relatively benign economic environment. The sector – with borrowings of over £31bn – has benefited from historically low interest rates and ready availability of credit. These have fed through to the housing market, allowing RPs to generate significant returns from property sales, and providing a steady stream of funding from Section 106 levies. The strength of the economy has also resulted in historically low unemployment, with inflation being mitigated by the influx of migrant workers.

However, the picture is now very different. RPs will be feeling the effects of the credit crunch due to falling asset values, scarcity of credit, increasing tenant arrears and difficulties with suppliers. The housing market has slowed significantly due to this reduced availability of credit and the unwillingness of people to buy in a falling market, while the price of essentials – particularly food and fuel – has increased.

How long the slowdown will last is a matter of debate and speculation. The extent of personal debt, which was £1.4 trillion at the end of 2007, is different to previous recessions. Families are now vulnerable to even small reductions in household income, and the need to reduce their borrowings indicates a sustained period of belt tightening.

We look at some of the questions facing RPs, their boards and senior management teams.

  • How might the credit crunch affect us?
  • How can we mitigate and manage the risks we face?

Increased risk of fraud

People commit fraud for a number of reasons, but some individuals facing financial pressure may be more likely to commit opportunistic fraud. Greater vigilance is required to ensure your controls for preventing and detecting fraud are being properly implemented and monitored. Risks may arise from:

  • frontline staff with access to rent receipts or tenant monies
  • staff expense claims
  • suppliers submitting inflated or fraudulent invoices or claims
  • collusion between staff and suppliers to inflate the costs of supplies or services.

Not only can the loss from fraud be financially significant, but the impact on your reputation, particularly with regulators, could be substantial.

Actions

  • Review your risk map to ensure it reflects the current economic environment.
  • Consider whether the work of internal audit in key areas is adequate and whether it is being performed on a sufficiently regular basis.
  • Ensure that whistle-blowing policies are widely understood and embraced within the organisation.
  • Investigate warning signs or reports of fraud promptly and professionally.
  • Don't forget that RPs have a duty to maintain a fraud register and to make reports to the regulator.

Impact on your staff

Lower-paid workers will be disproportionately affected and have limited discretionary expenditure. However, even higher-paid employees may be financially stretched – for example, by large mortgage payments.

This will create financial stress, which can lead to emotional stress. As the economic environment worsens we can expect to see staff:

  • taking more time off through stress and illnesses
  • working less effectively due to money worries – a phone call from a credit card company demanding payment during the working day could leave an employee distracted and prone to making errors.

Actions

  • Ensure that your HR procedures are robust by:
  • monitoring individuals' absences, recording days lost and causes

  • undertaking return to work interviews and, where absences reach a trigger level, involving a more senior staff member

  • confirming that appraisal systems – which capture staff performance data through the year and identify potential issues as soon as possible are in place.
  • Make sure that you have a suitable support structure in place – even if it is as simple as being able to refer staff to a Citizens Advice Bureau.

Impact on tenants

Tenants in financial hardship may divert their rent money to purchase food and other essentials. Those with personal debt will come under pressure to meet their obligations. They may be tempted to make a small payment to a credit card company, as that might potentially allow them to access further credit – alleviating their immediate problems.

Employed tenants also face the risk of redundancy. This recession may be the first experience people have of unemployment; they may not know which benefits they are entitled to, or how to access them. Housing benefit departments will also become increasingly busy, which will lead to more delays in processing and paying benefits.

Rent arrears are likely to rise, leading to increased financing costs for the sector and increasing losses from bad debts.

Actions

Offer help to the newly unemployed so they receive financial support.

Consider whether your systems will identify tenants facing problems as soon as possible – for example, if a tenant who has previously paid on time misses a payment, it may indicate that he/she has a problem, even though the level of rent arrears is low.

Key suppliers

Most RPs are highly dependent on key suppliers to undertake development work and repairs. The building industry is suffering substantially – some forecasts suggest that over 100,000 jobs will be lost across the sector. Business failures are expected, size being no protection against a lack of projects. You may find work ceases on your developments part way through and you have no-one to undertake urgent repairs.

Most contracts include standard terms which offer significant protection for an association in the event of a contractor becoming insolvent. However, the reality is that this protection may be illusionary as an insolvent building company will be unable to fulfil contractual obligations.

There is a limit to what you can do once you are committed to a building contractor; if it fails it is likely to be expensive and can cause significant delay. The impact of failure can be dramatic.

  • You will need to appoint a new contractor to complete the work, who will need to ensure that any work to date has met the design standards. For instance, the contractor may need to strip out partially complete work and recomplete it with obvious cost and timescale implications.
  • You may end up paying for subcontractors' work twice, if the main contractor did not pass on the money.
  • Subcontractors may demand additional 'ransom' payments to complete their work or provide the necessary certificates.
  • The schedule of work will be disrupted and the partially complete building may be abandoned for some time – acting as a magnet for vandals and thieves, and creating a risk of weather damage.
  • Subcontractors may not be able to reschedule their work to meet your revised requirements.

