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									Sources of finance for housing stock transfers
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Contents
Abbreviations
Executive summary
Part 1
Chapter 1 - Objectives of the study
Chapter 2 - Study process
Chapter 3 - Assessment of the current LSVT funding market
Chapter 4 - Value for money issues
Chapter 5 - Barriers to achieving improved value for money and a sustainable programme
Part 2
Chapter 6 - Poorer urban and large metropolitan stock transfers the risks faced by recipient
landlords
Chapter 7 - Full versus partial funding of stock transfers
Chapter 8 - Business planning issues and information issues for the vendor local authority
and recipient landlord
Chapter 9 - Transfer to existing RSLs and a competitive disposal process
Chapter 10 - Intermediary body to issue bonds to the capital markets
Chapter 11 - Alternative models for stock transfer
Appendix I - ODPM Workshop 26th June 2001
Appendix II - Questionnaire to banks and building societies
Appendix III - Questionnaire to LSVT borrowers
Appendix IV - Organisations contacted to ascertain their views
Appendix V - Banks and building societies assessment of return on loans to LSVT RSLs
Appendix VI - Funders main observations on funding stock transfers
Appendix VII - LSVT generic illustrative risk matrix
Appendix VIII - Leaseholder risk to LSVT RSLs in poorer urban and large metropolitan
stock transfers
Appendix IX - Investment procurement risk to LSVT RSLs in poorer urban and large
metropolitan stock transfers
Appendix X - Management structures risk to LSVT RSLs in poorer urban and large
metropolitan stock transfers
Appendix XI - Analysis of replies received from existing RSLs
Appendix XII - Calculation of a recipient RSLs risk buffer
Appendix XIII - Alternative models for stock transfer
Abbreviations
ALMO            Arms Length Management Organisation

B/P             Business Plan

CAPM            Capital Asset Pricing Model

CAR             Capital at Risk

CHA             Ceewood Housing Association

CHTF            Community Housing Task Force

CLT             Community Land Trust

CML             Council of Mortgage Lenders

DTLR            Department for Transport, Local Government
                and the Regions

E&Y             Ernst & Young LLP

EAD             Exposure at Default

ERCF            Estates Renewal Challenge Fund

FSA             Financial Services Authority

HA              Housing Association

HAG             Housing Association Grant

HC              Housing Corporation

HM Treasury     Her Majestys Treasury

IRB             Internal Ratings Based

IT              Information Technology
LGD      Loss Given (the) Default

LSVT     Large Scale Voluntary Transfer

M        Maturity

NHF      National Housing Federation

ODPM     Office of the Deputy Prime Minister

OECD     Organisation for Economic Co-ordination and
         Development

PD       Possibility of Default

PFI      Private Finance Initiatives

PI       Performance Indicators

RAROC    Risk Adjusted Return on Capital

RARORC   Risk Adjusted Return on Risk Capital

RDA      Regional Development Agency

RSL      Registered Social Landlord

RTA      Recognised Tenants Association

RTB      Right to Buy

SHG      Social Housing Grant

SLR      Southwark Land Regeneration

TMV      Tenanted Market Valuation

TUPE     Transfer of Undertakings (Protection of
         Employment) Regulations 1981

UK       United Kingdom

VAT      Value Added Tax
VFM    Value for Money

WACC   Weighted Average Cost of Capital
Executive summary
INTRODUCTION

The transfer of housing stock from local authorities to Registered Social Landlords
(RSLs)has been an important and successful part of successive governments social
housing policy.Around 148 housing stock transfers have been completed involving 593,000
properties,raising a total of around £9.5bn in private finance.

The programme is expanding and changing to meet new challenges of the decent
homesobjective, delivering improved housing services, greater tenant involvement and
increasinglyplaying an important role in the regeneration of towns and cities. The
Government hasmade clear it will support the transfer of around 200,000 units per year
where tenants wantto transfer. This has and will continue to involve potential transfers from
some of the largestlocal authority landlords. Future stock transfers are also likely to have a
larger share of homeswith high investment needs and in areas facing problems of falling
demand.

Against this background of change, Ernst and Young were commissioned by the Office
ofthe Deputy Prime Minister (ODPM) (previously the Department for Transport,
LocalGovernment and the Regions DTLR) to assess how the cost effectiveness of
fundingobtained by RSLs to support Large Scale Voluntary Transfers (LSVTs) might be
improvedor maintained. The specific requirements of the study were:


  to assess the current market for funding stock transfers;
  to identify any barriers to achieving better VFM in financing terms including
   anassessment of the cause of the barriers and their relative significance in
   restrictingcost effectiveness;
  to consider specifically the possible barriers and other issues related to achieving
   goodVFM for financing transfers of poorer quality urban stock, including stock in
   lowdemand areas;
  to consider the implications of the increased size of the stock transfer programme onthe
   capacity of lenders to provide sufficient finance; and
  make recommendations about how barriers identified might be overcome to improveor
   maintain VFM.

STUDY APPROACH

The study process included extensive consultation amongst existing or potential
stakeholders,financial modelling, risk analysis and discussions with external agencies. This
includeddiscussion with the ODPM, the Housing Corporation, the Community Housing
Task Force,leading LSVT funders, the Council of Mortgage Lenders, the National Housing
Federation,HM Treasury and RSLs.
ASSESSMENT OF THE CURRENT LSVTFUNDING MARKET

The current market was assessed by looking at the profile of recent transactions and
activelenders. Vulnerabilities arising from the wider market context in which the lenders
operatewere identified, including the potential impact of the New Basel Accord (Basel II).
The keypoints arising were:


  All LSVTs in the programme to date have been funded.
  There are relatively few financial institutions willing to act as lead arranger for
   stocktransfer loan facilities.
  The bond markets have not been widely used.
  Loan facilities are generally competitively priced.
  The low returns to lenders to the transfer market, whilst favourable to the
   LSVTprogramme, may render it vulnerable to withdrawal by key lenders.
  The implementation of Basel II may lead to greater differentiation in lending
   termsoffered to LSVT RSLs, with the possibility of higher rates for more risky
   transfers.However, the impact of Basel II is uncertain and its full implications are not yet
   known.

VALUE FOR MONEY ISSUES

An important question for the study to address was whether or not the funding structures
usedand the funding rates achieved in transfers to date offered good value for money to
the recipientRSL and the public sector more widely. These issues are differentiated for
transfers involvingshire, urban and large metropolitan Local Authorities. Some of the key
findings were:


  Shire and other strong transfers.

    In Ernst & Youngs (E&Y) opinion, the cost of funds to the RSL generally represents
    good valuefor money. Key value for money issues relate to the sale price received by
    the local authorityand the local authoritys inability to benefit from gains arising from any
    subsequent refinancing.

  Poorer quality urban transfers.

    Transactions to date represent good value for money, but are still in their infancy.

Higher risks relating to management, demand, regeneration and procurement
costs,coupled with the implementation of Basel II, may in the future lead to higher
pricedloans and therefore poorer VFM.

  Large metropolitan transfers.

    Loan facilities raised to date to finance these transfers, which thus far have
    beencomparatively few in number, have in E&Ys opinion represented good value for
    money.

The scale of transfers of large metropolitan housing stocks, should provide the
opportunityfor greater innovation in funding sources and techniques.

A key VFM concern is that the level of risk the RSL is required to take should
becommensurate with its ability to absorb it.

The table below sets out Ernst and Youngs view of the typical loan terms achieved for
eachtype of transfer.



Shires


Poorer urban stock


Larger metropolitan


                   [1]
Arrangement fee


1-1.25%


1.25%


1.25-1.35%


                   [2]
Interest margins


10 bp rising


85-100 bp


40-50 bp
early years


periodically




Interest margins


45-50 bp


75-100 bp (within


60-65 bp


later years


(yrs 7-10


a few years)




onwards)
Other costs


Commitment fees


Commitment fees


Commitment fees




are generally not


at around half the


at around half the




charged


interest margin


interest margin


[1] % of loan value
[2] Margin above LIBOR. 1,006p = 1 percentage point


BARRIERS TO ACHIEVING IMPROVED VALUE FOR MONEYAND A
SUSTAINABLE PROGRAMME

The study went on to assess the barriers which lenders and borrowers identified as
operatingagainst a fully effective transfer funding market providing good value for money to
thetransferring local authority and the RSL. The main barriers identified were:
  In some recipient RSLs, board members and senior executives may not be
   sufficientlyestablished to act as a well-informed and experienced client during the
   funding raisingprocess. There is a concern that advisers drive such transactions.
  The track record of all transfers securing funding, the process and comparatively
   shorttimetable which to secure funding has produced a commodity approach to
   funding,which may not produce optimal structures in all cases.
  All transfers are funded on an individual basis thus losing any potential cost benefits
   ofaggregated funding.
  The purchase price/discount rate formulae is mechanical and does not necessarily
   takeinto account all factors and risks.
  Under the current clean break system, local authorities can neither benefit
   frompost-transfer out-performance by the recipient landlord nor support weaker RSLs
   inmitigating early-year risks.


Specific VFM issues and potential means to address them were covered in more detail
inthe second phase of the study.

URBAN AND LARGE METROPOLITAN STOCK TRANSFERS THE RISKS
FACED BY THE RECIPIENT LANDLORDS

The study looked at the risk profile of urban and metropolitan transfers. A generic risk
matrixwas prepared along with discussion papers in relation to the risk mapping required
by therecipient RSL. The main messages from this part of the work were:


  The purchase price for the stock being acquired should reflect the level of risk
   absorbedby the recipient landlord.
  The purchase price should not be unduly influenced by other factors, for example
   thelocal authoritys need to cover interest breakage costs on its existing Housing
   RevenueAccount loans.
  If all risks cannot otherwise be absorbed, the public sector will need to support
   RSLsthrough dowries, transfer of additional land, subordinated loans or other
   supportmechanisms if the transfer is to go ahead.
  Comprehensive regeneration strategies and delivery programmes are imperative if
   thehousing investment from LSVTs is to lead to long-term sustained improvement.
  Other key risks faced by transfer RSLs were:

    those associated with leaseholders;


    procurement and implementation of the investment programme; and


    management structures.
  RSLs considering transfer should develop a comprehensive risk assessment matrix to
   identifythe risks they are most exposed to and then develop strategies to manage these
   risks.

FULL VERSUS PARTIAL FUNDINGS OF STOCK TRANSFERS

This section considers the arguments for and against full funding of peak debt on the day
oftransfer, including the perception of LSVTs as start-up businesses, the risks which would
beencountered in partial funding and the potential benefits of transfer to existing RSLs
giventheir strength as ongoing businesses.


  Current Housing Corporation policy on registering new transfer RSLs generally
   supportsup-front full funding of business plans.
  This reflects the perception of LSVT RSLs as start-up businesses with
   programmessubject to uncertain costings and external change.
  For urban and large metropolitan transfers, full funding is a necessary precaution in
   thelight of the substantially greater risks to the fulfilment of the housing investment
   programmewhich partial funding would present.
  For some strong shire transfers, arguments could be made for partial funding,
   whichwould allow greater flexibility, should reduce costs and may bring additional
   fundersinto the market.
  Existing RSLs are more likely to be able to absorb the risks of partial funding and
   betreated as established businesses for funding purposes.

BUSINESS PLANNING AND INFORMATION ISSUES FOR THEVENDER
LOCAL AUTHORITY AND RECIPIENT LANDLORD

A number of issues relating to the quality of information and business planning offered
byRSLs and their advisors were identified in the course of the study. The conclusion was
thata more structured allocation of responsibility for information collation, dissemination
andbusiness planning would address these issues. Particular points arising were:


  Much of the information provided by the RSL in its business plan and
   fundingprospectus is derived from local authority records and accounts.
  The local authority should provide core data in a Disposal Prospectus and create aDue
   Diligence Library or data room for inspection by the RSLs and their funders.
  The RSLs business plan could then focus on its governance and management, its
   intentionsfor the stock and neighbourhood and all future tenancy matters.
  Funding advisers should rigorously test business plan assumptions, identify and
   quantifyrisks to the business plan and consider all the available funding options.

TRANSFER TO EXISTING RSLS AND A COMPETITIVE DISPOSAL
PROCESS

This section considers the extent to which the VFM of funding for stock transfers would
beenhanced by the involvement of established RSLs in a competitive bidding process. It
analysesthe potential financial value of involving existing RSLs and summarises the results
of aquestionnaire designed to judge the appetite of varying sizes of these RSLs for this
potentialarea of business.


  Current ODPM policy is to encourage LAs to involve tenants in the choice of a
   newlandlord. In some cases this has involved a more formal competition between
   potentiallandlords, although the policy is still relatively new.
  Existing RSLs, or group structures involving existing RSLs, should be able to
   offerpricing benefits through marginal costing of management costs and access to
   cheaperprivate finance.
  Virtually all existing RSLs, canvassed as part of a survey, expressed keen interest
   inparticipating in future LSVTs.
  A disposal prospectus and data room could create the basis for a properly
   conductedcompetition for the recipient landlord role.
  Bidders could include prospective RSLs, existing RSLs and the alternative
   modelsdescribed below.
  Competition would need to be carried out prior to ballot against clear criteria and
   withmeaningful tenant participation in the process.
  The clear advantages of a more competitive process may be partly offset by the
   difficultiesof engaging tenants in an extended transfer process.
  Large metropolitan transfers face additional complexities in introducing competition
   forthe landlord function because of the policy that generally no more than 12,000
   homescan be transferred to a single RSL.

INTERMEDIARY BODY TO ISSUE BONDS IN THE CAPITAL MARKETS

This section discusses the reasons for the relative under-utilisation of the bond markets
andthe potential role of a bond-issuing intermediary, whether this is likely to emerge from
themarket or would require public sector support and whether such public sector support
couldbe justified.


  The bond markets have been comparatively under-utilised in providing funding to
   thetransfer programme to date.
  The most cost-effective bonds are large, liquid issues which may require the
   aggregationof a number of smaller transfers.
  The market has not yet produced a mechanism for aggregating LSVT issues
   althoughthis has been achieved in the traditional RSL market.
  There is no current evidence of the poor value for money or market failure which
   mightjustify public sector intervention to establish a body to issue group bonds for
   LSVTs.

ALTERNATIVE MODELS FOR STOCK TRANSFER

A competitive bidding process may open up opportunities for organisations with
governanceand funding structures different from those of traditional RSLs. This section
considers thepolitical, economic and stakeholder concerns raised by two such models. It
also considers lessonswhich can be learnt for the LSVT process from the proponents of
such models, in particularthe need to place the social housing investment programme in a
wider regeneration context.


  The current system of transfer to RSLs provides limited capacity to reconfigure
   estates,maximise for community benefit the value of development land or participate
   incomprehensive regeneration programmes.
  Enabling RSLs to carry out wider development and regeneration activities may requirea
   relaxation of ODPM and Housing Corporation rules and the risks may be too greatfor
   newly-formed RSLs to absorb.
  Governance and financing models have been proposed which offer alternative types
   oflandlord and a wider regeneration capability, but which would need to win the
   approvalof a wide range of stakeholders, in particular tenants.

    the structured finance model utilising equity/debt combined funding with returns
    toequity investors being capped at a level which would allow surpluses to be
    channelledinto a local regeneration fund.

the community land trust model, where transfer of the freehold interest to aCommunity
Land Trust would enable a comprehensive masterplan to be developedwith any resulting
enhanced value being retained for the benefit of the community.
Part 1

Chapter 1 - Objectives of the study
Introduction

1.1 The aim of the study as specified by the Office of the Deputy Prime Minister (ODPM)
(formerlythe Department for Transport, Local Government and the Regions DTLR) is to
identifypotential ways in which the cost effectiveness of funding obtained by Registered
SocialLandlords (RSLs) to support Large Scale Voluntary Transfers (LSVTs) might be
improved,taking into account the changing nature and increasing size of the stock transfer
programme.

1.2 The transfer of housing stock from local authorities to RSLs has been an important
andsuccessful part of successive governments social housing policy. Around 148 stock
transfershave completed involving 593,000 properties, raising a total of around £9.5bn in
private finance.

1.3 The government has expressed a desire to modernise the programme to make it
moreeffective in delivering a larger programme of around 200,000 units per year. In
particular,the government wants the programme to take account of the changing nature of
stock inthe programme as more large urban local authorities pursue stock transfer.

1.4 Cost effective forms of finance are essential in delivering the programme with more
transfersinvolving a large number of dwellings, generally in poorer condition, in large
metropolitanareas. This expanded programme also raises the issue of the availability of
private financeon competitive terms and conditions, from what at present is a relatively
small pool ofactive lenders.

1.5 Recipient RSLs taking the housing stock of local authorities have thus far adopted a
veryconservative approach in arranging their private finance requirement. Funding
packageshave tended to be very similar with comparatively little use of the capital markets,
thenatural source of long-term fixed rate funding.

1.6 Some stock transfers recipient landlords have a comparatively small funding
requirement,however others, particularly those arising from large metropolitan authorities,
can havefunding needs running into several hundred million pounds. These larger loan
facilitieshave incurred large arrangement fees, which are, with very few exceptions, netted
offagainst the purchase price as part of the recipient landlords set-up costs.

1.7 Loan covenants have become very standardised, generally being a proxy for
traditionalproject finance loan life and debt service cover ratios. Whilst these may appear
undulyrestrictive for strong stock transfers arising in shire districts, they, along with other
financialcovenants and ratios, may be essential in ensuring that lenders to poorer urban
and largemetropolitan stock transfers are able to adequately monitor the performance of
their borrower.

1.8 However, at transfer, lenders generally consider recipient landlords to be in a
start-upsituation. To an extent, this is understandable given the initial catch-up repairs
investmentprogramme. However, it could also be argued that stock transfer is the transfer
of an existingbusiness with a track record of its operational performance in the ownership
of the localauthority, and therefore should be treated as such by lenders.

1.9 Stock transfers arising from shire district authorities have for a number of years
become astandardised approach to improve the delivery of social housing. This status has
manifesteditself in relatively low fees for advisory services and generally little incentive to
innovate interms of new sources and styles of funding. In addition, as the terms and
conditions onwhich lenders provide funding has been steadily eroded in recent years, the
transfers sectorhas increasingly become unattractive to potential new lenders. The transfer
sector has alsoattracted very few new entrants in recent years, presumably a reflection of
lenders viewsabout the relative returns from lending to the sector. Given the Governments
desire to increasethe size of its annual programme, a continued lack of new lenders
coupled with mergersbetween existing lenders could become a cause for concern.

1.10 Given this background of a mature market with relatively few lenders, ODPM wished
toreceive a report which:


  provides an assessment of the financing terms, forms of funding and lender
   profilespresently involved in funding LSVTs and to assess the extent to which these
   representgood VFM;
  identifies any barriers to achieving better VFM in financing terms including an
   assessmentof the cause of the barriers and their relative significance in restricting cost
   effectiveness;
  considers specifically the possible barriers and other issues related to achieving
   goodVFM for financing transfers of poorer quality urban stock, including stock in
   lowdemand areas; and
  considers the implications of the increased size of the stock transfer programme on
   thecapacity of lenders to provide sufficient finance.


1.11 Implementation of the assignment has been divided into two stages. The first stage
was anassessment of the current LSVT funding market. This included canvassing the
views ofleading funders, advisors, borrowers, and potential new entrants to the market. An
assessmentof the VFM of the current funding arrangements has been made along with the
identificationof barriers to achieving greater VFM. This first stage of the project is covered
in Part 1 ofthis report, and was required to provide initial views on recommendations for
solutions tothe issues identified.

1.12 The second stage of the assignment, as detailed in Part 2 of this report, involved
investigatingpossible solutions to the barriers to VFM in the funding of stock transfers, as
identified inthe first part of the assignment. In particular, this involved:
a) identifying the risks faced by recipient landlords taking the transfer of housing stock
inpoorer urban and large metropolitan areas (Section 6);

b) investigating the possibility of changing the current norm of all stock transfers arranginga
loan facility on the day of transfer, sufficient to cover their expected future peak
debtrequirement (full funding). The implications and acceptability of a partial funding
approachto the leading interest groups in a stock transfer have been considered (Section
7);

c) considering the key business planning and information issues to be addressed in
arrangingfunding for a stock transfer (Section 8);

d) considering the possibility of increasing the involvement of existing RSLs in futurestock
transfers, including their ability to absorb greater risk than a newly formed RSLand to pay a
higher purchase price for the stock. In addition, investigating the possibilityof introducing
greater competition in the stock transfer process to secure greater VFMin the funding of
stock transfers whilst being mindful of the implications for other keystakeholders,
particularly tenants (Section 9);

e) investigating the possibility of forming an intermediary body to aggregate stock
transfersand to issue securities in the capital markets (Section 10); and

f) considering alternative structural and funding models to facilitate the transfer ofhousing
stock from local authorities (Section 11).
Chapter 2 - Study process
2.1 The study commenced with a workshop in June 2001, attended by the project
steeringgroup with representatives from ODPM, the Housing Corporation (HC), the
CommunityHousing Task Force (CHTF) and the Ernst & Young LLP Project Team. This
was used toidentify the concerns and perceptions of all parties and looked at the strengths
and weaknessesof the current transfer structures and processes. In particular the
workshop looked at demandfor, and supply of, funding for transfers (see Appendix I for a
summary of the findings ofthis workshop).

2.2 Following this workshop a questionnaire was compiled for distribution to leading LSVT
funders,including banks, building societies, investment banks, funding advisers, mono-line
insurersand investors. A copy of this questionnaire is attached at Appendix II. This
questionnairewas agreed with ODPM and distributed to a pre-agreed list of funders.

2.3 In addition, it was decided to send a slightly different questionnaire (see Appendix III),
toLSVT borrowers to ascertain their perception and experiences of the fund raising
process.

2.4 A short presentation of the scope of the project was made to a meeting of the Council
ofMortgage Lenders (CML) in June 2001 and a meeting was held with the National
HousingFederation (NHF), both members of the projects External Reference Group.

2.5 The next stage of the study consisted of a series of meetings, telephone conversations,
e-mailcommunications and written submissions designed to enable the project team to
assess thecurrent state of the market and to provide an opportunity for existing funders,
non-funders,borrowers, rating agencies, advisors, and trade bodies to comment on their
own experience.It was also an opportunity for these stakeholders to provide suggestions
for improvements,either to the fundamental funding structures or to the procedures
currently adopted (seeAppendix IV for list of contacts).

2.6 These stakeholders were pleased to be given the opportunity to have their views heard
andclearly some have taken a significant period of time in preparing their response.

2.7 Following a meeting with the External Reference Group comprising the CML, ODPM,
theHousing Corporation, HM Treasury, the CHTF and the NHF, in September 2001, areas
forfurther investigation and analysis were agreed.

2.8 The second stage of the project involved further research and analysis of options to
achievegreater VFM in the funding of stock transfers and pre-requisites to ensure as far as
possiblethe cost-effective funding of ODPMs stock transfer programme with a higher
proportion ofpoorer urban and large metropolitan stock transfers.

2.9 In particular, Ernst & Young undertook detailed financial modelling of different
fundingstructures to ascertain the potential effect on the purchase price that could be paid
for a givenportfolio of properties, of involving equity finance and existing RSLs in future
stock transfers.

2.10 We also used our experience of both past Estates Renewal Challenge Fund (ERCF)
transfersand current urban and large metropolitan stock transfers, to identify the risks
involved insuch transfers, and the extent to which it is reasonable to expect a newly formed
RSL, withno reserves, to absorb such risks.

2.11 In the first part of the assignment we clearly identified the possibility of existing RSLs
becomingmore involved in all aspects of future stock transfers. We canvassed a large
number of ChiefExecutives of existing RSLs to ascertain their appetite to become more
involved in stocktransfers. The responses were extremely useful in developing our thinking
on the value thatexisting RSLs could bring to stock transfers, and particularly those
involving poorer urbanand large metropolitan stock.

2.12 We considered options for greater involvement of the capital markets in funding future
stocktransfers. This involved discussions with leading investment banks, credit rating
agenciesand mono-line insurers to investigate potential structures.

2.13 The emerging findings from the second stage of the study were discussed at a
meeting ofthe External Reference Group in March 2002, as well as being presented at the
NHF FinanceConference in the same month. This final report was then prepared.
Chapter 3 - Assessment of the current LSVT funding market
Summary

  All LSVTs in the program to date have been funded.
  There are relatively few financial institutions willing to act as lead arranger for
   stocktransfer loan facilities.
  The bond markets have not been widely used.
  Loan facilities are generally competitively priced.
  The low returns to lenders to the transfer market, whilst favourable to the
   LSVTprogramme may render it vulnerable to withdrawal by key lenders.
  The implementation of Basel II may lead to greater differentiation in lending
   termsoffered to LSVT RSLs, with the possibility of higher rates for more risky
   transfers.However, the impact of Basel II is uncertain and its full implications are not yet
   known.


BACKGROUND

3.1 Since stock transfers began in 1988, around £9.5bn of private finance has been raised,
ofwhich around £422.7m (4.5%), has been from the capital markets. A number of stock
transferRSLs including Beacon HA, Suffolk Heritage HA and Broomleigh HA have raised
fundingfrom the capital markets through a partial refinancing exercise.

3.2 The total funding requirement for the 2000/01 transfer programme was the largest ever
at£1.8bn. The majority of the funding (around £1.6bn), was provided by banks and
buildingsocieties. One transaction, the transfer of 36,356 properties to Sunderland Housing
Group,was funded in part (£240m) through the capital markets. No transfer has been
unable toraise its required funding.

3.3 This reflects the trend of previous years LSVT funding, in which all transfers have
beenfinanced with the majority of funding being provided by a relatively small number of
banksand building societies.

TRANSACTION PROFILE

3.4 Headline margins were low as a result of competitive pressures for strong and large
transactions,where margins begin in the early years of the loan at extremely low levels, for
exampleinitially 0.1% points above base rates (typically LIBOR) rising to say 0.45%-0.50%
in thelater years of the loan. However, arrangement fees at around 1%-1.25% of the total
loanvalues, derivative costs and associated banking services, boosted overall returns to
lendersbut not, in Ernst & Youngs opinion, to an excessive level. As in previous years, the
vastmajority of transfers for the 2000/01 programme, were completed in the final two
monthsof the financial year.
3.5 In two transactions, a single underwriting bank/building society was pre-selected
withoutopen competition, but the subsequent syndication of the loan facility was tendered.
In generalthis practice was highly unpopular with other funders and some declined to
participate inthe subsequent syndication process. Any failure to involve all active lenders in
the fundraising process is likely to result in inefficient funding terms and conditions.

3.6 In a further two transactions, only two potential lenders were approached to bid for the
fundingmandate. Presumably the funding adviser concerned judged that the potential
funders identifiedwere most suited to providing their clients funding requirement on
competitive terms.

3.7 A total of 5 (Blackburn, Coventry, Calderdale, Manchester Handforth and Sunderland)
ofthe 17 LSVTs funded during 2000/01 could be said to be urban stock. In only one case
wasfunding not initially forthcoming (Blackburn) although this ultimately secured funding.
Thispractice of accepting a lender of last resort has, since the inception of stock transfers
in 1988,ensured that all transfers, including weaker borrowers, have been funded. From
the publicsector perspective, this is undoubtedly a strength of the funding market for stock
transfers.

LENDER PROFILE

3.8 There are currently five high street banks, two building societies, one non-UK bank
andtwo or three capital markets underwriters actively pursuing opportunities to lead
transactionswith relatively few smaller banks and building societies willing to participate in
syndications.

3.9 The merger or take-over of active and inactive bank lenders may have significant
implicationsfor the funding market. If the lending or returns criteria of the inactive lender
prevail, thenthe lending market may lose an active lender. This may have significant
implications for theLSVT funding market.

3.10 A formerly large active lender to LSVTs supplied very little funding to the 2000/01
LSVTprogramme. If this were a portent of a major lender reducing its lending appetite, this
wouldalso have a significant and detrimental effect on the LSVT funding market.

3.11 However, should these large funders reduce their appetite, and lending margins
increased inresponse, perhaps other relatively inactive lenders (for example Lloyds TSB
and HSBC) wouldbecome more aggressive in their appetite for new loans. At the moment
these relatively inactivelenders think that the risk:reward equation arising from stock
transfers is insufficiently attractive.

3.12 As far as Ernst & Young could determine, no lender had parcelled loans to LSVT
RSLs andsecuritised them in the capital markets. This may be because lenders value their
relationshipwith their borrowers and being a relatively close sector, securitisation of loans
may be perceivedas withdrawing from the sector or reducing commitment. Alternatively, it
may be becausethe lenders value assets on their balance sheet and their capital has not
been sufficientlyscarce or expensive to necessitate freeing-up capital by using
securitisation structures.
3.13 If a funder securitised part or all of its loans to LSVT borrowers, it would be unlikely
tomake a significant difference to the future pricing of loans to new LSVT borrowers. Thisis
because the lender would be likely to be freeing the capital for use in providing loans
tomore profitable sectors, for example Private Finance Initiative (PFI) transactions.
However,if the implementation of Basel II (see paras 3.19 to 3.38 below) results in lenders
beingrequired to assign more capital to loans to LSVT borrowers, there may be more
incentiveto lenders to investigate securitisation structures.

STUDY QUESTIONNAIRE TO LENDERS

3.14 All responses to the questionnaire thought returns from lending to LSVT borrowers
werevery low. However, all lenders wanted an open competition for the funding mandate.

3.15 The questionnaire to banks and building societies asked how the lender calculated
thereturn received from a loan to an LSVT borrower, and whilst a couple declined to
respondgiven the commercially sensitive nature of the question, it was interesting to note
the widevariety of methodologies employed and the varying degrees of sophistication.
Particularlyinteresting were the responses from large banks that are not currently active in
lending toLSVT RSLs. A discussion of how lenders might assess the returns arising from
loans toLSVT RSLs is contained in Appendix V.

3.16 The role of the Housing Corporation in regulating RSLs and ODPMs methodology
used todetermine the purchase price had a tendency to result in a relatively low risk and
comparativelyhomogenous sector. Given this low risk perception, loans to LSVT RSLs
should be attractiveto a wider population of potential lenders.

3.17 However, lending to LSVT RSLs has to compete with other parts of a banks
lendingoperations for the banks capital. Riskier, but higher priced, lending opportunities
may bepreferred to low risk: low return loans to LSVT RSLs. Unsophisticated return
calculationsthat do not reflect the risk associated with the lending opportunity, would be
expected tomake low risk loans to LSVT RSLs seem relatively unattractive.

3.18 Funders responses to the questionnaire are summarised at Appendix VI.

THE NEW BASEL ACCORD BASEL II

3.19 The first Basel Accord, launched in 1988, was aimed at strengthening international
bankscapital reserves. However, this accord proved not to be sufficiently risk sensitive and
flexibleand over time it became necessary to update the agreement in order to achieve its
initial goals.

3.20 The New Basel Accord or Basel II was released in 2001 for consultation. This seeks
toaddress the issues arising from Basel I by introducing a more risk sensitive framework
andthis may lead to more variations in lending pricing from lenders to RSLs. The
Accordcomprises three pillars:
  Minimum capital requirements.
  Supervisory review.
  Disclosure and market discipline.


3.21 These pillars link internal risk management and economic capital adequacy with
regulatorycapital. The overall intentions of the Accord are that:


  banks capital levels should be commensurate with risk;
  risk levels are to be estimated on a conservative basis; and
  where better data and risk management processes are in place, less capital will be
   required.


3.22 The timetable for Basel IIs implementation has not been confirmed, but currently it is
notexpected to be introduced until early 2007.

CAPITAL CALCULATIONS FOR CORPORATE EXPOSURES

3.23 Required capital levels to be maintained by banks are calculated by assigning risk
weights todifferent categories of exposure. Two approaches to assigning risk weights are
proposed byBasel II. Under the simplest, (the standardised approach, which is similar to
existing arrangements)these risk weights are set according to the type of asset and rating.
The second approach isthe Internal Ratings Based (IRB) approach, which has two formats
either foundation oradvanced. The Financial Services Authority (FSA) will determine
whether a lenders internalsystem is of sufficient quality for it to use the advanced system.

3.24 It is expected that given the size of the banks involved in the RSL sector, that either
mostwill start using the advanced methodology immediately, or would be permitted to do
soshortly thereafter. Some of the smaller lenders, mainly building societies, expect to be on
thestandardised approach, although they may move if this produces disadvantageous
resultscompared to IRB.

3.25 Under the current methodology arising from the 1988 Accord, an exposure to an RSL
isassigned with a 50% weighting. In contrast, most corporate exposures are 100%. The
combinedrisk adjusted exposure forms the base against which minimum capital reserve
levels arecalculated. The 50% weighting for RSLs is due to the sectors track record of no
defaultsto date, its legal status as a non-profit distributing sector supported generally with
collateralsecurity and the regulatory framework of a Government agency, the Housing
Corporation.

3.26 For the IRB approach, three variables have to be considered in establishing the
appropriaterisk weighting: Possibility of Default (PD), Loss Given the Default (LGD) and
Maturity(M), these combine to map a schedule of regulatory capital risk weightings. These
are then multiplied by the Exposure at Default (EAD) to give the capital requirement. This is
thenadjusted for granularity single borrower risk concentrations.
3.27 The quality of the lenders internal credit rating systems will be gauged by the FSA,
with thelender either permitted to calculate exposure under the foundation or advanced
approach.

3.28 Unlike the standardised approach, where an exposure is assigned one of six risk
weightings,of which an RSL is 50%, the proposed IRB approach has a continuous function
to providecorresponding risk weightings thereby giving a finer differentiation. The advanced
approachallows the lender to provide their own estimates of PD, LGD, M and EAD. This
may leadto a less generic sector-wide credit rating, and therefore lower risk weighting.

3.29 Under the foundation approach, the PD is calculated for each group of borrowers.
TheBasel Committee recommends that a lender generates an average PD for each
categoryover a one year time horizon. In the case of RSLs, who have little or no default
history, thisshould mean a low PD. This will need to be benchmarked to publicly available
ratings andindustry pool data.

3.30 The LGD is the estimate of each exposures average loss per unit (£) of exposure.
Given thealmost impeccable credit record of the RSL sector, most lenders do not have this
data in arobust format. Therefore Basel II prescribes a standards based approach at the
foundationlevel, which starts with a LGD for Corporate senior debt of 50% and
subordinated debt of75%. Some allowance will be given for residential mortgage collateral,
but the degree ofpossible mitigation is comparatively low.

3.31 With the advanced approach, the lender is permitted to provide its own internal
estimatesfor each category of LGD. This is beneficial as it takes account of lender specific
factorssuch as the lenders loss experience and transaction and borrower characteristics.
This willalso include a wider recognition of collateral than is available for the foundation
approach.

3.32 EAD is calculated as the estimation of the extent to which a bank may be exposed to
acounter-party in the event of and at the time of any default. This will also be calculated
undera standards-based approach at the foundation level. The total sum is currently
expected toequal 100% of the drawn amount plus 75% of any un-drawn amount. The
advanced approachwill permit lenders to make their own estimates of EAD.

3.33 Maturity is given as a standard figure for the foundation approach, and will therefore
haveno affect on the risk weightings. Under the advanced approach, it is expected that
lenderswill explicitly use the effective maturity, which emphasises the contractual maturity.

IMPLICATIONS FOR STOCK TRANSFERS

3.34 Most lending institutions have a corporate scorecard system for assessing the risk
arisingfrom a stock transfer borrower, which is used generically throughout the business. In
orderto convince the FSA that the quality of their internal ratings systems is good enough
to usethe advanced approach, the lender must prove that their risk assessments have
been suitablyadjusted for the sector specialisation. Given that most lenders have around
13 experiencesof lending to stock transfer RSLs this should not be difficult.
3.35 As highlighted above, the majority of lenders will be large enough to move rapidly
towardsan advanced IRB approach. Large lenders, who generally hold significant and
diverse portfolios,will be incentivised to develop systems compatible with the advanced
approach, as theiroverall capital requirements will be significantly reduced through its use.
Basel II requiresthat once a bank uses the IRB approach for one part of its total loan book,
it must take stepsto implement the IRB approach across all significant portfolios and
business lines. For thesereasons, subject to being able to meet the requisite standards, an
IRB approach is likely to beused for all RSLs lenders. Although the IRB approach will
initially be the foundation, in thelong run most lenders will move to advanced, and it is
therefore expected that RSL exposureswill fall below the current capital weighting of 50%
to somewhere between 20% and 40%.

3.36 The whole approach will mean that lenders under Basel II are expected to be more
sensitiveto the quality of lending. This is likely to trigger a strategic re-appraisal of sector
exposureand may lead to higher variations in pricing.

3.37 The current approach to risk weighting does not discriminate between assets of a
differentquality. The proposed IRB approach has a greater focus on asset rating with
different weightingsbeing assigned to assets of different quality. This may influence lenders
to migrate awayfrom riskier transactions, or to increase pricing so substantially that
transactions becomeunattractive to both lender and borrower.

3.38 Ernst & Young is grateful to the FSA and Abbey National Treasury Services in their
supportfor drafting parts of this section of the report.
Chapter 4 - Value for money issues
Summary




  Shire transfers


Key value for money issues relate to the sale price received by the local authorityand the
local authoritys inability to benefit from any gain arising from any subsequentrefinancing. In
Ernst & Youngs opinion the cost of funds to the RSL generallyrepresents good value for
money.

  Poorer urban transfers


Transactions to date represent good value for money, but are still in their infancy.


Questions remain about the sustainability of the market, given that some of theEstate
Renewal Challenge Funding transactions are still using the initial dowry theyreceived on
transfer to finance investment expenditure.


Higher risks relating to management, demand, regeneration and procurement costscoupled
with the implementation of Basel II, may in the future lead to higher priced loans.

  Large metropolitan transfers


Loan facilities raised to date to finance these transfers, which thus far have
beencomparatively few in number, have in Ernst & Youngs opinion, represented goodvalue
for money.


The scale of transfers of large metropolitan housing stocks should provide theopportunity
for greater innovation in funding sources and techniques.


The level of risk required to be taken by the RSL should be commensurate with itsability to
absorb it.
INTRODUCTION

4.1 The purpose of this chapter is to consider the current funding market for stock
transfersand the extent to which it represents value for money. Different types of stock
transfer willbe considered including:

a) transfers of stock in comparatively good condition with demonstrable demand,
generallylocated in shire district areas, but also in some suburban and urban areas;

b) stock requiring substantial investment, involving issues of uncertain long-term
demandand social exclusion often in poorer urban areas; and

c) transfers of most or all of the stock of a large metropolitan local authority,
demonstratinga variety of issues including a large initial investment requirement and
through thelarge number of properties involved, a large private finance requirement.

4.2 Our assessment of whether the current funding market for these different types of
transfersrepresents value for money for landlords is based on the following factors:

a) whether our assessment of the return on capital to the lender arising from the loan
isreasonable given the level of risk involved in providing the loan;

b) the implications for the purchase price received by the public sector for the stock
arisingfrom the terms and conditions attaching to the loan facility to finance the purchase;
and

c) whether the nature of the split of the return to the lender between arrangement feesand
the profile of interest margin over the life of the loan, represents VFM for therecipient
landlord and the vendor local authority.

SHIRE DISTRICT TRANSFERS

4.3 Funding for shire district stock transfers has become a standardised product for those
whichinvolve good quality stock, in locations generally without social exclusion issues,
withrelatively high vacant possession values, a solid business plan embodying reasonable
levelsof commercial flexibility and continuing high demand.

4.4 The availability of funding for better quality shire transfers on competitive terms and
conditionshas become assured, with considerable competition between potential lenders.
Whilst thearrangement fee, payable to the lender on the day of transfer, has remained
relatively constantat 1%-1.25% of the loan, interest rate margins have fallen to historically
low levels. Interestmargins above base rates begin at or around 10 basis points and rise to
around 45 to 50 basispoints from years 7 or 10 onwards.

4.5 E&Y understands that some extremely strong transfers even attract negative
interestmargins, but this is generally for loan tranches, which are not used to finance the
initialacquisition price. These tranches are often used to finance the major repairs
programme.For strong transfers where the need for initial investment in the stock may be
limited, theymay or may not be drawn down by the recipient RSL in future years.

4.6 These arrangement fees and interest margins (commitment fees are rarely paid as
competitionbetween potential lenders resulted in their removal several years ago) on any
measures ofreturn on capital (even with the 50% capital weighting for loans to RSLs) are
likely toproduce comparatively low returns to lenders, perhaps in the range 7% to 9%.
Indeed, inErnst & Youngs opinion, these loans are unlikely to be making a significant
contributionto the lenders shareholder value, given our estimate of a typical lenders cost of
capital (seeAppendix V). It may be that lenders returns from derivatives and other services
provided toRSLs, for example refinancing, increase lenders expected returns. Other criteria
may also beused to determine whether or not to lend. For example, the relatively high
arrangement feespaid on day 1 of the transaction may make the proposition attractive if a
lender monitorsfee earnings as a performance target.

4.7 Ernst & Young has therefore concluded that VFM questions in these transfers
relateprimarily to the price received by the local authority for the sale of its housing stock
ratherthan the cost of RSL borrowing.

4.8 The main issues arising in relation to VFM for shire transfers are discussed below.

STOCK PRICING

4.9 The system of a single up-front purchase price at transfer may not give the best
possible pricefor the stock given the uncertainties surrounding the cost of the repairs and
improvementprogramme and the possibility of excessively cautious business plans.
ODPMs methodologyof determining the Tenanted Market Value (TMV) for the stock using
a 6%-8% real discountrate over a 30 year period, may not generate the maximum price for
the stock in everyinstance. There may be a balance however between maximising receipt
to the public sectorand establishing a viable business plan for the new RSL with an
appropriate level of debt.

4.10 In particular, the involvement of existing RSLs, with experience of private finance
mayguarantee a higher price for a given portfolio of properties than a non-competitive
disposalprocess to a newly formed RSL.

REFINANCING

4.11 The majority of financially strong shire LSVT borrowers refinance their loan facilities
withinthe first 2-3 years following transfer. This is because their business plan has
stabilised, theyhave more information on the business they have acquired and they have
identified efficiencycost savings or generated treasury management savings. The issue is
whether the publicsector should participate in the refinancing benefits, and whether any
future refinancinggains can be captured at the time of transfer in the transfer contract.

FULL v PARTIAL FUNDING

4.12 Some financially strong shire transfers could consider partial funding on the day of
transfer.However, this approach to funding would be contrary to the Housing Corporations
currentprudent funding requirements. Knowing that they are likely to outperform their
initialbusiness plan, the recipient RSL of a strong shire transfer may be able to take a view
ontheir funding structure, recognizing that they would refinance and restructure the
transactionwithin a relatively short period after transfer.

4.13 Since the beginning of the stock transfer programme in 1988, the terms of loans to
stocktransfer RSLs have become more and more competitive, hence the appetite of LSVT
RSLborrowers to refinance their loan facilities. This advantageous position of improving
loanterms and conditions is not guaranteed to continue indefinitely and any LSVT RSL
onlypartially funding their business plan would run the risks of refinancing or raising
furtherfacilities on worse terms and conditions.

4.14 The subject of full versus partial funding for different types of transfers (strong shire
district,poorer urban and large metropolitan) is considered in more detail in Chapter 7.

PRICING OF POLITICAL RISK

4.15 There is a strong perception amongst lenders that the risks involved for lenders and
thereforethe rewards sought from new lending propositions are being heightened by
post-transfergovernment interventions in RSL rent and tax policies.

FEE APPORTIONMENT

4.16 The loading of the return to the lender on to arrangement fees, which are picked up by
thetransferring authority, encourages competition on margin but masks the underlying
returnsto lenders which may be higher than justified by the risk profile.