However, with plenty of capacity in the industry it should be possible to appoint new contractors and competitive pressure may lead to reduced pricing. If you have a performance bond in place, you will be able to call on the bond to recover any excess costs incurred – although this will only offer relief after the event.

Therefore, concentrate on reducing the impact of any failure of your suppliers, and also on monitoring your suppliers so that you have some warning of failure.

Actions to mitigate

  • Consider spreading your work amongst a number of suppliers to minimise your dependence on any one supplier.
  • Prepare contingency plans, for example, have a plan ready for securing any active development sites in the event of failure.
  • Before entering into any contract you should:
  • review the proposed contractual terms to ensure that they offer you as much protection as possible performance bonds are helpful

  • ask for up to date financial information (e.g. management accounts, including balance sheet information) rather than relying on out of date statutory accounts.
  • Where your repair work has been outsourced, make sure that any data collected by your agent is secure and accessible in the event of a failure (so that at least you know what repairs have been done and which remain to be done).

Actions to monitor

  • Identify which suppliers are critical to your activities.
  • Visit your development sites regularly – is progress in line with your expectations?
  • Closely monitor development work for signs of possible financial weakness, including:
  • subcontractors quitting the site, indicating they have not been paid
  • delays in undertaking the work due to unavailability of materials/ subcontractors
  • Use real-time monitoring tools so that you can be advised of County Court Judgements against your suppliers and other trigger events.
  • Talk to other RPs who use the supplier - are they experiencing problems?
  • Closely monitor payment applications - are they in line with work done or are they being inflated?
  • But most importantly, get to know your contractor - meet regularly and form a professional relationship.

Solvency

The demise of Ujima Housing Association demonstrates the absolute need for robust governance, effective management, regular and accurate internal reporting and realistic business planning. In troubled economic times this is even more important because:

  • plans which might have previously appeared prudent may become unachievable
  • the risks may escalate, as adverse events in one part of the economy impact on other areas
  • the speed of change may be accelerated – there may be less time to take remedial action than there had been previously
  • additional costs may be incurred through increased rent arrears, more temporary staff being required to cover staff sickness, possible problems with developments and increased financing costs
  • not only may proceeds from property disposals be substantially less than forecast but they may also be delayed for prolonged periods.

Actions

  • Review your business plan sensitivities – flex key assumptions downwards and ensure that your plan is still viable.
  • Ensure that your management reporting is timely and clearly shows trends (e.g. by using graphical analysis).
  • Identify key performance indicators which could warn of a worsening economic environment and monitor these closely.
  • Take necessary action sooner rather than later.
  • Don't be afraid to take difficult decisions – for example, might it be better to defer a new development, even if that means not meeting Housing Corporation targets?

Most RPs are financially robust and wellmanaged and will weather this economic storm. Awareness of the wide ranging impact of the credit crunch will help them to manage their activities in these difficult times.

It is not all bad news for the sector. Economic hardship could drive down certain costs and could also present significant opportunities for those with the ability and willingness to take on additional commitments: for example, one large developer recently reportedly offered 43% discounts to buyers of six or more flats.

TOPICAL TAX ISSUES FOR RPs

The credit crunch and LCHO

The current economic climate is having a significant effect on the strategies adopted by housing associations, both charitable and non-charitable, in providing lowcost home ownership (LCHO) units. The package of measures and reforms announced by the Government in early September, in response to the challenges faced by the housing market, will also have an impact on strategic thinking.

In considering new profiles for development schemes designed to deliver this housing to the market, associations need to be aware of current tax developments which can give rise to unforeseen liabilities and could affect the financial viability of some schemes.

Charitable trading and LCHO

The joint guidance on the tax implications of Affordable Home Ownership for charities, prepared by the Housing Corporation, the Charity Commission and HMRC, was formally published in May 2008. While there are many grey areas, particularly around the definition of a charitable beneficiary, the guidance does make it clear where some pitfalls may arise. A charitable housing association may develop a block of units for sale to charitable beneficiaries on sharedownership terms as part of its charitable trading activities, but then discover that such beneficiaries are not going to come forward and decide instead to sell the units outright on the open market. In these circumstances, profits from these sales will be taxable in the charity and cannot be sheltered by gift aid payments.

Impact of the new SORP for RPs

The introduction of the 2008 accounting SORP for RPs is mandatory for the year ending 31 March 2009. This requires that housing associations recognise the profit on first tranche shared ownership sales in the income and expenditure account. This is done by including a prior year adjustment in the year of recognition of the first tranche, to reflect profits applicable to earlier years.

In a charitable housing association, this new treatment will highlight the scale of this LCHO activity and make it more open to scrutiny by HMRC. For a taxable RP, the change in accounting treatment can impact on the timing of corporation tax payments and bring into charge profits that were realised some time ago, without the generation of any new cash.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.