TIMETABLE AND PROCEDURES

4.17 The timetable and procedures for transfer do not always enable the RSL to act as a
properlyprepared and expert client in arranging its initial funding. This is considered in
more detailin Section 8 below.

POORER URBAN STOCK TRANSFERS

Background

4.18 Poorer housing stock can be located anywhere; it does not have to be in urban areas.
Suchstock is generally characterized by the need for significant investment, it may be
systembuilt, perhaps multi-storey flats and is often unpopular with tenants. Stock located in
urbanareas may exhibit some or all of the features of poorer stock, but alternative use
values mayvary considerably. Social housing in Oldham may have a low alternative use
value; in contrastsocial housing in Hackney may be in a similar poor condition but being
close to the City ofLondon, may have a very high alternative use value. Although
alternative use values arenot reflected in the TMV, they would be taken into consideration
by potential lenders.
4.19 For transfers with poorer quality urban stock, the business plan of the recipient
landlord mayinvolve significant risk, including low demand levels, high investment needs
and evidenceof social exclusion, the loan facilities struck to date have in Ernst & Youngs
view representedgood VFM to the vendor local authority and recipient RSL, when the
risk:reward balanceis considered.

4.20 Loans to these LSVT borrowers generally attract a higher arrangement fee of say
1.35%-1.5%,interest margins starting at say 30 basis points to 45 basis points and rising
relatively quicklyto around 65 basis points. Occasionally the borrower has only received
one funding proposalwith higher arrangement fees and interest margins.

4.21 These transactions have clearly benefited from the reputation of the RSL sector as a
wholebeing considered generally as low risk and well regulated. Without these two key
strengths,poorer urban stock transfers may have been unfundable. There are VFM
questions goingforward relating to the sustainability of this position, as outlined in the
following paragraphs.

Sustainability of the Market

4.22 There are increasing concerns about how to sustain the level of lender demand for
thesetransfers in the light of their perceived higher risk: low reward nature. Strategies to
makethese transactions more attractive to potential funders are considered in Chapter 6.

4.23 The wider issue is to ensure that for poorer urban stock transfers the level of risk
assumedby the recipient LSVT RSL in relation to such areas as long term demand, social
unrest andconstruction and repair contract pricing, is commensurate with its ability to
absorb such risk.

4.24 The impact of Basel II is difficult to assess at this stage, but it could have a
significantimpact on the pricing for poorer urban stock transfers, which are seen as less
credit worthyand would achieve poor internal credit ratings. The possible implications of
Basel II arecovered in the later paragraphs of Chapter 3.

Pricing for Continued Investment

4.25 Obviously funding of poorer urban stock transfers has to be judged in the long-term.
Urbanstock may require substantial further investment even after the implementation of the
largeinitial investment programme, (particularly if they include multi-storey flats that may
beapproaching the end of their useful life), and the ability of the RSLs business plan
toaccommodate that expenditure will be highly important.

LARGE METROPOLITAN TRANSFERS

Background

4.26 The funding process for these transfers to date has not generally been qualitatively
differentfrom that of the shire transfers despite their radically different size and complexity.
(The maintransfers completed to date within this category are Tameside (£213m), Coventry
(£240m),Calderdale (£111.5m), and Sunderland (£415m)).

4.27 The selection of a lead arranger pre-ballot for the potential transfer of Birminghams
CityCouncils housing stock to Birmingham Housing Alliance, was a departure, however
thenegative ballot result has meant that the VFM from this approach will not be tested.
Analternative approach was taken by Glasgow City Council and following the successful
tenantballot it is currently working towards a whole stock transfer to Glasgow Housing
Association.It is expected that a lead arranger will be selected in May/June 2002. The VFM
of adoptingthis approach will be interesting to observe.

4.28 The size of the funding requirements of these transactions (as indicated above) has
made themattractive to potential funders. Arrangement fees are constant at around
1.25%-1.35% withinterest margins beginning at say 40 basis points and climbing to around
60-65 basis points.Because of the size of the borrowers total funding requirement,
commitment fees may bepayable, broadly at half the level of the interest margin. This
pricing leads Ernst & Youngto the conclusion below given:


  the size of the funding required;
  the risks inherent in the transactions;
  the fact that these are long-term loans; and
  the borrower has no reserves.


These loans represent good VFM for the vendor local authority and recipient RSL.

4.29 These transfers are likely in the future to experience a number of challenges
associated withlarge metropolitan communities and the long-term VFM of their funding
facilities will needto be kept under review.

4.30 Whilst it may be appropriate to treat smaller shire transfers as a commodity
financingoperation, the scale of these transfers and those proposed for Glasgow and
Sheffield, shouldprovide an opportunity for:


  further innovation in funding structures;
  an exploration of a wider range of funding projects; and
  funding sourced from a wider variety of funders and markets.


4.31 Both poorer urban and large metropolitan housing stocks generally require the
involvementof other agencies to facilitate a joined-up approach to neighbourhood renewal.
Investmentin education, health, law and order and other community facilities are generally
required toensure long-term sustainable regeneration. The whole area of holistic
regeneration is consideredin Part 2 of this report.
WHAT FUNDERS LOOK FOR IN LARGE METROPOLITAN LSVTs

4.32 Whilst funders are relatively pragmatic in their credit assessment of shire transfers,
they are veryrigorous in their assessment of large metropolitan LSVTs. In particular, they
consider whether:


  all sources of income are deliverable and any grant income or public subsidy
   iscontractually committed;
  the purchase price being paid by the recipient RSL is a fair reflection of the conditionof
   the properties being acquired and their future repairing requirements as well as
   thesocial and economic well-being of the area;
  the LSVTs business plan will deliver a demonstrably better service to tenants
   andsecure regeneration of the area;
  the LSVTs business plan is viable both in the short and long term;
  the plan includes robust and prudent assumptions for all key variables, substantiated
   byindependent research wherever possible, involving a margin of comfort to meet
   unexpectedcost increases and income reductions;
  the business plan is fully understood by the Board of the recipient landlord and
   isdeliverable by the property, staffing and financial resources available to the them;
  the level of risk assumed by the LSVT RSL is commensurate with its ability to
   absorbsuch risk;
  the proposed transfer has widespread political and stakeholder support;
  the LSVT RSLs business plan cashflows generate a reasonable level of reserves as
   soonas possible; and
  the LSVT RSL has undertaken a full risk assessment and has a risk management
   strategy.


4.33 Given that stock transfers emanating from poorer urban and large metropolitan
authoritiesare expected to constitute a larger proportion of ODPMs stock transfer
programme, thefundability of these transfers will be considered in more detail later in this
report.

4.34 Our estimates of the elements of financing costs of shire, poorer quality urban and
largemetropolitan transfers are set out in Section 9. These are indicative only actual terms
forany transaction may differ.
Chapter 5 - Barriers to achieving improved value for money and
a sustainable programme
Summary

  Recipient RSL boards and senior executives are occasionally not sufficientlyestablished
   to act as a well-informed and experienced client during the fundingraising process.
   There is a danger that advisers drive such transactions.
  The track record of all transfers securing funding, the process and comparativelyshort
   timetable has produced a commodity approach to funding, which may notproduce
   optimal structures in all cases.
  All transfers are funded on an individual basis thus losing any potential cost benefitsof
   aggregated funding.
  The purchase price/discount rate formulae is mechanical and does not necessarilytake
   into account all factors and risks.
  Under the current clean break system, local authorities can neither benefit
   frompost-transfer out-performance by the recipient landlord nor support weaker RSLsin
   mitigating early-year risks.


5.1 The responses to the questionnaire, meetings and telephone conversations as
summarisedin Appendix IV, clustered into several key themes which begin to address the
VFM questionsoutlined in Chapter 4. We describe these themes in this section and then
look at a numberof possible options for addressing six key issues in Part 2 of the report.

THE LSVT RSL AS BORROWER

5.2 There was broad agreement that the current system is unsatisfactory in that:


  The RSL has very limited time after the tenants ballot to achieve registration,
   appointkey personnel, train board members and prepare for the complex handover of
   propertymanagement.
  External advisors are often effectively taking key decisions in the absence of
   anintelligent client.
  Given the standard nature of LSVTs, and the comparatively low fee levels of
   fundingadvisers, the incentive for borrowers to innovate new structures and source new
   funders,is severely restricted.
  The standard of information distributed by funding advisers is very variable and insome
   instances inadequate for potential lenders to undertake a full credit assessment ofthe
   proposal. The implications of this are likely to become more significant when BaselII is
   implemented and lenders have to undertake a rigorous credit assessment of
   thepotential borrowing opportunity.
  Business plans are typically drawn up by advisors, who have no on-going
   responsibilityfor their delivery.
  The Finance Director is generally appointed only shortly before transfer and
   occasionallyeven afterwards. (Indeed, in the proposed Birmingham City Council transfer
   to BirminghamHousing Alliance the lead arranger was being selected, prior to the
   unsuccessful ballot,with no Chief Executive or Director of Finance having been
   appointed.)
  Boards may be appointed with very little capital financing and treasury management
   experience.
  The focus of attention is understandably on the delivery of the transfer and
   repair/improvementprogramme with the arrangement of a funding facility providing a
   vital but relativelyunwelcome distraction.


5.3 For shire transfers, which can be fairly homogenous in credit terms, these barriers have
hadrelatively limited impact on pricing levels, although they present a perception of a
start-uprisk, which is arguably unnecessary.

5.4 However, for poorer urban and large metropolitan transfers they may be serious
barriers towell thought out, sustainable business planning as a platform for appropriately
structuredfinance achieved on a fully competitive basis. Such deficiencies could lead to a
greaterrequirement for post-transfer reappraisal of both the business plan and the funding
structurewhich in turn necessitates a more flexible, and therefore possibly costlier, initial
fundingstructure than should be necessary.

5.5 Given that recipient landlords for poorer urban and large metropolitan stock transfers
facemuch greater risks in implementing their business plan it is crucially important that
theserisks are fully investigated and quantified before transfer. Such rigorous assessment
wouldenable the recipient landlord to be as comfortable as possible that the purchase price
it waspaying, or the dowry it was receiving, and its business plan on the day of transfer was
a fairreflection of the risks it was about to assume.

5.6 It may be that in order to undertake the transfer of poorer urban or large metropolitan
stock,the recipient landlord is tempted to absorb more risk than is reasonable given its level
ofreserves, or to pay a price that is not a fair reflection of the stock being acquired and all
theother issues detailed in paragraph 4.32 above.

5.7 Our view is that this is highly inappropriate and could cause the recipient
landlordproblems in implementing its business plan post transfer. Indeed, if the recipient
landlordpays a purchase price which equates to the breakage costs on the local authoritys
HousingRevenue Account loans there is evidence that this is very unlikely to be closely
related tothe fair value for the stock particularly in poorer urban and large metropolitan
areas. Anygap between purchase price and fair value is likely to be revealed when the
selected leadarranger undertakes its detailed due diligence of the transaction.

5.8 Taken to the extreme, if this practise is implemented to any degree, the recipient
landlordmay be forced to effectively change its status from a manager of social housing to
a residentialproperty manager with a significant development exposure as it tries to realise
land valuesand live with an investment programme which is substantially lower than the
stock investmentrequirements as identified in the stock condition survey. This would have
significantimplications for tenants, funders and the Housing Corporation

5.9 Part 2 of this report will look at the key risks absorbed by recipient landlords in
poorerurban and larger metropolitan stock transfers, and strategies to mitigate these risks.

COMMODITY OR BESPOKE FUNDING

Commodity Status

5.10 The transfer programme particularly for shire transfers has developed many of the
characteristicsof commodity funding. Indeed, this characteristic coupled with a small
number of assethungry lenders, produces very low priced loans. This serves as a
disincentive to potentialmarket entrants, particularly as the funding of LSVTs is a mature
market.

5.11 In contrast the interest margins payable by PFI transactions are currently
substantiallyhigher, but the arrangement fees are slightly lower than LSVT loans. It could
be arguedthat with relatively certain income flow on long-term contracts, senior debt
facilities to PFIprivate sector contractors should be lower risk than loans to LSVT RSLs.

5.12 The commodity status of loans to LSVT RSLs is characterised by:


  Standardised business plans; this is perhaps understandable given that the
   recipientlandlords initial business plan is often little more than the Tenanted Market
   Value (TMV)model repriced for inflation with a few other adjustments. This produces a
   very standarddebt profile, which lends itself to a tried and tested funding structure.
  A developing track record of performance of past transfers building up a
   substantialinformation base within funders that probably exceeds the knowledge of
   most advisersand vastly exceeds the understanding of new LSVT boards and some
   newly appointedDirectors of Finance.
  Standardised loan tender documentation.
  Short timescales for funding responses and from amending the funding mandate
   toclose. This arises because of the presumption that all but the most risky transfers
   willsecure funding and the involvement of funding advisers at a relatively late stage.
  Small number of advisors and funders working on very small profit margins; hence
   theLSVT market has become unattractive and virtually closed to new entrants. If the
   poolof funders could be expanded, it may introduce greater innovation and different
   fundingstructures. Whilst such innovation is unlikely to improve the VFM of funding for
   shiretransfers (because loan terms and conditions are already extremely fine), it may
   havea significant impact on the VFM of funding for poorer urban and larger
   metropolitanstock transfers. The potential for innovation and the forms it may take, are
   consideredin more detail in Part 2 of the report.
  Relatively unsophisticated treasury management strategies concentrating on
   certaintyduring the rent guarantee and catch-up repair periods, and predicated on the
   potentialof a fairly rapid refinancing with its potential for additional fee income. However
   theappetite to undertake a refinancing has only existed whilst interest margins have
   beenreducing and loan covenant requirements have been loosening. Any reversal of
   thistrend would probably see the number of refinancings decline.

Bond Structures

5.13 Bond structures have been used in four stock transfers, raising a total of around
£422.7m,developed by the bond underwriting houses, but the primary funding model has
beenrelatively straightforward bank and/or building society lending.

5.14 This commodity financing treatment has delivered the ODPM stock transfer
programme,but may not deliver optimal funding in the future particularly for the larger
metropolitantransfers where a variety of risk profiles may require a range of layered funding
structuresand sources.

5.15 Capital market segments, which have not been tapped to date, include: non-UK public
bondmarkets; private bond placement markets in both the UK and US; and equity markets.
Inaddition the sub-ordinated debt market has not been accessed and this may have a role
inhigher risk urban and large metropolitan stock transfers.

The Possibility of Aggregating Funding Requirements

5.16 Bond markets specialists in particular raised the question as to the relative efficiency
of fundingeach transfer on an individual basis or embarking on some form of centralised
procurementprogramme at least for the core acquisition funding of a number of stock
transfers.

5.17 Public bond markets prefer issues to have an active secondary market and, in effect,
thismeans trying to achieve bond sizes of £150m-£200m at the outset with, preferably,
thepossibility of later growth.

5.18 The size of each transfers funding requirement is often a barrier to efficient bond
financingbut the overall annual programme of around £2 billion if funded at least partially by
bonds,could create a series of liquid benchmark issues.

5.19 The possibility of creating a specific intermediary to facilitate the aggregation of
fundingrequirements of different stock transfers and subsequently issuing securities in the
capitalmarkets is considered in Chapter 10 of this report.

THE ROLE OF THE LOCAL AUTHORITY IN THE STOCKTRANSFER
PROCESS AND THE PURCHASE PRICE

5.20 Borrowers and lenders both acknowledged that the system of establishing the transfer
priceof the stock does not always result in the best deal either for the local authority or
therecipient RSL.

Purchase Price
5.21 The methodology used to determine the purchase price, including rents based on
theGovernments social rent reform programme and in most cases a large initial catch-up
repairsprogramme, results in an escalating debt profile which, it is argued, is often not
readily appropriatefor anything other than a fully funded loan facility. The purchase price is
determined usingODPMs TMV model. This discounts the projected real cashflows arising
from the stockbeing purchased for the next 30 years using a discount rate of between 6%
and 8%.

5.22 The purchase price paid for the local authoritys housing stock needs to reflect the
physical,demographic and financial attributes of the stock and the environment of the
surroundingarea. It should not be determined (particularly for poorer urban or large
metropolitan housingstock), by factors which do not relate to the stock, for example the
breakage costs arisingon the vendor local authority housing loans.

5.23 The risk assumed by the LSVT RSL in acquiring the stock needs to be commensurate
withits ability to absorb such risk. Any attempt by the vendor local authority to secure a
saleprice which does not recognize these criteria, is likely to result in the LSVT RSL
receivingvery few offers of funding and the possibility that the recipient landlord
experiences difficultiesin implementing its business plan post transfer. Indeed in some
stock transfers in urban areas,the purchase price produced will be negative, as
experienced in ODPMs ERCF programme.

5.24 The TMV methodology should reflect the potential for negative values, particularly
forpoorer stock transfers. Other short-term solutions to supporting what should be
negativelyvalued stock, for example structures to mitigate the VAT impact of major repair
andimprovement programmes, fail to address the fundamental weaknesses of the stock
beingtransferred. Indeed, transfers of negatively valued stock can represent good value to
thepublic sector when the full extent of risk transfer is considered.

5.25 Funders generally have developed their lending policies for LSVT RSLs from their
mortgageand commercial lending criteria. In these types of loans, a loan to value covenant
is important.Generally the loan has to be covered by the property portfolio acting as
security to 110-115%.If the purchase price is too high and the valuation for loan security
cannot provide therequired level of cover, raising funding can be very difficult.

5.26 In addition, if the purchase price is too high, the degree of risk being absorbed by
theLSVT RSL may be excessive and it can take a significant number of years of business
planout-performance before any reserves are created.

5.27 The discount rate used in the TMV calculation of 6% real to 8% real includes an
implicitrisk buffer, which can be seen as a reflection of the risks to the LSVT RSL of
acquiring thestock. The size of this buffer is implicitly included in the discount rate and can
be ascertainedby comparing the LSVT RSLs Weighted Average Cost of Capital (WACC) to
ODPMs discountrate of 6% to 8%. This calculation is carried out in Appendix XII. It shows
the buffer to bebetween 3% and 5% in real terms based on conventional loan funding. In
Ernst & Youngs view,it may be questionable as to whether the buffer is sufficiently large to
absorb political risk.
5.28 Part 2 of this report looks at the risks in poorer urban and large metropolitan stock
transfers,the potential for involving established RSLs in the transfer process, and more
competitionin the selection of the recipient landlord and its funders. If more open
competition wasintroduced, the public sector would have greater confidence that it was
achieving optimumVFM for the stock being transferred at the point of transfer.

Post Transfer Involvement for the Vendor Local Authority

5.29 In transfers with a stronger credit, the local authority has very little protection against
andgains no benefit from:


  Over-egged repair/improvement programmes.
  Over-cautious assumptions about interest rates.
  Refinancing deals by the recipient landlord within the first few years post transfer.


5.30 Once the transfer price is determined, and the transfer completed, the local authority
mayhave no continuing stake in the performance of the RSL. To an extent this clean
breakapproach may be attractive to ODPM, however both ODPM and HC have
considerableinfluence over the recipient RSLs business plan and viability. This potential
political risk,without what some see as commensurate political responsibility, is very
unpopular with funders.

5.31 Conversely, in poorer quality transfers, the local authority is currently limited in its
abilityto assist by mitigating the early year risk to the lenders funding the new RSL. This
results inthe recipient landlord having to adopt very prudent assumptions in its business
plan whichmay result in a lower purchase price being received by the vendor local
authority.

PROCEDURAL BARRIERS TO SECURING VALUE FOR MONEYIN
FUNDING FOR STOCK TRANSFERS

5.32 A number of specific points were identified by respondents as creating
unnecessarycomplications or barriers to funding efficiency. These can arise from ODPM or
HousingCorporation procedures and regulations, or from the LSVT RSL.

ODPM and Housing Corporation Requirements

5.33 Notwithstanding ODPMs requirement for local authorities to demonstrate that they
haveconsidered options for the recipient landlord, there is limited evidence to suggest that
thisis vigorously pursued by all local authorities. It is widely expected that an existing RSL
withan experienced management team and board, with expertise in raising private finance
loanfacilities, would obtain loans on different terms and conditions than start up landlords.

5.34 The Governments rent restructuring programme has heightened the awareness of
thereality of political risk. Where lenders have significant exposure to existing LSVT
RSLswhose business plans and covenants have been placed under pressure, they are
very vocalin their objection to post-facto alteration in the high level alteration of key
assumptions intheir borrowers business plan.

5.35 The provision of warranties by the local authorities to both lenders and RSLs is often
amatter of contention and re-negotiation for each transfer.

LSVT RSL Procedural Issues

5.36 The quality of demand studies is very variable with no dissemination of best practice.

5.37 There appears to be comparatively little attempt to learn from other sectors with
regard tothe long-term fixed price procurement of building, repairs and improvement
programmes.

THE FUNDRAISING PROCESS

5.38 Competition has not always been in evidence at all stages of the funding process; this
isunpopular with the funders not involved in such exclusive arrangements. More
importantly,it is highly unlikely to deliver good VFM to the recipient landlord.
Part 2

Chapter 6 - Poorer urban and large metropolitan stock
transfers the risks faced by recipient landlords
Summary

  The purchase price/dowry for the stock being acquired must reflect the level of
   riskabsorbed by the recipient landlord.
  The purchase price should not be influenced by the local authoritys need to
   coverinterest breakage costs on its existing Housing Revenue Account loans.
  The public sector will need to support RSLs through dowries, transfer of additionalland,
   subordinated loans or other mechanisms, if risks cannot otherwise be absorbedby the
   recipient landlord and the transfer is to go ahead.
  Other key risks faced by recipient landlords are:

those associated with leaseholders;
procurement and implementation of the investment programme; and
management structures.

  Transfer RSLs should develop a comprehensive risk assessment matrix to identify
   therisks that they are most exposed to and then develop strategies to manage these
   risks.


6.1 The ability to raise private finance for a housing stock transfers in a poorer urban or
largemetropolitan area is substantially determined by potential funders perception of the
degreeof risk being assumed by the recipient landlord (their potential borrower).

6.2 In Part 1 of this report we highlighted how as these types of transfers are likely assume
greaterprominence in ODPMs stock transfer programme. But the implementation of Basel
II maycause funding for such transfers to become relatively more expensive or the ultimate
riskthat these transfers become unattractive to the small population of funders. This
chapterlooks at the risk profile of poorer urban and large metropolitan transfers in more
detail.

6.3 For poorer urban and large metropolitan transfers, it is highly important that the
purchaseprice paid by the recipient landlord to the vender local authority for the stock
should reflect:


  the condition of the stock to be acquired;
  the social and economic circumstances of the area and its inhabitants;
  a level of risk commensurate with the potential landlords ability to assume such risk;
   and
  a viable business plan which should secure long term sustainable regeneration of the
   area.


6.4 If the purchase price (or dowry) does not reflect these issues, it is likely that potential
funders(who have considerable experience of analysing risk and the implementation of
businessplans by their existing LSVT RSL borrowers) may conclude that the potential
borrower isassuming too much risk and therefore decline the funding opportunity. In such
circumstances,the recipient landlord may be unable to raise the required private finance,
thereby substantiallyeroding one of the key strengths of ODPMs transfer programme since
its inception in 1988.

6.5 Funders have considerable experience of both funding stock transfers and monitoring
theirborrowers financial and operational performance post transfer and are therefore able
to takea view on the price that should be paid or dowry received for the stock. If the
purchase pricefor stock is determined by the local authoritys Housing Revenue Account
loan interestbreakage costs, rather than the factors and issues detailed in paragraph 6.3
above, thetransaction may be unfundable on that basis.

6.6 The local authoritys housing loan interest breakage cost is a reflection of how much
hasbeen spent on capital investment in the past, which has no relevance as to the
investmentneeds of the stock into the future. Indeed if a stock condition survey has
demonstrated theneed for a substantial initial and on-going investment programme,
questions may be raisedin both the minds of the recipient landlord and its potential funders
as to the sustainabilityof that past expenditure and the implications of this for future
investment.

6.7 The level of interest breakage costs are substantially determined by the prevailing level
of grossredemption yields on Government gilts and the local authoritys average loans pool
rate appliedto Housing Revenue Account loans at the time of transfer. The recipient
landlord and its fundershave no influence over these economic variables and therefore
they should not drive thedetermination of the purchase price. Neither of these factors have
any relevance to the risks beingassumed by the recipient landlord and the purchase
price/dowry that should reflect those risks.

6.8 If the major risks detailed in the following sections are not fully addressed in the
recipientlandlords business plan and/or purchase price paid to the vendor local authority,
then thetransaction may not be fundable on a stand-alone basis. If that was the case, the
publicsector may find it necessary to provide some or all of the following to the recipient
landlord:


  a dowry;
  valuable land at nil cost with limited clawback arrangements;
  a non-interest bearing (repayable or non repayable) grant or loan; and
  grants or other financial support.
6.9 The next section of this chapter looks at the whole area of risk in poorer urban and
largemetropolitan stock transfers. We initially outline a generic risk matrix, with columns
tostate a judgment of the probability of the risk occurring and the potential financial
impacton the recipient landlord if the risk occurs.

RISKS TO RSLS ACQUIRING POORER URBAN ANDLARGE
METROPOLITAN STOCK

6.10 Each RSL considering the acquisition of housing in poorer urban or large metropolitan
areaneeds to undertake a detailed risk assessment exercise. This process involves
identifying therisks that the RSL would assume in acquiring the stock and subsequently
undertaking anassessment to identify the most significant risks.

6.11 A useful starting point is to use a generic risk matrix and through a rigorous process,
to supplementthis with additional risks specific to the property portfolio being acquired. A
generic risk matrix isa framework to ensure that all risks are identified and quantified. An
illustrative example is shownin Appendix VII. This is not designed to be all inclusive, but a
template of a generic matrix.

6.12 Following the process of risk identification and quantification, involving a wide range
ofprofessional disciplines, it is possible to identify the most significant risks and to
developstrategies to mitigate such risk.

6.13 In the case of newly formed RSLs their ability to absorb the possible consequences of
therisk occurring may be severely limited. They may have no option but to secure a
reductionin the purchase price, seek insurance to cover the risk or to seek a
warranty/indemnity fromthe vendor local authority. In contrast, an established existing RSL
with reserves may beable to take a view and effectively absorb some or all of the risk(s)
from their reserves.

6.14 This section goes on to investigate in detail four key risk areas identified by the
projectsSteering Group. Some of the risks identified appear similar or result from the
occurrence ofanother risk. Obviously other significant risks exist in poorer urban and large
metropolitanstock transfers, for example demand risk, however the Steering Group thought
that thesewere being adequately considered in other assignments or projects.

Leaseholder Risk

6.15 Appendix VIII includes a detailed description of the risk to LSVT RSLs of leaseholders
inimplementing the investment programme in poorer urban and large metropolitan stock
transfers.The purpose of Appendix VIII is to outline the risks to transfer organisations in
assumingthe obligation for repairing and improving properties, which contain both
leaseholders,(otherwise known as owner occupiers) and tenants.

6.16 The implications for recipient RSLs of decanting both tenants and leaseholders,
particularlyin blocks of properties earmarked for demolition, are considered. It also
examines potentialmitigation strategies that stock transfer RSLs may be able to pursue in
order to reduce therisks associated with properties involving leaseholders. The cost of
repairing common (shared)elements of the property will in the case of stock transfer, lie
with both the recipient RSLand the leaseholders within the block.

6.17 Recipient landlords will face a number of issues in relation to the leasehold
arrangements:


  the leaseholder may only be responsible for certain types of work and may not be
   responsiblefor payments relating to improvements to the property, or may only be
   responsible incertain defined, circumstances;
  the landlord may be required to provide an estimate of future service charges to
   tenantsconsidering becoming leaseholders under the Right to Buy (RTB). Leaseholders
   cannotbe charged more than this amount during the first five years after purchase; and
  leaseholders will generally have the right to consultation, before contracts with
   contractorsare placed and work commenced.


6.18 These issues will mean that recipient landlords will have to assess how:


  they will fund the full cost of improvement works;
  how they will deal with repairs to properties where some leaseholders have
   boughtwithin the past five years; and
  how they will manage the programme to ensure their obligations to tenants during
   theconsultation phase are met.


6.19 In addition, leaseholders may not be able (or wish) to afford to pay their service
charge forthis work. This needs to be fully assessed by the recipient landlord before
transfer and strategiesidentified to ensure that the implementation of the investment
programme is not delayedand the cost of implementation is not increased.

6.20 Transfer landlords will therefore have to consider in detail the risks associated with
propertiescontaining leaseholders and mitigate against them through a thorough
assessment of costs,legal requirements, available grant and through robust assumptions in
the business plan.Additionally, they may seek to share the risk with the vendor local
authority and potentiallycentral government, through the effects on the purchase price and
through assistance toleaseholders (probably based on need) with grant and other financial
support.

Investment Procurement Risk

6.21 Appendix IX considers the procurement and implementation risks for the initial
investmentprogramme in poorer urban and large metropolitan stock transfers.

6.22 In these types of transfer, the implementation of the large initial investment
programme is of criticalimportance. Not only is it very often the primary reason for the
transfer, but is central to deliveringsustainable regeneration of the recipient RSLs housing
stock. In addition, the RSLs funderswill be keenly interested to see the efficient and
effective implementation of its borrowersinvestment programme, thereby achieving its loan
to asset value financial covenant requirements.

6.23 The purpose of this section is to discuss the risks associated with the procurement of
investmentworks related to the LSVT of large urban and metropolitan authorities housing
stock.

6.24 In this context, procurement describes the methods, systems and processes used by
an LSVTlandlord to secure the services required to deliver the investment programme
contained inits business plan. The investment programme is likely to be the largest area of
cost incurredby the landlord and so funders will be concerned to ensure that:


  the costs are accurate, ie, that they address the sustainable investment requirements
   ofthe stock and are not significantly under or over-stated; and
  the landlord can control the programme, ie, that the risk of cost overruns, slippage
   anddelays is minimised.


6.25 There are three broad categories of risk which are worth exploring:


  specification risk: the risk that the wrong work is procured or that the correct work isnot
   procured;
  sustainability risk: the risk that the work procured does not maintain or increase
   thevalue of the stock; and
  delivery risk: the risk that the landlord cannot implement the investment programmeas
   planned.


6.26 The following table sets out some specific risks under the three broad risk headings,
identifies key issues in the context of urban and metropolitan transfers and suggests
mitigation approaches. Further discussion is in Appendix IX.

Risk category


Specific risk


Urban/metropolitan


Mitigation
LSVT issue




Specification


Landlord fails to:


Stock condition


Stock condition survey




  identify all of the works required




Management skills & expertise
Regularly update plans




Set a standard




  programme the works appropriately
  draw up accurate specifications




Sustainability


Investment does not add


Demand


Test sustainability




sufficient value to the assets




pre transfer




Stock condition
Value added is short lived




Develop a management




Low Value




strategy




Tenant profile
Ascertain what has




Social exclusion


worked and failed in the




vendor LAs experience




Management skills & expertise
Delivery


Tender price inflation


Stock condition


Local market analysis




Cost overruns during


Low Value


Use appropriate




the contract




procurement method
Management skills & expertise




Delays in letting/starting




Put in place appropriate




the contract




control systems
Delays in delivering




the contract




Management Structures Risk

6.27 Appendix X considers the risks arising from management structures in poorer urban
andlarge metropolitan stock transfers.

6.28 One of the key risks associated with stock transfer is that the management structure,
skillsand experience of the LSVT landlord might not be adequate to deliver the transfer and
thebusiness plan efficiently and effectively.

6.29 Our analysis in Appendix X looks at the risks arising from LSVT landlord structures
including:


  group structure versus a standalone organisation; and
  a subsidiary of an existing RSL.


6.30 Although registration with the Housing Corporation provides a substantial degree
ofassurance about management standards, it does not provide complete assurance that
anymanagement weaknesses, which existed before transfer will not endure after transfer.

6.31 In addition to the choice of structure, recipient landlords need to assess a number of
otherimportant management issues such as the appointment of senior staff and the risks
andrewards of expanding the scope of their activities as a means of mitigating some of the
risksof transfer.

Investment Coordinated With Regeneration: Delivery ofImproved Housing and
Regeneration

6.32 As outlined previously in this report, all parties associated with stock transfer
proposalswould benefit from the holistic and sustainable regeneration of the area where
the transfertakes place. One potential barrier to attracting suitable investors into stock
transfer projectshas been the concern that once initial investment has been made, without
other action toimprove economic prosperity, and increase opportunities in education,
health, transport andemployment, the area may continue to decline, with increasing
anti-social behaviour, voidlevels and other symptoms of social exclusion. Investors wishing
to see asset value enhancedare particularly concerned with ensuring that an area is
regenerated in a holistic way andthat improvements are maintained in the long term.

6.33 The success of public agencies in securing a joined-up approach to sustainable
regenerationis important in delivering stock transfers. This area has been subject to
significant governmentreview with new policies introduced over recent years, which should,
over time, be reflectedin measurable tangible results.

6.34 The link between low demand for housing and stock quality/condition is mainly evident
ineconomically disadvantaged areas, where employment opportunities are limited. This
meansthat in areas of high employment, demand exists for all forms of housing good and
poor.The simplistic observation therefore is that in order to ensure investor confidence in a
LSVTin a poorer urban area, a wider employment generating strategy needs to be
developed.

6.35 Structures are now emerging to ensure that holistic regeneration and economic
growthtakes place. National policy is now being reflected in Regional Development
Agenciesobjectives and in turn more localised strategies are being determined for specific
areas andcommunities. However this framework is not complete and in certain poorer
urban areas,where stock transfers may be proposed, no true economic regeneration plan
may yet exist.Over time it is highly possible, however, that this will alter and as such any
proposal forstock transfer could, in theory, be in support of a specific community-wide plan
to improvethe local economy.

6.36 Further consideration should be given to the area of regeneration and its relationship
withstock transfer. It is important that housing investment is not undertaken in isolation and
inlater years shown to have been an inappropriate decision.

6.37 Bricks and mortar investment alone may not be sustainable and required economic
measuresshould be identified, which will best ensure that any recipient landlord investment
will besustainable and will not have to be repeated in the near term (at present ERCF
transfershave not been tested in the long-term).

6.38 A related key concern of lenders in the protection of asset value and sustainable
investment,is that active housing management is required. Anti-social behaviour has to be
managedand eradicated in order protect the condition of the housing stock and prevent the
areafalling back into decline.
Chapter 7 - Full versus partial funding of stock transfers
Summary

  Current policy supports up-front full funding of business plans.
  This reflects the perception of LSVT RSLs as start-up businesses with
   programmessubject to inaccurate costing and external change.
  For poorer urban and large metropolitan transfers, full funding is a necessary
   precautionin the light of the substantially greater risks to the fulfilment of the
   renovationprogramme which partial funding would present.
  For some strong shire transfers, arguments could be made for partial funding
   whichwould allow greater flexibility, should reduce costs and might bring additional
   fundersinto the market.
  Partial funding may increase tenants perception of risk associated with transferand
   could therefore affect ballot results
  Existing RSLs are more likely to be able to absorb the risks of partial funding andbe
   treated as established businesses for funding purposes.


CURRENT POLICY

7.1 To date it has been standard practice, supported by the HC and ODPM, to ensure
thateach LSVT RSL enters into loan facilities which on the day of transfer:


  cover the projected peak debt including any proposed new development activity as
   wellas the initial catch-up repairs and improvement programme;
  are capable of full capital repayment from the projected net rental income arising
   fromthe RSLs property portfolio within the term of the loan facility;
  have an amortising structure which in theory achieves full repayment leaving the
   LSVTRSL debt-free at the end of the loan term; and
  have a reasonable margin of flexibility to meet unforeseen and detrimental
   movementsin key cashflows.

WHAT ARE FUNDERS FUNDING?

7.2 A key consideration in the full versus partial funding debate is what are funders being
askedto fund on the day of transfer. A number of issues need to be considered in
determining theanswer to this question. A particularly important issue is the type of transfer
that is being funded.

7.3 The risk characteristics of strong shire stock transfers are, notwithstanding the
harmonisingeffects of the purchase price by ODPM TMV model, fundamentally different
from the risksinherent in poorer urban and large metropolitan stock transfers. The specific
risk issuesrelating to the full or partial funding of shire, poorer urban and large metropolitan
stocktransfers are discussed later in this chapter.

A Start-up or Established Business?

7.4 A key issue is whether potential funders consider the LSVT RSL as a start-up or
established business.

7.5 LSVT RSLs are generally treated by most leading stock transfer funders as being akin
tostand-alone project financings. On the day of transfer, they may be perceived to have
afinite life similar, for instance, to PFI projects, which have initial investment costs
financedby injections of equity, sub-ordinated debt and senior debt, which are repaid from
incomearising during the life of the loan facility. An LSVT RSLs business plan and funding
structureare based on the capacity of the net rental income stream arising from its portfolio
to fullyrepay loans within a 25 to 30 year term.

7.6 The LSVT RSL is generally treated as a start-up rather than an established business.
Thisis, of course, technically correct, although in many instances the management team,
and inall cases the financial cashflows arising from the properties being acquired, have a
track-recordwhilst in the ownership of the vendor local authority.

7.7 A LSVT RSLs loan facilities on the day of transfer are set at levels which allow for
drawdownover an extended period before peak debt is reached. This occurs typically
between 12 and15 years and the loan facilities are set to cover the LSVTs maximum
projected borrowingrequirement over that extended period.

7.8 It is, however, anticipated by both funders and their funding advisers, that facilities may
berestructured several times during the life of the loan, with a major restructuring once
peakdebt has been passed. This is generally because:


  the RSL undertakes new activities not envisaged at the time of transfer;
  it has to implement changes in government policy affecting key elements of its
   business;
  it out performs its original business plan;
  it needs to restructure its business plan to reflect new information learned after transfer;
   and
  at, or shortly after, peak debt, the LSVT is generally seen to be performing as an
   establishedbusiness, generating surpluses and reserves and in most cases is able to
   negotiate a moveto traditional RSL corporate-style financial loan covenants based on
   an on-going mature and developing business and balance sheet. These traditional
   covenants are generallyfocused on gearing and annual interest coverage ratios rather
   than the more restrictivefinancial covenants faced by new LSVT RSLs.

IS FULL FUNDING INEFFICIENT?

7.9 It could be argued that the system of full funding stock transfers on the day of transfer
isinherently inefficient because:
  Treatment as a start-up business fails to take account of the continuity of business
   betweenthe vendor local authority and the LSVT RSL. The properties being transferred
   mayrequire major investment but they generally provide an immediate and relatively
   certainincome stream, with documented performance in terms of income and
   expenditure,arrears and voids. The day-to-day management is likely to be carried out
   by the samesenior management team under TUPE transfer arrangements from the
   local authority.In addition, the Board of the LSVT RSL consists partially of local
   authority representativesand residents who are familiar with the management issues of
   the stock.
  Most on-going businesses would expect to run with a level of on-going debt to meettheir
   investment requirements and this form of funding is generally cheaper than
   equityfinance. In addition, established businesses would expect to access the debt
   marketswhen rates are favourable and in a timely manner to meet their funding
   requirements.In this respect the older LSVT RSLs that have passed peak debt and
   moved to traditionalRSL financial loan covenants, maintain an on-going level of
   indebtedness that meetstheir continuing development and investment requirements.
  The requirements for full repayment during the term of the initial loans ignores
   thenature of the rental income stream which continues to flow beyond the term of
   theloan, particularly if the properties have been well maintained. There is no
   concessionperiod as in housing PFI projects, as the LSVT purchases the freehold
   interest in theproperty assets in perpetuity. Full repayment leaves a high surplus
   making potential atthe end of the loan term.
  The assumption that refinancing will take place possibly several times during the lifeof
   the initial facility can drive the treasury management policy towards short/mediumterm
   fixed rate loans. Greater emphasis on the long-term business plan and treatmentof the
   LSVT as an on-going business rather than a project financing would allow
   moreconsideration to be given within the treasury management policy for the
   appropriate useof both short term loans and long-term fixed rate products to balance
   out the risk profileand to take advantage of specific market conditions (for example, an
   inverted yield curve,when it is cheaper to borrow long-term fixed rate loans rather than
   short-term loans).


7.10 The requirement for full funding of anticipated expenditure is potentially more costly
thannecessary in that:


  Lenders may endeavour, subject to the effects of competition, to charge
   commitmentfees on loan facilities that are not drawn down. They may argue that the
   fact that theloans are not drawn down is the LSVTs choice, generally assisted by out
   performanceof their business plan. In stronger shire transfers, the ability to charge
   commitment feeshas been competed away. Even if specific non-utilisation fees are not
   charged the banksand building societies may endeavour to seek to recoup their
   associated costs in committingcapital, whether through arrangement fees or margins.
  A fully funded approach is likely to be more attractive to a relatively small pool oflenders
   than partially funded structures, which may attract new lenders more familiarwith
   corporate style funding structures. Clearly this may have implications for thecompetitive
   pricing of funding offers.
  Actual peak debt has typically been lower than projected, at the time of transfer this
   isachieved through out-performance of the business plan and any funder costs
   associatedwith providing a fully funded loan facility have therefore been wasted.
   However, to theextent that the lenders return requirements are substantially met by the
   ArrangementFee on the total size of the loan, these are included in the set-up costs of
   the LSVTRSL and are deducted from the purchase price and therefore met by the
   vendor localauthority. If these arrangement fees were paid by the recipient landlord, the
   extent towhich they would be borne by the public sector or reduce the return to the
   lender woulddepend on the degree of competition for the landlord role and whether the
   recipientlandlord is an established RSL or a newly formed organisation.
  If the recipient landlord is a large RSL in competition with others for the role, it may,
   aspart of the competitive selection process, agree to absorb the arrangement fees
   knowingthat with its financial strength, existing relationships with funders and
   experience ofraising private finance, it will be able to negotiate these to levels they are
   able to internallyfinance. This approach has been implemented in a number of past
   transfers involvingestablished RSLs.
  In contrast, a newly formed RSL with no reserves will have no option but to requirethat
   the arrangement fees are deducted from the purchase price.
  Costly re-financing exercises are virtually built in to the system to take account of
   thechanging circumstances of the LSVT RSL. The original lender may have a strong
   incentiveto try and tie in the borrower and reduce the borrowers opportunities to
   negotiate betterterms and alternative sources of funding for later requirements.
   However, a number ofLSVT RSLs have changed their lead funders on refinancing and
   new funders have beenbrought in to provide funding particularly when the LSVT RSL
   moves to traditionalRSL status, generally after peak debt.


7.11 There is a case for funders to consider some LSVT RSLs as on-going businesses that
wereeffectively established prior to the transfer and will continue beyond the term of the
transferloan facility. Debt will be required at various times for the original purchase of the
housingstock, for the catch-up repairs and improvements programme, to meet the payment
ofinterest before peak debt or the reconfiguration of estates including new build
programmes.These could, and arguably should, be raised at the time required, not many
years in advance.

7.12 This argument, however, takes no account of the risks inherent in leaving likely
fundingrequirements unfunded on the day of transfer. Many of these risks may also affect
fully fundedtransactions in terms of the ability to drawdown loans, but are mitigated by the
existence ofan ongoing banking relationship where it would be expected that the bank
would be familiarwith the history of the business plan and the management of the RSL and
would want (subjectto a rebalance in the risk:reward equation) to help the RSL through
short-term difficulties.

PARTIAL FUNDING RISKS

7.13 Clearly if a recipient RSL is facing risks in the portfolio of properties it has purchased
from a localauthority, the likelihood of these risks occurring is not affected by whether the
RSL is fully orpartially funded. However, the materialisation of some risks may give a
partially funded RSLsignificant problems in raising additional finance or securing a
refinancing when its existingloan facilities are due for repayment. The occurrence of
significant risks would make the RSLa much less attractive lending proposition for potential
new lenders and the RSL may be forced,with very little bargaining power, to renegotiate its
existing loan facility with its current lender.

7.14 This section proceeds to look at the potential environment of both the funding market
andthe RSL, when a partially funded LSVT may be seeking to raise additional finance.

7.15 If the LSVT RSL assumes a future funding risk by only partly funding its peak debt
requirementon the day of transfer, it may need to raise further funds at a time when:


  there is a general credit squeeze and bank and building society lending may be difficult
   to achieveeither at all or at margins that can be accommodated within the LSVT RSLs
   business plan;
  the existing funder may have undergone a change in lending policy through merger
   orreaching sector limits leading the LSVT RSL to rely on attracting funds from new
   lenders.Such new lending would result in new arrangement fees (which would not be
   paid bythe vendor local authority), perhaps legal costs in effecting the new lenders
   securityrequirements, if a security trustee has not been put in place at the time of the
   initialtransfer funding, and any interest rate breakage costs; and
  the impact of Basel II may be more apparent and require lenders to revise their
   riskweighting requirements, particularly for high risk poorer urban and large
   metropolitanstock transfers, which may result in higher margins and arrangement fees.

Management and Performance Risks

7.16 There are a number of risks associated with the management and performance of the
RSL:


  Catch-up repairs programme may have been delayed and/or the costs
   underestimatedleading to a higher than anticipated funding requirement and lower
   lender confidencein the managements ability to efficiently and effectively implement its
   business plan.
  Underperformance on rent collection and voids turn-around may have adversely
   affectedcash-flow and, again, lender confidence.
  The performance of the board and senior management team may not have
   metexpectations leading to the risk of non-availability of finance or finance at higher
   costsand with tougher covenants and ratios. There have been a relatively small number
   ofLSVT RSLs where the Housing Corporation has found it necessary to make
   appointmentsto the RSLs board. If these LSVT RSLs had been seeking additional
   funding at any timeafter the identification of deficiencies in the organisational or
   financial position, theywould have found this a challenging exercise. Indeed there is
   evidence that the RSLs thathave had HC nominations to their boards, have found it
   difficult to effect refinancings.

External Risks

7.17 The following risks may be particularly important for poorer urban and large
metropolitanstock transfers:


  The local economy may have suffered a severe blow through the closing down of a
   majorindustry leading to a migration of tenants to other areas so reducing demand from
   tenantsin paid employment and leading to: increased reliance on housing benefit;
   higher managementcosts; and a tougher environment for loan negotiation.
  The local authority or other regeneration agencies may have failed to meet
   theircommitments to invest in ancillary regeneration projects in the area leading to
   reduceddemand, increased fear of crime, low educational achievement, inadequate
   infrastructurefacilities and consequential lower demand for social housing. Alternatively
   the investmentmay have failed to produce sustainable regeneration and neighbourhood
   renewal, withthe result that further investment is required.

Political Risks

7.18 Lender confidence may have been undermined by changes in government policy
pastexamples would include the withdrawal of Section 54 grants to cover Corporation
Taxliabilities; rent restructuring proposals; and the imposition of RPI linked rent controls.
Thefinancial consequences arising from changes in Government policy may result in the
LSVTRSL having to:


  revise their business plan;
  seek additional loan facilities, generally from their existing funder as they will oftenhave
   a first fixed charge over all of the LSVT RSLs property portfolio;
  seek the extension of both the profile of loan repayments and the final repayment
   dateof the loan.

STAKEHOLDER PERSPECTIVES ON PARTIAL OR FULL FUNDING

The Housing Corporation

7.19 In registering any new LSVT RSL, the Housing Corporation requires that there is a
fullappreciation by the organisations Board of the nature of the business, the financing
structuresbeing entered into and the risks being assumed. The Housing Corporation takes
the viewthat unless a Board can demonstrate that it has taken into account future financing
orrefinancing risk and has strategies in place to deal with those risks, it will not
normallyapprove registration where full funding is not ensured. A very small number of
exceptionshave been made to this policy.

7.20 The Housing Corporation would expect the LSVT Board to be prepared to
acknowledgepublicly any consequential risks to the programme as promised to the tenants
at ballot.

7.21 However, there may be instances, particularly where a large established RSL is part
of agroup structure involving an LSVT RSL, where a partly funded loan facility would
notrepresent an unreasonable risk. This may also apply to some strong shire transfers
and,perhaps more unlikely, some urban transfers.

The LSVT RSL Board

7.22 The Board will need to be sure that it has a business plan and funding facilities which:


  enable it to fully meet its commitments to tenants as outlined in the
   consultationdocuments sent to tenants;
  enable it to fully meet its obligations to its lenders;
  do not contain any excess risks at any point in time, for example particularly during
   theperiod of the relatively high risk initial development/regeneration programme;
  contain risk management strategies for those risks which cannot be assigned to other
   parties;
  provide for the generation of reserves as soon as possible; and
  contain a margin of flexibility within its loan facilities over and above the basic
   requirementsof the business plan.


7.23 A newly formed board of LSVT RSL is likely to take the advice of its Director of
Finance(assuming this person is in place) and/or its funding advisor as to the relative risks
and rewardsof a full versus partially funded loan facility. If the arrangement fee associated
with the loanfacility is to be paid by the vendor local authority (by a reduction from the
purchase price),the LSVT RSL may be ambivalent as to its level. In such circumstances
there would needto be clear benefits in the other terms and conditions of a partially funded
loan facility forits selection in priority over a fully funded loan facility.

FUNDERS

7.24 A number of existing bank and building society funders have expressed their very
strongpreference for initial loan facilities to fully fund the LSVT RSLs peak debt
requirements.This is particularly so in the more risky poorer urban and large metropolitan
stock transferswhich going forward may constitute the bulk of ODPMs annual stock transfer
programme.It is arguable that this may partly be because of the additional returns achieved
by fundersthrough arrangement fees on larger loan facilities some of which may never be
drawn.However, lenders would contend that they are able to adapt more flexibly to the
changingfunding needs of the LSVT RSL when they know they have a long-term
commitment toprovide the peak financings and can work with the LSVT towards mutually
satisfactoryrestructurings on the back of a developed relationship.

7.25 During our consultation of potential lenders not currently active in the LSVT funding
arena,a number indicated that the length of loan facility requested, and the current market
termsand conditions, are a disincentive to becoming involved in the sector. This barrier to
entrymay be reduced if partially funded loan facilities were more widely used.

7.26 Capital markets funders, who thus far have only provided around 5% of the total loan
facilitiesto LSVT RSLs, may find it generally easier to sell bonds to investors if they were
on a bulletrepayment basis. However, the credit rating agencies generally require full
amortisation ofthe capital market issue to assign the necessary rating level to attract
investors, which willachieve optimal pricing advantage for a capital markets issue for the
LSVT RSL.

7.27 Rating agencies, in order to retain their credibility and market standing with investors,
arenaturally very prudent and cautious in the structures to which they are prepared to
assignstrong credit ratings. The most prudent funding structure for a LSVT is fully funded
andfully repaid, based on robust assumptions by the end of the period of capital markets
issue.Hence full repayment of the loan facility within the period of the bond issue has been
thestructure adopted in the bond markets for LSVTs to date. Otherwise the rating assigned
bythe credit rating agencies would command a margin over gilts which would make
capitalmarket issues unattractive to LSVT borrowers.

FULL VERSUS PARTIAL FUNDING FOR DIFFERENT TYPESOF
TRANSFERS

Shire Transfers

7.28 Shire transfers may have characteristics which could enable their boards to make the
casethat partial funding was an appropriate and realistic possibility without undue risk.
Thefollowing characteristics of shire transfers may support the boards case:


  The property assets, though requiring some repair and improvement generally
   haverelatively high alternative use values in the wider housing market and will typically
   notconstitute a major proportion of the housing stock in the district.
  The stocks average rent levels are not excessive and are a reasonable margin
   belowopen market rents. Rent collection performance will probably have been strong,
   witha reasonable proportion of tenants in receipt of housing benefit and relatively
   minimalvoid losses.
  Evidence of strong sustainable demand for the RSLs properties for the foreseeable
   future.
  Local economies will typically be vibrant, with below average unemployment levels,
   witha wide variety of robust employment opportunities for relatively low paid
   employment.
  Repairs and improvement programmes may be relatively modest, with little or no
   demolition.
  A strong management team, including people with private sector or RSL
   experiencealong with the detailed knowledge of former council officers of the stock to
   be acquired,and the resources to efficiently and effectively implement the LSVT RSLs
   business planmay be able to out-perform the business plan.


7.29 If such criteria are met, the transfer could be argued to be the transfer of an on-going
businessrather than a start-up business, primarily because of the lack of a large initial
investmentprogramme. The board will still need to take account for the future financing
risks detailedabove but could argue that certain risks are no more than a well-founded
business would beexpected to manage.

7.30 The advantages of such an approach, if accepted by both the Housing Corporation
andfunders, would be that:


  the LSVT RSL may be subject to traditional RSL financial covenants and balance
   sheettests and may not be subject to annual business plan approval by funders;
  the range of funders willing to provide short-term finance to established businesses
   iswider than those providing long-term project-style finance to start up RSLs;
  the facilities would be negotiated to match the realities of a well managed,
   relativelymature business and with lower arrangement fees; and
  the LSVT RSL would have more flexibility to utilise a variety of financing sources
   andinstruments as its business develops in the private sector.

Poorer Urban and Large Metropolitan Transfers

7.31 It is difficult to envisage the Board of a newly formed RSL to take the transfer of
poorerurban stock, being able to satisfy itself or the Housing Corporation that it had the
necessaryongoing business strength to warrant taking on the additional risk of partial
funding. Indeedpotential funders are likely to stipulate that a key term of them providing
funding for suchtransfers is that it is for a fully funded loan facility. The following issues may
in aggregaterepresent too much risk to facilitate a partially funded loan facility:


  the scale, duration and cost of the initial investment programme;
  a lack of confidence in demand levels into the future;
  the alternative use value of the stock in the wider housing market may be low, and
   insome instances negative;
  the performance of other agencies in providing the regeneration context for the
   housingstock may be uncertain;
  the weakness of the local economy; and
  the local area may have many of the features of a poorer urban area, including
   socialexclusion, low academic achievement, low expectations, high unemployment
   levels,and high crime levels.


7.32 Shire transfers generally have the benefit of being able to source financing on the
back of theirasset strength as and when required, but poorer urban and large metropolitan
stock transfersmay need to benefit from the security of knowing that they have a committed
funder in placefor their full requirements and for the full term. In the event that the RSL fails
to perform toits business plan, the business plan is revised to ensure full repayment of the
loan within theloan period. Clearly this is easier if the loan period is 25-30 years rather than
say only 10 years.If the re-costing of the business plan fails to deliver an acceptable
repayment profile, theinvolvement of the Housing Corporation in its regulatory role is
quickly sought by funders.This position may change when the LSVT RSLs initial
investment programme has beencompleted and has been demonstrated to have produced
long-term sustainable regeneration.

7.33 If, however, some of the risks identified in Chapter 6 of this report were not
transferredwith the stock then the need for a fully funded loan facility may be reduced.

Transfers to an Existing RSL

7.34 Funders might be prepared to advance a partially funded initial loan facility if the LSVT
RSLwas a financially strong existing RSL or part of a Group Structure involving a
financiallystrong existing RSL, with a reasonable level of reserves and unencumbered
assets. Lendersattitudes towards such a funding proposition, might depend on:


  the strength of the existing RSLs balance sheet including its gearing and annual
   interestcoverage levels;
  its past performance in relation to both major repairs, project control and
   housingmanagement; and
  if the transferee RSL was only a subsidiary of an existing RSL, the level of
   managementand financial support to be provided by the parent, or other asset owning
   subsidiaries inthe group.


7.35 Subject to these caveats, existing RSLs taking LSVTs are more likely to be capable of
beingtreated as ongoing businesses for transfer funding and may have significantly
greaterexperience of treasury management and risk appraisal than newly formed LSVT
RSL.

7.36 To an extent, this demonstrates the difference between a project funding loan
facilitysecured on the cashflows arising from the assets being financed and a corporate
loan facility,secured on the financial strength of the borrowers balance sheet.

FULL AND PARTIAL FUNDING CONCLUSION

7.37 Thus far, LSVTs have with virtually no exceptions been fully funded on the day of
transfer.This is extremely prudent, but is strongly preferred by funders, and particularly
their creditcommittees, and has served the sector well since the stock transfer programme
began in 1988.

7.38 Some strong shire transfers have been fully funded on the day of transfer but due to
thestrength of their cashflows, have not had to draw down much in the form of additional
loansin the years following transfer. Clearly these and similarly strong transfers in the
future couldadopt a partial funding approach with no significant increase in the risk
assumed. This alsoapplies to LSVTs that take place to a RSL which is part of a group
structure including alarge strong existing RSL which would be able to provide additional
finance in the future.

7.39 Given the inherent additional risks, LSVT RSLs (unless they are part of a financially
stronggroup structure) taking the transfer of poorer urban or large metropolitan stock,
should befully funded on the day of transfer. This is a prudent approach, but is fully justified
by thechallenges these transfers face from the day of transfer onwards.
Chapter 8 - Business planning issues and information issues
for the vendor local authority and recipient landlord
Summary

  Much of the information provided by the RSL in its business plan and
   fundingprospectus is derived from local authority records and accounts.
  The local authority should provide core data in a Disposal Prospectus and create aDue
   Diligence Library or data room for inspection by the RSLs and their funders.
  The RSL business plan could then focus on its governance and management,
   itsintentions for the stock and neighbourhood and all future tenancy matters.
  Funding advisers should rigorously test business plan assumptions, identify andquantify
   risks to the business plan and consider all the available funding options.


INTRODUCTION

8.1 The terms and conditions of the loan facilities received by the recipient landlord should
bedetermined by the strength of their business plan, the level of risk being absorbed, the
purchaseprice, the experience and expertise of management (including the Board) and the
standardof information supplied to potential funders to enable them to undertake their
creditassessment and due diligence.

8.2 For the reasons outlined in Part 1 of this report, the standard of information supplied
topotential lenders will become increasingly important following the expected
implementationof Basel II. Under the IRB approach of Basel II, the level of capital that a
lender has toassign to a loan more accurately reflects the level of risk involved in providing
the loan, thepotential for default and the loss arising to the lender if default occurs.
However, Basel IIwill not be implemented prior to 2007, albeit many banks will begin to
implement earlierthan this. At this stage, it is not clear what the effects will be.

8.3 Given this background it is important that stock transfers landlords adopt best
practicein the provision of information to potential lenders. This chapter considers how
recipientlandlords can ensure that the information supplied to potential lenders generates
maximumcompetition in the tendering of the funding mandate.

CURRENT POSITION

8.4 The business plans of the transfer RSLs which are circulated to funders as the basis for
theirfunding bids are at present an uncomfortable hybrid including elements which could
moreproperly be seen as the vendor local authoritys Disposal Prospectus as well as
elementswhich are more genuinely the purchasers forward business plan and funding
prospectus.
8.5 The RSL is currently responsible for producing the business plan and running the
fundingcompetition. However, the results of the funding process may have a material affect
on thepurchase price and so the local authority, which in any case holds much of the base
informationabout the stock, has a strong interest in ensuring that the information received
by the fundersis comprehensive and accurate. Under present arrangements, as was
particularly highlightedby existing funders in the survey of views conducted in Part 1 of the
assignment, key RSLappointments (including the Finance Director) have sometimes been
delayed to the extentthat the business plan is effectively put together by the RSLs financial
advisers.

8.6 The Community Housing Task Force is well positioned to give advice to local
authoritieson the extent and quality of the information which they should be providing to
form aDisposal Prospectus.

DUE DILIGENCE LIBRARY

8.7 To enable the RSL, whether new or existing, and its funders to carry out due
diligenceeffectively and quickly, and to avoid duplication of effort by the local authority and
theRSL, a Due Diligence Library could be established by the local authority and its
advisers.The provision of such a library is standard practice in PFI projects and was used
effectivelyby the Housing Corporation in the disposal of its own loans portfolio. It should
enhance thearguments for a reduction in arrangement fees and places the responsibility for
core dataprovision where it best belongs.

CONTENTS OF A DISPOSAL PROSPECTUS

8.8 The local authority disposal prospectus could include the following information:


  stock analysis age, type, size, location, built form etc;
  recent stock condition survey;
  description of the local economy employment levels, concentration of employersin any
   one industry, retail buoyancy, land price trends, inward investment levels,regeneration
   strategies;
  description of the local housing market tenure split in area covered by transfer or
   inwider district, house price trends, private rented market, any special features, for
   examplelarge student population;
  demographic analysis of existing tenants, waiting list, local population;
  demand expectations covering short, medium, long term. A full independent
   DemandSurvey could cover this and the preceding 3 points;
  local authority Management Performance with 3 year minimum record to
   demonstratetrends and the reasons for them:

    void levels

average length of tenancy by demographic group
rent collection history

bad debts write offs;

  warranties being offered preferably on a standardised basis and/or backed byinsurance;
   and
  for urban areas/large metropolitan transfers, the regeneration strategies for the area
   includingcommitments by the local authority and other partners in the fields of
   neighbourhoodmanagement, education and health improvement, local transport, retail
   and leisure facilities:

    how well developed are programmes

is the necessary funding committed

who is responsible for efficient and effective delivery.


BUSINESS PLAN AND FUNDING PROSPECTUS

8.9 With the aid of the Disposal Prospectus and Due Diligence Library the new or existing
RSLwould be in a better position to develop its business plan for the future and its
fundingprospectus, based on adequate information about the stock and the broader
context of thetransfer. The Business Plan would focus on:


  details of the new landlord and relationship with any existing RSL group;
  financial projections for the stock and organisation;
  details of assumptions used;
  rental, voids and bad debts policies to be adopted;
  rent and other guarantees;
  management costs;
  planned repairs and improvement programmes;
  new development plans;
  diversification plans if any;
  housing management and services provision; and
  proposed role of RSL in local housing market.

THE ROLE OF THE FUNDING ADVISOR

8.10 Armed with data from the local authority and the business plan the RSLs funding
advisorshould be expected to:


  identify and analyse the risks inherent in the business plan;
  stress test the assumptions in the business plan and their impact on cash-flows;
  devise a funding structure and tendering strategy which as far as possible:
    allows for adequate flexibility to meet changing conditions

mitigates the identified risks

minimises lender control over the business plan;

  explore the full range of market opportunities to allow the management and Board
   toinformed choices; and
  explain the consequences of the funding strategy for future treasury management.
Chapter 9 - Transfer to existing RSLs and a competitive
disposal process
Summary

  Current ODPM policy is to encourage local authorities to involve tenants in the choiceof
   a new landlord. In some cases this has involved a more formal competition
   betweenpotential landlords, although this policy is still relatively new.
  Existing RSLs, or group structures involving existing RSLs, should be able to
   offerpricing benefits through marginal costing of management costs and access to
   cheaperprivate finance.
  Virtually all existing RSLs canvassed as part of a survey, expressed keen interest
   inparticipating in future LSVTs.
  A disposal prospectus and data room could create the basis for a properly
   conductedcompetition for the recipient landlord role.
  Bidders could include newly formed RSLs, existing RSLs and the alternative
   modelsdescribed in Chapter 11.
  Competition would need to be carried out prior to ballot against clear criteria andwith
   meaningful tenant participation in the process.
  The clear advantages of a more competitive process may be partly offset by
   thedifficulties of engaging tenants in an extended transfer process.
  Large metropolitan transfers face additional complexities in introducing competitionfor
   the landlord function because of the policy that generally no more than 12,000homes
   can be transferred to a single RSL.


INTRODUCTION

9.1 This chapter considers the extent to which VFM of funding for stock transfers would
beenhanced by the involvement of established RSLs. In addition, it considers whether
theinvolvement of one or more established RSLs in poorer urban or large metropolitan
stocktransfers would enhance their fundability and the terms and conditions on which they
couldsecure private finance.

COMPETITIVE DISPOSAL PROCESS

9.2 Government policy is to encourage local authorities to consider a range of potential
landlordswhen planning the transfer process, but competition for the recipient landlord
remainscomparatively rare. A Disposal Prospectus and Due Diligence Library, as
described in theprevious chapter, would be a useful tool in providing the information base
for a competitivedisposal process for stock transfers, introducing competition for the
landlord function amongstexisting RSLs and other forms of landlord.

9.3 The advantages of running a competitive transfer process would include:
  The local authority runs the competitive process and stands to gain maximum
   valuefrom the competition.
  Tenants would have a high degree of certainty of achieving a base level of
   commitmentsbut would also gain from added value commitments by bidders.
  It would bring the management and financial strengths of existing RSLs into the system.
  Funders would have the opportunity to work with RSLs as partners to develop
   attractive,flexible and innovative funding packages.
  Using the information supplied by the vendor local authority, the RSLs could run
   apre-competition for funding partners and would be able to decide for instance
   betweenbond and bank finance on the basis of knowledge and experience This
   competitionwould ask funders what the maximum price was they would be prepared to
   fund andon what terms and conditions.
  It might be more possible for funders and the RSLs to defend the position that in
   theparticular structures and circumstances the risks of not signing up for full funding
   andfull loan repayment during the loan period had been analysed and adequately
   mitigated.


9.4 The disadvantages of undertaking a competitive process could include:


  Tenants may not feel integral to the process and therefore vote against transferring
   tothe selected landlord.
  The whole transfer process may become protracted leaving tenants to become
   disenchantedwith progress to transfer.
  Existing RSLs may be prepared to pay too high a price for the stock purely to
   increasetheir property portfolio thereby jeopardising their long term financial strength.


9.5 The report now considers the findings of a financial analysis between newly formed
RSLsand established RSLs undertaking stock transfers. It seeks, in particular, to examine
the priorsuspicion that an existing RSL will achieve better loan terms and conditions and
will generallybe able to pay a higher purchase price or receive a lower dowry, at the point
of transfer.

FINANCIAL ANALYSIS

9.6 The analysis focuses on management and funding costs since these elements in the
determinationof the purchase price have the propensity to differ most significantly
dependent upon thestructure of the recipient RSL. Other items of income and expenditure
are not consideredas part of this exercise, as they tend to be more stock specific and less
sensitive to the typeof recipient landlord.

9.7 Management costs have a direct impact on the determination of ODPMs TMV for
thestock and hence the transfer price. Funding costs could have an impact on the TMV if
theyenable the discount rate used to determine the TMV purchase price to be at the lower
endof ODPMs 6% to 8% range. They may also influence the final transfer price indirectly
ifthe recipient landlord is able to achieve cheaper funding and therefore bid a higher
purchaseprice for the stock. This reflects the ability of an established RSL to take a view as
to whatpurchase price it is prepared to pay for a portfolio. In the only real competitive
bidding for aportfolio of around 1,024 social housing properties sold by the Ceewood
Housing Association(CHA) to Shaftsbury Housing Group, the results of a competitive
process were seen. Theprocess resulted in an attractive sales price to the vendor Smith
Industries, with no detrimentto the rent levels and services provided to CHAs tenants.

MANAGEMENT COSTS

9.8 The management cost structure of an existing RSL will differ from that of a new RSL
vehicleestablished for the purpose of undertaking a stock transfer. Differences arise for a
variety ofreasons, but primarily because an existing RSL will have an asset base and so
can incorporatemanagement costs on a marginal cost basis into its business plan for the
transfer stock.

9.9 A new RSL on the other hand will be obliged to incorporate management costs on a
fullcost basis as it has no other assets over which to spread its costs base. Economies of
scaleavailable to the existing RSL may not be available to newly formed organisations.
Specificsavings can be expected in terms of central overheads, the Chief Executive
function, thefinance department, IT systems and other central support services, as the
support serviceinfrastructure already exists.

9.10 Table 1 provides the results of a present value calculation which reveals the potential
impacton the TMV purchase price and hence additional purchase price that an existing
RSL couldpay in comparison to a newly formed landlord from various levels of
management cost savings.

9.11 Table 1 highlights that comparatively modest cost savings can have a significant
impact on the TMV purchase price of a transferring stock. A relatively small saving of £25
per unit per annum for 30 years in management costs equates to a present value of around
£1.0m for 3000 units transferring. This increases to £3.9m for 12000 units.

Table 1 Present value of management cost savings

Annual saving




                                    Impact on TMV (£m)
in management


cost per unit:

                 3,000 units

                 6,000 units

                 9,000 units

                 12,000 units


£25

                     1.0

                     2.0

                     2.9

                     3.9




£50

                     2.0

                     3.9

                     5.9

                     7.8
£75

                                          2.9

                                          5.9

                                          8.8

                                         11.7




£100

                                          3.9

                                          7.8

                                         11.7

                                         15.6

9.12 The Housing Corporation Performance Indicators (PIs) for 00/01 report that the
sectoraverage management cost equated to £536 per unit. Therefore, a saving of £25 per
unitwould equate to around 4.5% of the average management cost.
9.13 Obviously the management cost structure of individual stock transfers is contingent
uponthe specific characteristics of the stock being transferred. The Housing Corporations
00/01PIs detail that the unit management costs of individual RSLs range from £44 per unit
to£2,729, thereby reflecting the diversity of the sector. However, the above analysis,
althoughextremely generalised, appears to support the prior suspicion that existing RSLs
have thepotential to offer a higher purchase price or sustain a lower dowry for a property
portfoliopurely on the basis of management costs.

FUNDING COSTS

9.14 Of the 146 stock transfers undertaken to the end of the 2000/01 programme fewer
than 30have been to existing RSLs, or subsidiaries of existing RSLs. Of these, a great
majority havebeen comparatively small estate based or ERCF stock transfers. Given this
limited history oftransfers to existing RSLs, there is a relatively small population of
evidence with which tocheck the comparative funding costs of funding transfers to existing
and newly established RSLs.

9.15 From discussions with various lenders, existing RSLs are able to attract more keenly
pricedlending facilities than newly formed RSLs. This arises for a number of reasons, but is
directlyrelated to the lenders perception of the risk inherent in their financial strength and in
thetransaction they are proposing to undertake.

9.16 Table 2 highlights that existing RSLs are generally able to achieve lower arrangement
fees,interest margins and commitment fees than newly formed RSLs particularly for poorer
urbanand large metropolitan transfers. It also demonstrates that lenders will price the
facilitydependent upon the perception of the risks inherent in the lending proportion. That
is, ashire transfer is perceived as comparatively less risky by the lenders and is priced
accordingly.

9.17 Clearly with the lower arrangement fees detailed above, existing RSLs or newly
formed subsidiaries in a group would be able to pay a higher purchase price for a portfolio
of properties than a newly formed standalone RSL. With regard to interest margin this
analysis needs to be broken down into shire transfers and poorer urban/large metropolitan
stocks.

Table 2 Funding terms new and existing RSLs


                                           New RSL

                                         Existing RSL
                      Shires

                      Poorer

                    Metropolitan

                      Shires

                      Poorer

                    Metropolitan




                       urban

                       stock



                       urban

                       stock


Arrangement fee %

                       1-1.25

                        1.25

                     1.25-1.35

                        0.25

                        0.25

                        0.25
Interest Margin %




Early years

                    0.10

                    0.85-1
                  0.4-0.5

                  0.4-0.5

                  0.4-0.5

                  0.4-0.5




Late years, say

                  0.4-0.5

                  0.75-1

                  0.6-0.65

                  0.4-0.5

                  0.4-0.5

                  0.4-05


year 10 onwards
Commitment fee

                                             Nil

                                   50% of interest margin

                         Nil in early years then 50% interest margin


SHIRE TRANSFERS

9.18 At first sight it may appear that the extremely low initial margins (reflecting a subsidy
fromthe higher arrangement fee) would enable a newly formed RSL to pay a higher price
for thestock than an established RSL. In E&Ys view this is unlikely to be the case.
EstablishedRSLs with treasury management experience, would be less reliant on funding
advisers andtake a wider loan portfolio view and build less margin of comfort into their real
interest rateassumptions. This would enable them to undercut the 6%-8% ODPM real
discount ratein the determination of the purchase price, and thereby pay a higher purchase
within thecontext of a viable 30 year business plan.

POORER URBAN / LARGE METROPOLITAN STOCK TRANSFERS

9.19 In the case of these transfers, the interest margins payable by a newly formed RSL
are higherthan for an established RSL. This lower interest cost and the factors outlined in
the previousparagraph of being able to undercut the 6%-8% real discount rate, mean that
establishedRLSs would, if they chose to, be able to pay a higher purchase price than newly
formedRSLs for poorer urban and large metropolitan housing stocks formed RSLs.

COMPETITIVE BIDDING PROCESS

9.20 Invitations to bid for a portfolio of stock would need to be made prior to the tenants
ballotand perhaps under OJEC rules. They could be directed towards:


  Existing RSLs wishing to take the stock direct into their own ownership, with or
   without,local management arrangements.
  Existing RSLs which were prepared to commit to the creation of a community
   basedRSL within their group structure utilising local authority and resident board
   membersand consulting fully with residents about the nature of the new organisation.
  A newly formed RSL if it felt sufficiently strongly established to bid independently.
  Private sector companies subject to other policy considerations considered elsewherein
   this report.
  Community Land Trusts or similar organisations where surpluses are directed to
   communitybased projects, possibly in conjunction with either private sector companies
   or RSLs.


9.21 Bidders would select funding partners, construct business plans and funding models,
andestablish the price which they could afford to pay for the stock. Bids would be judged
on anumber of criteria which would have to be pre-established and transparent. The
selectionprocess would potentially have much in common with PFI selection
methodologies. Involvingtenants would also be very important in establishing ownership of
the process and supportfor the preferred landlord.

9.22 The criteria used in the selection process could include:


  commitment to fulfilling the aspirations of tenants for local management
   involvementeither through the RSL or by other means;
  management support offered to a subsidiary or locally based management structure;
  evidence of general commitment to resident empowerment;
  track record of delivering major development or improvement programmes on timeand
   to budget;
  track record of day to day management and maintenance including peer
   groupperformance indicator ranking;
  deliverability of business plan;
  funding availability and flexibility;
  evidence of wider regeneration success; and
  purchase price offered.

CIRCUMSTANCES FOR COMPETITIVE BIDDING
9.23 Competitive bidding could only take place where there were sufficient numbers of
RSLsinterested in expanding their operations in this way and with the capacity to handle
thelong-term results. Transfers of over 10,000 units may struggle to find sufficient interest
asthere are relatively few existing RSLs with the management capacity to handle such a
large transfer and even fewer who could sustain a programme of such large transfers.
Smaller townbased transfers or partial city transfers could, however benefit. Where stock
can be splitinto manageable groupings even the larger metropolitan transfers could reap
the benefits,although there may be over-riding policy and practical considerations which
preclude splittingthe stock. These include:


  the complexity for large metropolitan authorities of having multiple competitions orthe
   need to have a number of competitors every year over a number of years to achievefull
   transfer;
  the implications for the balloting process;
  the number of RSLs with the capacity to handle several thousand units of possibly poor
   stock;
  the problems of attracting bidders for the poorest areas; and
  the desire to mix poorer and better areas into larger groupings to maximise sale
   proceeds.

Other issues in transfers to existing RSLs

9.24 Whilst the review of management costs and funding costs appears to support the
suggestionthat promoting competition in stock transfers could lead to higher purchase
prices, a numberof other issues must be considered. These include:


  The impact of TUPE. RSLs may be slightly restricted in how competitively they can
   pricemanagement costs if they are required to accept a full transfer list of former local
   authority staff.
  The costs associated with integrating stock into an existing RSL will mitigate, to
   someextent the level of savings achievable. In addition, the transferring stock will be
   expectedto make a contribution towards central overheads which will also lower
   potential savings.
  The impact on the objectives of community ownership. It could be perceived
   asdetracting from community ownership unless a local community based RSL
   subsidiaryis formed as part of a large group structure.
  The impact on the success rate of ballots. Tenants perception is extremely important
   inthis regard.
  The perception of staff and in particular senior management is important. Often
   theimpetus for stock transfer comes from senior officers.
  The perception of members is also important and ties into community
   ownership.Members may be less supportive of stock transfer if they feel that there is a
   loss ofcontrol or influence over a key local service.
  The principles of competition are well established in local government.
   Compete,challenge and compare are 3 of the fundamental principles of the Best Value
   regime.Therefore, extending competition to the selection of the recipient landlord
   process isin line with best value.

RSLS QUESTIONNAIRE

9.25 In order to gauge their interest in participating in future LSVTs, E&Y wrote to the
ChiefExecutives of 109 existing RSLs. These included the largest RSLs in England and
thoseformed by previous LSVTs. The main questions asked and a summary of the
responsesgiven is set out below. More detail is given in Appendix XI. We received replies
from 67RSLs, of which 40 were from established RSLs and 27 from RSLs created by an
earlierLSVT, an overall response rate of 61%. The replies are summarised below. More
detail isgiven in Appendix XI.

1. What extent would your organisation, or an organisation linked to your organisationwant
to increase its stockholding/size through stock transfers from local authorities?

Of those questioned, all but two would like to increase the size of their holding
throughstock transfers.

2. If the answer to 1. is no, what factors would need to change for your organisationto
consider becoming involved as a recipient landlord?

One of the nos gave no reason, the other had only recently completed a stock transfer
andwas not looking for another for the next five years.

3. Do you have a view on how many properties your organisation would be interestedin
acquiring, recognising ODPMs guidance that the maximum number of propertiesto be
transferred to any one new RSL should generally be no more than 12,000?

A wide variety of replies were received for this question as can be seen in Appendix
XI.Established RSLs were more ambitious overall in their target number, however,
invariablythey were already larger on average. Some RSLs had no view on the amount
whilst 8 statedit depended on the circumstances. For those wishing to have more than
12,000 transferred,either a group structure was already in place, or this was planned in the
near future.

4. Would you target a particular type of transfer ie, shire district councils, poorerurban
stock, large metropolitan transfers etc?

A majority of respondents wished to remain geographically local to their current
housingportfolio. 25 respondents did not target a particular type of transaction, but would
considereach opportunity on its merits. RSLs tended to opt for the opportunity most likely to
occurin their existing geographical region or where they had expertise, ie, Shire RSLs
indicated acontinued preference. Finally, six respondents with specialist skills such as
regeneration orsheltered accommodation specified that these were the areas they would
target.

5. Would you wish to pursue partial or whole stock transfers?
Most RSLs would go for either partial or whole stock transfer. A number indicated that in
theirarea, either a partial (metropolitan/urban) or a whole (shire) transfer would be most
likely.

CONCLUSIONS ON RSL QUESTIONNAIRE

9.28 The conclusion is that there is a strong appetite within established RSLs to
undertakeLSVTs whether through partial or whole stock transfer. The replies indicated
strong localgeographical preference, with 50% of respondees indicating that they would
wish to staywithin their current area of operation. Established RSLs also indicated an
overall desire tocontinue to work with property types in which the RSL already had
expertise.

9.29 A number of London based established RSLs already have expertise in poorer urban
andmetropolitan stock and so wished to remain in this field of activity. Other established
RSLsexpressed a preference to continue working with shire transfers based in areas where
theyalready have a presence. Several established RSLs expressed concern about the
financialviability of poorer urban stock.

9.30 The number of properties that a RSL would be interested in acquiring generally
related toits current size, area of operation and group structure. Smaller RSLs were
generally unwillingto take on housing in excess of their current size. A number of the
medium and larger sizedRSLs either specified that they could take up to the 12,000 home
general limit or wouldexamine each potential project as the opportunity arose.

9.31 A minority of respondents were willing to take on any locality or number of properties.
MostRSLs indicated that they would examine potential transfers on a case-by-case basis to
ensurethat its management arrangements for its current stock would not be jeopardised.
Chapter 10 - Intermediary body to issue bonds to the capital
markets
Summary

  The bond markets have been comparatively under-utilised in providing funding tothe
   transfer programme to date.
  The most cost-effective bonds are large, liquid issues, which may require the
   aggregationof a number of smaller transfers.
  The market has not yet produced a mechanism for aggregating LSVT issues
   althoughthis has been achieved in the traditional RSL market.
  There is no current evidence of the poor value for money or market failure, whichmight
   justify public sector intervention to establish a body to issue group bonds.


TRANSFERS AND THE BOND MARKETS TO DATE

10.1 Long term fixed rate debt is an important option for transfers to have available in
determiningtheir treasury management strategies as it can provide a core level of certainty
to the fundingof their business plan. The bond markets are the traditional source of
fixed-rate debt withlong-dated loan stock being issued by both government and corporate
borrowers.

10.2 However in recent years the swaps markets have extended out to 30 years enabling
banksto offer significant competition in this market. The traditional RSL sector has used
bothbanks and bonds extensively with increasing levels of sophisticated decision making
basedon their relative covenant and pricing packages. Bonds have been issued by
individual RSLs(primarily to finance Housing Association Grant (HAG) and Social Housing
Grant (SHG)supported development), groups of RSLs organised by lead underwriters, and
by the independentintermediary The Housing Finance Corporation on behalf of aggregated
groups of RSLs.

10.3 The bond markets are under-represented in the financing of housing stock transfers
althoughto date their relative unpopularity has not proved to be a problem in funding
ODPMs annualtransfers programme because of the active participation of sufficient banks
and building societiesto ensure the successful funding of the full programme. If the
banking/building society marketdeclines, or the size of the total annual funding requirement
substantially increases, theimportance of a well-developed bond market would become
increasingly significant.

THE BORROWERS PERSPECTIVE

10.4 Bonds have not been the preferred mode of financing for a number of reasons
primarily asthey are seen by RSL boards and by most of the funding advisers as inflexible,
expensive torepay early and complicated to launch. Against this it is argued that banks
flexibility mayalter with market circumstances and the covenant structures required by the
banks allowfor very significant intervention and control if business plan performance
deteriorates; bondholders have a far more hands off approach with Trustees only taking
action when minimumlevel performance covenants are actually breached.

10.5 Underwriters would also argue that there should be no need for, or expectation of,
earlyrepayment for the core debt of the transfer and that breakage costs will also be
significantfor bank-funded fixed rate debt. The complications of launch depend on the
timing of theissue and can largely be handled by the underwriter.

THE INVESTORS PERSPECTIVE

10.6 A key factor inhibiting the wider development of suitable bond structures from the
investorspoint of view is the volume of individual transactions. Until 3 to 4 years ago, the
acceptedwisdom was that a liquid issue (which by definition would attract active secondary
markettrading and therefore the keenest pricing) would need to be in the order of £75
-£100 million.

10.7 This size of issue would now be regarded as illiquid and require an additional margin
premiumof probably upwards of 25 basis points (0.25%) to meet investors appetite.
Liquidity in thesecondary market is generally agreed to commence at an issue of over £200
million withamounts below that being treated effectively as private placements with little
anticipationof future trading.

THE NEED FOR AGGREGATION

10.8 Very few of the largest transfers require core fixed rate funding of over £200 million
andso active use of the bond market for smaller transfers would require the use of
potentiallymore expensive private placements rather than liquid public issues or the
aggregation of anumber of transfer transactions into a single bond issuance programme.
The latter in turnwould require the establishment of an intermediary vehicle to act as the
bond issuer. Suchan intermediary could be a shell vehicle set up by the lead underwriting
bank with thebank structuring the bonds and dealing with the issuing process. Alternatively,
it could bean independent organisation carrying out its own financial structuring and
seeking competitiverelationships with underwriters.

10.9 Neither form of intermediary vehicle has yet emerged in the funding market for
stocktransfer despite both forms having been used extensively by non-transfer RSLs. This
wouldappear to be because:


  Banks have, to date, been prepared to offer full, flexible funding packages for
   alltransfers at margins which were very competitive with what the bond markets
   couldhave offered.
  Bond underwriters have found it difficult to break into the market even for the
   largertransfers (with a few notable exceptions) and there are limits to the extent to
   whichthey will invest in innovative products when the potential rewards are so tenuous.
  The bond markets need to be used in conjunction with more traditional banking
   productsin order to add the flexibility and variety which a total transfer funding package
   requires.Bond underwriters therefore either need to have a banking division within their
   ownorganisation prepared to work closely to provide the full package in-house or they
   needto establish partnerships with other banks or building societies.
  This may prove difficult when the same banks and building societies are both hungryfor
   loan assets at relatively low margins and are capable of providing a fixed rate
   productthemselves (albeit in some market circumstances at higher cost to the
   borrower).
  The timing of transfers is such that any attempt to co-ordinate an aggregated
   approachto the bond market at or around the time of transfer is fraught with difficulty.
   WhichRSL would be prepared, or indeed well-advised, to enter into a funding deal
   whichdepended for its ultimate success on a number of similar RSLs agreeing to
   participate atthe same time? Warehousing of transactions until the size of the first issue
   was adequatewould require the interim (or bridging) banking facilities referred to above
   and thecapital markets out-take would be hard to guarantee within a defined period.
  An independent intermediary issuing in its own name would overcome some of
   thecomplexities of the aggregation process but unless it was adequately capitalised
   fromthe outset it would face questions about its own creditworthiness which would be at
   themercy of its weakest borrower until it had built sufficient track record and reserves
   tooffer a genuine spread of risk to investors.
  The rating agencies have not to date been prepared to rate an open-ended bond
   whichallowed for the addition of later transfers. Transfer RSLs are seen as having a
   muchbroader spectrum of credit characteristics than traditional RSLs which have
   significantbalance sheets, experienced management teams and do not generally
   require majorinitial investment programme in their stock.


10.10 The lack of progress in establishing a structured bond financing which could be used
on anaggregated basis has not been for the want of trying. The two leading underwriters
active inthe field have considered this possibility and continue to investigate further.

10.11 The Housing Finance Corporation has indicated its willingness to establish new
vehicles forthe purpose and work with the underwriters to find a way through the problems.
However,despite its position as a successful independent issuer it does not have sufficient
balancesheet strength to capitalise such a vehicle and gain the credit rating in its own
name whichwould overcome the perceived weakness of the underlying credit position of a
number ofdisparate transfer RSLs.

A ROLE FOR GOVERNMENT?

10.12 ODPM is thus faced with a policy dilemma as to whether it feels that the benefits of
acentralised and capitalised intermediary are sufficiently substantial to warrant public
sectorintervention in the market. These benefits can be summarised as:


  providing access to a wider range of markets for all transfers and thus protecting
   theprogramme from any potential narrowing of the current limited lender base;
  the generation of a comparatively untapped source of funding, thereby stimulating
   theexisting funding market which whilst delivering funding for all transfers thus far,
   isclearly showing signs of contraction and stagnation; and
  gaining the economies of scale and process efficiency which a unified bond
   issuanceprogramme can provide.


10.13 If it was thought to be justifiable, public sector involvement could take a number of
forms including:


  Investment in the capitalisation of an independent intermediary to provide it
   withsufficient strength to attract a high investment-grade rating in its own name.
  Purchase of bonds issued by an intermediary until such time as the bond size
   wassufficient to trade in the public markets.
  Entering into a partnership with an existing public/private organisation such
   asPartnershipsUK (PUK) to develop a bundling approach to smaller stock
   transferswhich would necessarily involve individual transfers being encouraged or
   required tobuy into a centralised funding solution.


10.14 The difficulties of government intervention in an established funding market are
significant borrowers will not wish their freedom to select their preferred funding solution to
be diminishedand lenders will complain, with some justification, that such intervention is
anti-competitiveand provides one element of the market with advantages not available to
the rest.

10.15 In addition, a key justification for Government intervention is market failure. Given
that allstock transfers since the inception of the LSVT programme in 1988 have been
funded andthere is still strong funding appetite for new transfers, (albeit from a limited pool
of funders),it is extremely difficult to justify Government intervention in such circumstances.

10.16 E&Y does not therefore recommend that the establishment of a centralised vehicle
withgovernment assistance should be contemplated at this time. It could, however, be
useful forODPM to acknowledge publicly the desirability of aggregation, to indicate that it
wouldwelcome proposals emerging from the market, and to be prepared either now or in
the futureto offer to work with the private sector to try to overcome some of the process
problemswhich have been a contributory factor to date in deterring such initiatives.

CONCLUSION

10.17 We conclude therefore that the market may eventually produce a new bond and
vehiclestructure which will meet the varied requirements of transfer RSLs, investors and
ratingagencies. This is most likely to happen if the available banking/building society
financeweakens or more large transactions with a core funding requirement of over £200m
occuror returns improve. Until then it is difficult to envisage there being sufficient incentive
forthe major investment in time and money which such an exercise would require.
Chapter 11 - Alternative models for stock transfer
Summary

  The current system of transfer to RSLs provides limited capacity to reconfigureestates,
   exploit, for community benefit, the value of development land or participatein
   comprehensive regeneration programmes.
  Enabling RSLs to carry out these wider activities may require a relaxation of ODPMand
   Housing Corporation rules and the risks may be too great for newly-formedRSLs to
   absorb.
  Governance and financing models have been proposed which offer alternative typesof
   landlord and a wider regeneration capability but which would need to win theapproval of
   a wide range of stakeholders, in particular tenants:

the structured finance model utilising equity/debt combined funding with thereturns to
equity investors capped at a level which would allow surpluses to bechannelled into a local
regeneration fund.


the community land trust model, where transfer of the freehold interest to aCommunity
Land Trust would enable a comprehensive master plan to be developedwith any resulting
enhanced value being retained for the benefit of the community.


11.1 Private sector equity investors seek investment opportunities secured by strong
income streams.The delivery of social housing services, with tenant rental flows supported
to a substantialdegree by housing benefit payments, is seen as a potential future
investment area, subject tochanges in RSL governance rules. There is also a second
reason for private sector interestin stock transfers, namely inherent land values. In certain
areas of England and Wales theland transferred or that created via demolitions, has
redevelopment potential assuming thatthe tenanted units can be re-provided by site
reconfiguration and density changes.

11.2 Recently Ernst & Young has seen a number of private sector led proposals to bring a
newapproach to the area of stock transfers and as part of this project we were asked by
ODPMto examine the Regent Integrated Housing Model in particular. The Regent proposal
couldbe described as a structured finance RSL with a limited or capped return to equity
investors.Surpluses would be retained in the community through a form of trust.

11.3 A second model is also examined in this section, which is the Community Land
Trust,where transfer of the freehold to such a body would facilitate the preparation of
acomprehensive master-plan resulting in benefits being retained for the community.

REGENT INTEGRATED HOUSING MODEL
11.4 Regent Integrated Housing is owned by Charlemagne Capital and has been set up to
developinnovative social housing finance solutions. Regents proposals are aimed at
reducing thecost of financing stock transfers and hence increasing the opportunities for
successful transfersand increasing the level of payments to local authorities for their
assets. Their proposals areoutlined in more detail in Appendix XIII.

11.5 The Regent Model utilises structured finance to improve financial terms available for
stocktransfers, with the financial partners (particularly equity) controlling the management
ofthe Housing Company to which the housing stock is transferred. The Regent Model
involvesusing competitive mortgage and capital markets for procuring the majority of the
finance.The Housing Company is to be an RSL. Changes to current policy may be needed
as themodel proposes that funders gain ultimate control over key management
appointments.

11.6 Under the proposals the total return paid to investors would be capped and any
excessprofits covenanted to the public sector via a Trust for which it is envisaged that
tenants andthe Council will make up the board. The transferred surpluses would enable the
Trust toundertake wider social, economic and physical regeneration works in the area.

11.7 The Housing Company would be able to use and develop the assets to provide,
undercontract, a flexible housing service to accommodate social housing tenants in
propertiesthat matches their changing needs. Regents model goes further than other
proposals wehave previously seen in that it might involve substantial flexibility in the
management ofthe stock, to allow appropriate remodelling and redevelopment of assets.

11.8 As a form of security Regent has proposed that a golden share be retained by the
publicsector and that a Bond could be taken out to insure the public sector position in the
eventof the Housing Company getting into financial difficulty. These measures are
designed tohelp protect the interest of tenants as well as the public sector investment in the
stock.

COMMUNITY LAND TRUSTS

11.9 A Community Land Trust (CLT) is a model for the mutual ownership of land. The
landowned by the local authority and the community is pooled together with either the
communityor the local authority retaining the assets freehold interest. Depending on the
exact structure,the CLT will invariably have a board containing much the same composition
as that proposedfor an Arms Length Management Organisation a third tenants, a third
independents anda third local authority representatives.

11.10 The CLT would enable a comprehensive master plan to be developed with any
resultingenhanced value solely being retained for the benefit of the community. Proposals
to datehave centred on the CLT leasing the housing units to an RSL, which will manage
andrepair the stock, with the ground lease rents enabling community projects. If it is
necessaryand possible to tackle major regeneration projects, it is likely that the CLT would
prepare amasterplan and then seek a commercial development partner to undertake the
project.
11.11 The Council of Mortgage Lenders (CML) has stated its concerns regarding CLT
optionswhere stock is leased to RSLs, arguing that it will be more expensive for borrowers
toapproach lenders without the benefit of security of freehold land.

11.12 The approaches above both focus on creating profits to enable regeneration but
simplyhave different primary objectives. The private sector models such as Regent must
createprofits to maintain investor confidence. The CLT model is centred more on
communitywide requirements but without a commercial partner it is unlikely that major
regenerationprojects would be possible. We envisage that proposals for CLTs will become
further developedas more regeneration opportunities are implemented and following this,
methods for financingand managing the Trusts may become more innovative.

STAKEHOLDER KEY ISSUES

11.13 From a general economic perspective, it is desirable to make the most efficient use
of thefinancial markets and also maximise the value derived from the underlying land
assets.However, balancing the financial requirements of debt investors, equity investors
with thesocial and service provision requirements of the public sector is not straightforward.
Thereare several sets of key stakeholders whose interests must be balanced. These are:


  Tenants.
  Council Members.
  Public Sector ODPM and the Housing Corporation.
  RSLs, Housing Company or Community Land Trust.
  Debt and Equity Investors.


The interests and concerns of each of the above are considered below.

TENANTS

11.14 Tenants require appropriate accommodation provided by a landlord they trust at an
affordablerent. Tenants are often wary of change and the benefits of any change of
landlord have tobe acceptable to the residents affected. Tenants currently have the right to
veto transfer byway of their ballot and as has been recently seen, if tenants are not
convinced of the benefitsassociated with transfer then the ballot result will be against
transfer.

11.15 In any transfer, and perhaps particularly in any new approaches, tenants first
concern will bethe prospect of rising rents and security of tenure, but to many a further
concern will be thepotential movement of communities as residents are re-housed to
enable regeneration activity.

11.16 Tenants will need to see significant benefits in order to allow this and improved
homes willonly be one part. Total community-wide regeneration with financial assistance to
also targeteducation, employment, crime and health will be needed. Communities will
require sympatheticre-housing and additionally there may be a need to allow tenants to
participate directly inthe benefits from development.

11.17 It cannot be overestimated how vital the tenants support of any new approach would
be.In particular, proposals involving equity or other private investors are likely to be
highlysensitive and potentially an easy target for groups opposing stock transfer. Tenants
wouldneed to be provided with the full facts and allowed choice.

11.18 It needs to be remembered however, that any reconfiguration of estates is likely to
offertenants considerably more choice, not only in the provision of new homes but also
increasedopportunities for mixed tenure accommodation. This combined with a
commitment todeliver sustainable regeneration through health, education and employment
improvementscould secure tenant support, if communication and consultation is clear and
inclusive.

Council Members

11.19 Council Members currently hold the political responsibility for ensuring housing
servicesare provided appropriately and demonstrate that Best Value is obtained by the
public pursein the procurement of these services. Additionally, if the Housing Company,
CLT or otherlandlord were to actively work the land assets and generate development
value then CouncilMembers also have responsibilities to achieve best consideration on the
initial sale of thoseassets. That means that at the time of transfer if the portfolio has
development potentialthen the Council must achieve a sale price which reflects the
potential or alternativelymakes appropriate initial claw-back arrangements. A claw-back
arrangement would protectthe Council and wider public sector from excessive asset and
value leakage to the privatesector over and above the pre-agreed returns.

11.20 From a wider community perspective Council Members do not only require housing
improvementsbut in line with national regeneration policy, require a holistic approach to
improving thelives of residents in more deprived areas. Improvements in education,
employment, crimeprevention and health are now seen as essential bricks and mortar
regeneration is knownnot to work in isolation. The roles of the Housing Company, Trust,
CLT, RSLs and otherorganisations in undertaking wider regeneration activities would need
to be clearly understoodand agreed.

11.21 A local authority also holds municipal powers for planning and compulsory
purchase.Compulsory purchase powers in particular mean that a local authority is uniquely
placedto assist a housing organisation to instigate major development activity.

11.22 Being responsible for housing service procurement Council Members in particular
will wantconfidence in the managing organisations ability to meet the changing needs of
tenantsgoing forward. Councillors and Tenants on the board of the Housing Company or
CLTwould help achieve this.

PUBLIC SECTOR (ODPM/Housing Corporation)

11.23 The wider public sector may have similar concerns regarding stock transfer to
CouncilMembers in that appropriate housing services are to be provided at a reasonable
cost tothe state. The ODPM has stated national policies to provide Decent Homes for all
and thatno one should be disadvantaged because of where they live or who their landlord
is. TheGovernments joined up approach to regeneration is now pivotal to neighbourhood
renewaland stock transfers, in that improvements simply to housing is seen as insufficient.

11.24 Raising money by redeveloping key areas may be currently encouraged, where
funds raisedcan be targeted at education, employment, crime, health as well as physical
developmentworks. What is of political concern would be the leakage of valuable sites from
the publicsector without true value being derived from the transfer. Currently potential value
is notrealisable because RSLs are substantially restricted to maintaining existing estates.

11.25 A number of innovative regeneration schemes have been approved by ODPM, some
underthe auspices of the Estate Renewal Challenge Funding programme. In particular
OptimaCommunity Housing Association, formed specifically to take the transfer of around
2,800properties in Birmingham, undertook wider commercial development activity, which
isbeing used to support neighbourhood renewal in Optimas business plan.

11.26 The Government is likely to require complete assurance that the proposals meet
therequirements and aspirations of local tenants. Disputes with tenants not wishing to
move orfailing to see the benefit of the regeneration proposals would need to be avoided to
ensurestakeholder and lender confidence.

11.27 There are also wider housing related issues for the public sector stakeholders to
considersuch as the need for key worker accommodation. For example, land values in
GreaterLondon are high and hence it is attractive to consider regeneration proposals.
However,these must be implemented with appropriate regard not only for the needs of
tenants butalso nurses, teachers etc who require affordable housing in their area of work.
The need foraffordable housing may be greater than the need for a local authority to unlock
proceedsvia purely private sector development and should be reflected in overall policies.

RSLS/ Housing Company/Community Land Trust

11.28 In any new approach the in-house management team must have the experience and
resourcesto meet tenant expectations, provide appropriate housing services (to meet
current andfuture needs) and also have the ability and freedom to work the underlying land
assets toidentify and exploit potential opportunities. In E&Ys opinion, it is not essential that
theorganisation has direct development resources as it is possible that such experience
can begained indirectly by joint ventures with developers.

11.29 Experienced, professional board members are required, who have the capability and
knowledgeto identify opportunities and negotiate with developer(s). Retaining staff of
appropriateexperience may be dependent on the ability of the organisation to provide
remunerationin line with comparable private sector positions.

Investors

11.30 Investors prime concern is the security of their investment/loans and achieving an
appropriatereturn on that investment. The key to this will be having complete confidence
and in thecase of more investor-driven approaches, some degree of control over the
management ofthe housing organisation.

11.31 Although it has been argued that there is a significant market for structured finance
in propertymanagement firms, it is our belief that equity investors in particular will only
achieve appropriatereturns if the management is able to take on some development related
activity and henceneed higher risk capital from equity investors. If this is the case then
maintaining investorconfidence in the board and senior management is paramount.

11.32 Investors will also want to see value in the underlying assets protected and
discussions withfinance providers has indicated a growing recognition that holistic
regeneration of an areais the key way to ensure the success rather than decline of a
housing area.

11.33 Investors are likely to seek some degree of political reassurances with regard to
stock transfer.The tenants rental income stream underpins the managements core
Business Plan. Policystability would be desirable to investors especially in the area of
rental levels and housingbenefit regulations, obviously this also applies to the present tried
and tested existing stocktransfer regime.

Summary

11.34 As a summary the table below highlights key issues and requirements of each
stakeholder:

Tenants


Council members


Public Sector


RSL/Housing


Investors




(ODPM/HC)
Company/CLT




Decent homes


Best consideration


Best consideration


Robust


Degree of control




for land including


achieved and Best


management


over RSL board and




coverage for


Value for services


board
Management




value uplift




Communities


Best Value for


Financial regulation


Freedom to asset


Access to improved


maintained


provision of


of the RSL


sweat portfolio


returns from RSL
housing services




(directly/indirectly


ability to asset sweat




via developer




involvement)




Rent rises in line
No leakage of


No leakage of


Appropriate


Political stability


with Government


assets to private


assets to private


remuneration for


limited policy change,


policy and


sector


sector


key posts


for example re rent


protected tenure
levels


Holistic


Holistic regeneration


Holistic regeneration


Holistic regeneration


Holistic regeneration


regeneration:




meet national


in order to maintain/


in order to maintain/


employment




policy objectives
enhance underlying


enhance underlying


health




asset values


asset values


crime




education
HOW DO THESE ALTERNATIVE APPROACHES DIFFERFROM THE
PRESENT RSL APPROACH?

11.35 As identified above, two key differences between the new approaches and the
present RSLsystem are the involvement of equity capital and the greater importance
placed on theunderlying assets in the transaction the land. Some of the new proposals
(such as Regent)also seek to bring commercial property management experience to
increase the level offlexibility in managing housing assets and meeting tenant needs. This
may be acceptableto tenants if it results in them receiving a wider choice of better
accommodation.

Equity Capital

11.36 In present models, where development activity is generally restricted to social
housing, theneed for high-risk equity capital does not arise. The current arrangements are
low riskwith tenant rentals effectively guaranteed to ensure business plan projections are
achieved.Structured finance arrangements are appropriate for higher risk activities and the
highercost reflects the risk incurred.

11.37 Only if ODPM and Housing Corporation rules are relaxed to allow increased
developmentactivity and give funders greater control over key management appointments
will structuredfinance really be appropriate. This is likely to have implications for the way in
which theHousing Corporation assesses and regulates RSLs exposure to risk.

11.38 In this regard, the HC would need to review its guidelines for regulating the
non-coreactivities of RSLs, as embodied in Regulating a Diverse Sector.

Land Asset Value Leakage/Local Authority Asset Valuation

11.39 Asset value leakage is a particular issue due to the present approach to determining
thestock transfer price. Assets are currently transferred at a value (Tenanted Market
Valueover 30 years), which has no regard for redevelopment potential. Local authorities
shouldnot enter into transfer arrangements before undertaking a comprehensive review of
theirportfolio to identify future development potential and ensuring that this is
appropriatelyreflected in the stock transfer price and any claw-back arrangements.

Claw-Back Arrangements to the Public Sector

11.40 Given a local authoritys requirement to obtain best consideration for the sale of its
assets,even if the management is giving surplus returns to the community, there may be
the needfor the local authority to have claw-back arrangements. Claw-back arrangements
come intoplay if proceeds generated on sales are beyond the expectations assumed in
determining theoriginal transfer price from the local authority. These arrangements often
run for a set periodof time say 5-10 years perhaps on a sliding scale and would allow the
authority to recoup apre-agreed percentage of the additional proceeds after reasonable
costs.

Regional Variance

11.41 The new approaches may have a significant regional variance in their application.
Thepossibilities to relocate, for example city-centre tenants to create redevelopment sites
withvalues of significant magnitude are far greater than those available in less affluent or
ruralareas. It could be argued that in the areas where there is sufficient demand from
equityinvestors to enter into stock transfer arrangements, the local authorities concerned
wouldbe best identifying potential sites and examining all other available options to secure
fullvalue for the sites. The resulting proceeds could be allocated to regeneration activities.

11.42 It would only be after a review of all available options that the public sector could be
assuredof receiving Best Consideration for the assets. Alternatively, local authorities could
producea masterplan for the area and then use the Housing Company, CLT or RSL to
implementthe plans and hence trap rising value in the area for the local
authority/community.

ALTERNATIVE APPROACH AND ECONOMIC DOWNTURN

11.43 Existing RSLs are generally counter-cyclical businesses, as the economy constricts
and unemploymentincreases, social housing demand generally rises. However, if RSLs
have undertaken commercialdevelopment activity the business may be exposed to risk of
falling property markets. Given thelong term nature of many regeneration projects, markets
may fluctuate. This, added to risksassociated with securing planning consents for projects,
may mean that the price paid to thelocal authority at the time of transfer undervalues the
future development potential and thereforethe public sector bears the cost of those risks by
failing to secure an appropriate developmentvalue. This is a key reason why rigorous
claw-back arrangements would be required.

11.44 In addition the financial track record of RSLs is exemplary with no private lender
havinglost money as a result of lending to an RSL. If RSLs attract equity capital and start
toundertake riskier investment and development activities, the risk profile of the sector
maysubstantially change. This is fully recognised in the Housing Corporation guidelines
onRegulating Diversity by RSLs. In an economic downturn the risk profile of an RSL
undertakingdevelopment activities would change substantially.

11.45 In fact no RSLs have ever gone bankrupt. However, many property developers have.
A keyconsideration in examining the possible changes necessary to the structure of RSLs
to permitdevelopment activity therefore would be how the provision of housing services can
bemaintained and tenants protected if financial problems were encountered. Proposals
such asRegent have suggested the retention by the local authority of a golden share the
protectiontruly offered by such a proposal or any bond guarantee would have to be
examined in detailand shown to offer true protection to the public sector, as well as
tenants, so it does notbecome the ultimate risk taker.
CONCLUSION

11.46 New approaches have to demonstrate value for money and need to ensure that
ultimately,risks do not simply remain with the public sector, through reduced land sale
proceeds withuncertain claw-back arrangements for enhanced values. In situations where
there is developmentvalue, the local authorities may be best placed to develop planning
frameworks and analysedisposal options to ensure optimum receipts are secured by the
public sector. It is possiblethat local authorities and RSLs could initiate not-for-profit
regeneration schemes throughwhich community trusts could have a more significant role.

11.47 However, we believe that proposals such as the Regent Model and CLT do raise
importantissues for further consideration and where perhaps ideas could be transferred to
existingmodels of stock transfer landlords. These include:


  RSL management boards must be robust and gain and maintain the confidence
   ofinvestors (lenders).
  Value from the national housing portfolio should be further utilised for the benefit
   oftenants and local communities. Local authorities could review their housing
   propertyand land portfolios to identify redevelopment value and identify options to
   secure BestConsideration for key sites.
  Holistic regeneration is necessary and required by all key stakeholders in the
   stocktransfer process.


11.48 The discussion above has identified a number of potential difficulties with the
alternativemodels. But notwithstanding these, we believe that there may be merit in some
of the newproposals to improve social housing in deprived areas. However, we could
envisage localauthorities being more proactive in identifying regeneration options and then
seeking privatesector partners to take on appropriate development risk, either in
partnership with a localauthority or as part of an RSL consortia on transfer.

11.49 A further option is to allow landlords based on new models such as Regents to
compete openlywith other RSLs to become the recipient landlord and so allow communities
to expresstheir preference. If this occurred then it would be the potential new landlords
challenge toconvince local authorities and tenants regarding the value of their proposals
and demonstratewhether their proposals can provide greater benefit than RSL
organisations.
Appendix I - ODPM Workshop 26th June 2001
IN ATTENDANCE

Simon Llewellyn ODPM
Tom Oscroft ODPM
Richard Clarkson ODPM
Gill Rowley The Housing Corporation
Mary Marshall Community Housing Task Force
Ms Barbara Ainger Ernst & Young
Dougald Middleton Ernst & Young
Bruce Mew Ernst & Young

The purpose of the workshop was to draw on the wide range of experience of the
processfor, and funding of, stock transfers and to identify the strengths and weaknesses of
thedemand and supply for funding.

SUPPLY OF FUNDING

Strengths

  All stock transfers have been funded raising a total of around £9.3bn for
   approximately117 stock transfers since 1988.
  The suppliers of funding have shown the ability and willingness to absorb the
   adverserisks that have arisen since 1988 including falling Right to Buys, low inflation,
   highinterest rates, the removal of Section 54 grant, and rent restructuring.
  Loan covenants are generally reset each year reflecting the development of their
   borrowersbusiness plan.
  Loans are relatively finely priced.
  No loan defaults have been called by lenders, although they will certainly have
   hadgrounds to do so.
  Funders have shown a willingness to adapt to new transactions and structures,
   includingfunding negative value transfers.

Weaknesses

  A limited number of funders exist and bank mergers may reduce this number further.
  Relatively little innovation has taken place since 1988, with a noticeable
   underrepresentation of the capital markets.
  Transactions with a weak credit status often only receive one consortium offer of
   funding.
  Arrangement fees are relatively high, and have shown considerable resistance toany
   reduction.
  The returns received by funders are not transparent, particularly for swaps, fixedinterest
   breakage costs and refinancing costs.
DEMAND FOR FUNDING (LSVT BORROWERS)

Strengths

  Loans to LSVT Registered Social Landlords secured on residential property have
   acapital weighting of 50%.
  The discount rate used to determine the purchase price.
  The borrowers belong to a Government regulated sector.
  Borrowers generally require a large initial drawdown to fund the purchase price, this
   isvery attractive to lenders.
  The treasury management requirements of LSVT borrowers are attractive to lenders.
  Negligible default history and a growing performance track record.
  Considerable flexibility exists within a 30 year business plan and loan term to rectifyany
   financial underperformance.

Weaknesses

  Naïve borrowers, every deal is funded individually with inexperienced boards.
  Appears to be little mechanism for disseminating funding lessons learnt.
  Poor financial and funding advisers in some cases, low fees do not allow top
   qualitystructuring and funding advice.
  Finance Director often not appointed early enough in the process.
  Little incentive to innovate.
  LSVT transactions are not readily appropriate for partial funding.
  LSVT RSLs have escalating debt profiles, requiring undrawn loan facilities for anumber
   of years.
  Subject to political risk.
  Basel II may create wider credit differentiation, with a commensurate effect on price.
  Once transfer complete sponsoring local authority has no residual stake (other
   thanboard members) and currently does not participate in the benefits of refinancing.
Appendix II - Questionnaire to banks and building societies
1. Name of organisation

2. Name and position

3. Exposure to LSVTs


  Commitments outstanding.
  Drawn balances.
  Other products offered, for example derivatives.
  What determines your level of exposure to the sector?


4. Appetite to advance further funding to LSVTs


  Shire District transfers.
  Poorer Urban Stock transfers.
  What market factors would lead you to increase your exposure to LSVTs?


5. What credit assessment criteria do you use in reviewing LSVT funding proposals?

    Do you consider LSVTs to be primarily a

1) Property risk or,

2) A project cash flow risk.

What Credit Risk Assessment Methodology do you use?

6. What returns calculation methodology do you use?


  Risk Adjusted Return On Capital (RAROC).
  Risk Adjusted Return On Risk Capital (RARORC).
  Other.


7. What are you thoughts on the potential implications of Basel 2 on your returns from
LSVTs?

8. What are your thoughts on the implications of consolidation of leading LSVT funders?
  Halifax/BoS.
  RBS/Natwest.


9. Please let us have your views on the current LSVT process


  Timescales.
  Standards of advisers.
  Degree of innovation.
  Timing of funders involvement.
  Competition for funding.
  Quality and quantity of information provided by funding advisers.


10. Do you have any suggestions as to improvements that would encourage you to
increaseyour exposure?


  Procedural.
  Structural:
Price calculation


Cash flow, for example involvement of sub-debt
  Precedents from PFI/Scottish system for stock transfers.


Do you have any radical suggestions/proposals to improve the attractiveness of LSVTs to
funders?

11. Do you have any other views/observations on poorer urban stock transfers to
encourage youto increase your exposure to them?


  Risk allocation.
  Demand studies.
  Procurement and implementation of investment programmes.
  Size of funding requirement.
  Other.


12. How do you think the market will develop in the absence of changes to the process?
 Implications of recent transfers experience, for example Coventry, Sunderland.
 Changes to covenants/ratios.
 Full v partial funding at transfer.
 Other potential developments.
Appendix III - Questionnaire to LSVT borrowers
1. Name of Organisation

2. Name and position of interviewee

3. Size of original loan facility, size of expected loan facility, size of loan facility now

4. Strategy in fund raising process


  Debt.
  Other styles of funding.


5. Number of funding offers received/expected


  Types of funding offers received/expected.
  Form of competition.


6. Satisfaction with original loan package


  Pricing.
  Flexibility.
  Covenants.
  Any trade-offs accepted.
  Post completion relationship with funders.


7. Views on role of ODPM/Housing Corporation/local authority in fund raising process

8. Views on fund raising process generally

9. Standard of funding advice received


  How selected.
  Value for money.


10. Views on full or partial funding at time of transfer
11. Understanding of funding package at time of transfer


  Timing of appointment of Finance Director.


12. Post transfer experience


  Out-performance of business plan.
  Risks encountered:
Demand issues.


Procurement and implementation of investment programme.
  Number of refinancings undertaken.
  Benefits of refinancing(s) and options considered at the time.


13. Any other views/experiences
Appendix IV - Organisations contacted to ascertain their views
Royal Bank of Scotland
Halifax plc
Bank of Scotland
Nationwide Building Society
Abbey National Treasury Services
Bradford & Bingley Plc
Barclays Bank Plc
Lloyds TSB Bank Plc
Britannia Building Society
HSBC
Helaba
Hypo Vereinsbank
BN Paribas
Dexia
KBC Bank
Nomura
Royal Bank of Canada
ABN AMRO
Dresdner Kleinwort Wasserstein
Morgan Stanley
NM Rothschilds & Sons Ltd
PUK
Standard & Poors
Freud Lemos
Regent Pacific Group
Sector Treasury Services
Hacas Exchequer Services
AMBAC International
Beacon Housing Association
Sheffield City Council
Burnley & Padiham Community Housing
National Housing Federation
Council of Mortgage Lenders
Trowers & Hamlins
Jenkins & Hand
Appendix V - Banks and building societies assessment of
return on loans to LSVT RSLs
INTRODUCTION

Banks and building societies receive a significant number of lending proposals every
year.Each lending proposition has to compete with other lending opportunities for the
lendersscarce and theoretically expensive capital.

The purpose of this appendix is to outline how leading lenders to the LSVT sector
wouldassess the potential returns arising from the lending proposition. It begins by
consideringthe requirements of the lenders regulators for the maintenance of adequate
levels of capitalto meet the potential loses arising from the loan.

The appendix then considers how returns would be measured against the capital set
asideto meet the potential losses.

Finally, it looks at the lenders cost of funding loans to LSVT RSLs and how a hurdle
ratemight be established to identify transactions that add to the lenders shareholder value.

This Appendix should be read in conjunction with the sections earlier in the report
discussingBasel II, which when implemented, is likely to codify a number of existing capital
adequacy practices.

CAPITAL ADEQUACY

Capital adequacy aims at setting a minimum level for a lenders capital base as a function
ofrisks. A bank and building societys capital base is not limited to equity plus retained
earnings;it includes any debt, which is subordinated to its other commitments.

The Cooke ratio is an industry measure which is used to assess the minimum
requiredcapital as a fixed percentage of assets weighted according to their nature and is
designed tocater for credit risk. In the calculation of this ratio, assets are weighted
according to theirquality in terms of credit standing.

The rating scale starts at zero, for commitments with public counter parties up to 100%
forcorporates. Other weights are 20% for banks and municipalities within OECD
countries,and 50% for mortgage backed loans, including loans to Registered Social
Landlords (RSLs)secured by a fixed charge over residential property let to a tenant.

The Bank of England stipulates that a banks capital base should be at least 8% of
weightedassets. For building societies this was set by the Building Societies Commission,
and now bythe Securities and Futures Authority, at around 10%.

Without capital, banks and building societies would fail at the first loss not covered by
baddebt provisions.

RISK: RETURN EQUATION

Each new proposition brings risk and the risk:return equation arising from the
lendingproposition, should subject to other strategic priorities, meet the lenders targets.

If the lender only considers the potential returns arising from a lending proposition, and
theassociated risks part of the equation is ignored, a number of important issues cannot
beaddressed. These include:


  the performance of individual transactions and business units, may not be
   fullycompared without adjustment for their inherent risks;
  the assessment and pricing of the risks of lending to counter parties is uncertain; and
  the optimal allocation of the banks total risk exposure to business units or transactions.

RISK-ADJUSTED PROFITABILITY

Risk-adjusted profitability measures seek to address the issues raised in the previous
paragraph.

The main functions of such measures are:


  the reporting and comparison of profitability and risk across business units, productsand
   customers;
  measurement of transactions and portfolios against profitability targets;
  aid pricing of risks; and
  the allocation of the lenders capital across business units, products and
   customers,based on the risk reward profile.


This allocation of risk and capital is firstly at the strategic level of lending to different
sectors,for example corporates, public authorities, Private Finance Initiative transactions,
RegisteredSocial Landlords and other types of borrowers. Through the allocation of risk
and capital,a bank is able to establish exposure limits and target returns for each sector.

Secondly there may be a balancing between different loan portfolios within a business
unit,for example between portfolios of loans within the banks corporate lending division.

Allocation of risk within a lenders portfolio of loans to a particular sector, for examplea
lenders loan portfolio to RSLs may be sub-divided into traditional associations andLSVT
landlords.

Risk should be allocated to individual borrowers to ascertain target returns and
exposurelimits for each borrower. However, there may be some lending propositions
where, whateverthe potential returns, the lender is not prepared to accept the inherent
risks. This has beenseen where some high risk, negative value, poorer urban stock
transfers received very fewfunding proposals.

REGULATORY AND ECONOMIC CAPITAL

There are two measures used by lenders to assess the amount of capital that has to
beassigned to support their lending activities, regulatory and economic capital.

Regulatory capital
Some lenders use relatively simple methods to measure the risk: return equation. They
maycompare total interest and fees, net of costs and expenses, with the level of
regulatorycapital that has to be set aside in accordance with the Bank of England/FSAs
requirements,to cover the possible losses arising from the potential loan.

Using this approach, the calculation to determine the amount of regulatory capital
requiredto support a loan to an RSL would be:


  Amount of Loan x Capital Adequacy requirement x Risk Weighting of Asset.
  For a loan of £1m to an RSL assuming an 8% Capital Adequacy requirement, thiswould
   be:

    £1m x 8% x 50% = £40,000.

Economic capital
The methodology of adjusting a banks capital for the risks inherent in a funding
propositionis based on determining the level of Economic Capital or Capital at Risk (CAR)
from thepotential losses arising from individual lending propositions, business units or the
banksentire portfolio.

Funding propositions with strong counterparties (for example large, financially
strong,established RSLs, with unencumbered reserves) will appear more attractive based
on riskadjusted returns than based on regulatory capital, because they will be deemed to
require lesseconomic capital. In contrast, riskier propositions with poorer counterparties (for
examplenew RSLs with no reserves or track record) are advantaged when regulatory
capital is used,because under an economic capital methodology they would require more
capital.

Economic capital is intended to correct such distortions and is defined as the amount
ofcapital that the bank needs to set aside for the potential loses (expected and
unexpected)arising from its loan facilities, (including derivatives) to borrowers.

The calculation to determine the amount of Economic Capital required to support a loanto
an RSL would be:


  Amount of Loan x Capital Adequacy requirement x Economic Capital requirement.
For a loan of £1m to a weak RSL taking the transfer of stock in a poorer urban
area,assuming an 8% Capital Adequacy requirement, this might be:

    £1m x 8% x 75% = £60,000.

Regulatory v economic capital a comparison
The simplest way of defining CAR is to use the regulatory capital requirements of the
Bankof England for banks or the Securities and Futures Authority for building societies.

Simplistically, there would appear to be no need to be more accurate than the
regulatorsrequirements. However, using regulatory capital as a substitute for economic
capital resultsin important distortions because of the divergence between the real risks
arising from lendingpropositions and the forfeited risks of regulatory capital. For regulation
purposes, the amountof capital to be set aside is dependent on outstanding balances
(amounts at risk), and on asmall number of categories of counter parties, including loans to
RSLs.

With regulatory capital, credit risk is identical for short-term and long-term loans, in spiteof
the obviously higher risk in the case of long-term loans. Most loans to LSVT RSLs arefor
25 to 30 years and should carry a higher capital requirement than say 5-year loans tothe
same borrower.

The regulatory capital requirement for LSVT RSLs is the same for all loans to RSLs
securedon residential property, regardless of whether they are LSVTs and their individual
creditstanding. In the case of an LSVT for a poorer urban stock, a loan to a financially
strong,well established existing RSL, with substantial unencumbered reserves, has the
same regulatorycapital requirement as lending to a newly formed RSL with no track record
and no reserves.Thus regulatory capital fails to reflect the real risks to the lender of two
very differentstrength potential borrowers.

Whilst LSVT RSLs are members of a regulated sector, and therefore one could argue
thatthe credit standing of the two RSLs described in the previous sentence should have
relativelysimilar credit standing, this clearly fails to recognise the significant gap in potential
defaultrates between the two borrowers.

Finally, the regulatory capital requirement measures risk over a portfolio of loans, by
simplyadding together the individual credit risks ie, the sum of the 50% Cooke ratio
requirementsfor drawn balances to RSLs in the portfolio. This ignores the diversification
effects and resultsin the same measure of risk for all loans in a widely diversified portfolio,
such as loans toLSVT RSLs.

RAROC MEASURES

The ratios used to calculate risk-adjusted returns are known as RAROC or RARORC.
Theyare very similar, but either use regulatory capital or economic capital (Capital at Risk).
Theyare normally calculated on a before tax basis. This is on the premise that a banks
lendingoperations has little or no influence over its tax policy and liability.

RAROC or Risk-Adjusted Return On Capital adjusts the returns for risks, for instance
bycalculating returns net of statistically expected defaults.

The RARORC or Risk-Adjusted Return On Risk Capital is profitability arising from
theproposition, loan or portfolio of loans, calculated on Capital at Risk.

These measures are designed to contribute to a banks shareholder value, by steering
theoverall credit portfolio towards a more optimal risk/return balance. However, a
fundingproposition that meets risk adjusted return requirements does not necessarily make
it agood deal.

Risk Adjusted Return On Capital (RAROC)
The RAROC ratio adjusts the earnings to the bank over the expected life of the loan tothe
LSVT RSL and uses regulatory capital as a measure of the banks capital required
tosupport the loan.

The RAROC calculation becomes:

Present Value of Risk Adjusted Net Earnings less Losses arising from statistically
expecteddefaults/Regulatory Capital.

Calculation of risk-adjusted net returns
A banks earnings for a loan to an LSVT RSL would include Arrangement Fees,
CommitmentFees (if payable by the LSVT RSL), Interest Margin, Renewal Fees, and
Annual MonitoringFees etc. These would be calculated for each year of the loan period
using the loans expecteddraw down and repayment profile.

Where a relatively large Arrangement Fee is received with commensurately lower
initialinterest margins, the model may amortise the Arrangement Fee over an appropriate
numberof years.

The financial model may use either nominal (projected outturn) prices or real cash
flows.For positive value LSVTs the loan profile is relatively standard, with a peak debt in
years12-15 and repayment between years 25 and 30.

From the annual net interest and fee income, is deducted the lenders costs, including:


  Servicing the loan.
  Marketing costs.
  Loan administration cost.
  Client relationship management.
  Back office costs.
  An allocation of central overheads to cover credit department and other costs.
All of these costs will be projected forward for the entire period of the loan, along
withassumptions for annual increases.

Credit grading of LSVT RSLs
In order to risk-adjust annual returns, the bank has to risk assess or grade the
potentialLSVT RSL. This may be done in a variety of ways, including subjective judgement
or ananalytical methodology. In this respect Basel II accepts the principle of Internal
RatingBased (IRB) approaches.

One approach may be to compare a new LSVT proposition with industry
performancestandards (including those published by the Housing Corporation) or the
banks internalexperience of LSVT borrowers, to ascertain a comparative measure of risk.

Alternatively, a relatively sophisticated credit rating method may be used to compare
thepotential LSVT borrower and its funding proposition against a number of factors to
determinea weighted average rating. Each factor may have a weighting to reflect its
importance ordegree of risk.

The factors that may be considered include:


  constitution;
  political and tenant support for the transaction;
  experience, expertise and composition of the board;
  recourse to unencumbered assets and reserves of a large, financially strong RSL;
  executive management skills and experience;
  management understanding and ownership of the organisations business plan;
  standard of advisers;
  size of organisation;
  secured or unsecured facility;
  number and type of properties being given as security (proportion of flats,
   shelteredaccommodation etc);
  demand for the recipient landlords properties;
  construction programme and risk;
  social inclusion challenges facing the potential borrower;
  degree of intended diversification into non-core activities;
  rent levels;
  purchase price being paid;
  perceived margin of comfort/flexibility in potential borrowers business plan; and
  valuation for loan security headroom.


Once the weighted rating of the potential borrower is established (and perhaps agreed
withthe banks internal and independent credit function) this can be used to ascertain a
shadowcredit rating. This would be achieved by comparing the internal weighted rating to a
tableof shadow ratings from a recognised credit rating agency. Given the role of the
HousingCorporation and its strict regulation and monitoring criteria, one might expect these
shadowratings to fall in a relatively narrow range.

When a shadow rating for a funding proposition is ascertained, the bank is able to add
anappropriate interest margin to a risk free rate to derive a risk-adjusted interest rate.
Thisappropriate interest margin is such as to increase the risk free rate to a level reflecting
therisk attaching to a transaction with the risk profile of the funding proposition.

The risk free rate may be the Gross Redemption Yield on UK Government gilts with
asimilar maturity to the average life of the loan. The average life of the loan will be less
thanthe final repayment date of the loan because of the loans amortising profile.

This risk-adjusted interest rate is used to discount the cash flow of the banks future
netearnings to a present value.

Loss severity
Given this potential default guideline, the severity of the banks loss that would result froma
default scenario, needs to be ascertained. This is generally a matter of the judgement ofthe
lending officers and the independent credit function. In the case of LSVT RSLs, degreesof
severity would be determined by the location, standard and quality of properties
beingacquired by the borrower and charged to the lender as security. Properties
(particularlymulti storey flats) in poorer urban areas are unlikely to score highly in contrast
to 3 bedroomsemi-detached houses in market towns.

The severity loss rating would normally be the percentage of the total loan facility
outstandingthat would be lost by the lender at the time of default. Independent valuers
would have animportant role in determining the open market vacant possession value of a
phased disposalof void sales.

The lending bank would determine the amount of capital arising from the LSVT
lendingproposition that it has to earmark for unexpected losses.

Statistically expected defaults arising from the funding proposition are derived from
theshadow credit rating and historic data of losses arising from borrowers with that grade
overthe life of the proposed loan facility. In the case of LSVT RSLs losses arising from
statisticallyexpected defaults might be relatively small given the performance track record
of the sectorand the role of the Housing Corporation in arranging transfers of engagements
of ailingRSLs. In this respect the losses experienced by the lenders to LSVT RSLs, might
provideuseful background.

The risk-adjusted present value of the banks future net returns less the losses arising
fromstatistically expected defaults, is divided by the amount of regulatory capital required
tosupport the loan to determine the RAROC of the funding proposition.

Risk Adjusted Return On Risk Capital (RARORC)
The RARORC calculation is:

Present Value of Risk Adjusted Net Earnings less Losses arising from statistically
expecteddefaults/Risk Adjusted Capital (CAR)
The shadow ratings outlined in the previous section, would enable the bank to refer to
arating agencys table of potential default risk. It should be recognised that the potential
ofborrower default increases with the period of the loan facility. So in this respect,
notwithstandingthe role of the Housing Corporation in arranging transfers of engagements,
LSVT RSLswith 25 to 30 year facilities may have a relatively high default risk potential.

Given that banks do not publicise their default history for borrowers, nor have they
creditgraded all borrowers in the past, the reference table will probably relate to public
capitalmarket issues, particularly debt issues. These public issues are often rated by a
recognisedrating agency and as they are listed instruments on a recognised Stock
Exchange, theredefault history is readily available.

Hurdle rates and the lenders cost of funding
Simplistically, each lender has a rate of return (generally in terms of a percentage)
whichmarks the watershed between a lending proposition being worth undertaking and not.
Thepercentage may be on a risk-adjusted basis as discussed above. If the lending
propositionsreturn were higher than the hurdle rate then the lender would be creating
shareholdervalue by providing the loan. If the return from the lending proposition is less
than the hurdlerate it would (absent of other profitable transactions with the borrower) be
destroyingshareholder value if it undertakes the transaction.

Hurdle rates may be set at artificially low levels where the lending proposition is seen
asbeing of strategic importance for the lender. Loans to LSVT RSLs are unlikely to be seen
asstrategic for lenders as the market for these loans is mature having been developed
since1988 with around £9.3bn of loans outstanding.

Capital asset pricing model
The Capital Asset Pricing Model (CAPM) provides a useful guide as to the return a
lenderhas to earn on a lending proposition in order to justify the assignment of capital to
the loan.

Using the CAPM, the cost of equity for a lender may be defined as:

    R = rf + Brm

Where, rf is the risk free rate of return, rm represents the market risk premium and B(beta)
is the systematic risk of investing in that share.

The risk free rate of return is generally taken as the return that an investor can achieve
byinvesting in UK government securities (gilts). Loans to LSVT RSLs are looking at
futurecashflows, so we look at returns on gilts over the length of the lending proposition.
For loansto LSVT RSLs where the loans are generally for 25 to 30 years, returns on gilts of
this maturitymay be used. However, if the loan were expected to be refinanced in say 5 or
10 years, returnson gilts of this maturity would be used. Given the relatively flat shape of
the current yieldcurve, the difference between yields on short and long dated gilts, is not
significant.
The beta of a share measures the relationship between changes in an individual share
priceand the changes in the underlying share index. It measures the systematic risk taken
whenan investor buys that share and identifies to what extent the share price of that share
willmove in line with the market. The higher a shares beta, the riskier the share. A share
havinga beta greater than one will generally move more than the market and is sometimes
describedas a volatile share. A share having a beta of less than one generally moves less
than the marketand is sometimes thought of as a defensive share. Betas are generally
calculated using historicdata over a 60 month moving average. This time horizon is often
used as it generally containsa full business cycle.

The market risk premium represents the additional return an investor can obtain
frominvesting in equities as compared with risk-free alternatives such as government gilts.
Estimatesof market risk premium can be either forward or backward looking. This reflects
what an institutional investor needs to give up for the relative security of the bond market
for themore uncertain equity market.

Leading equity market commentators (including Ernst & Young), and the London
BusinessSchool prepare estimates of the market risk premium. Looking backwards, ABN
Amro andthe London Business School calculate that over the last 100 years the nominal
market riskpremium has been 5.8% and 5.3% on a real basis.

Barclays Capital calculate that real market risk premia have been as follows:

10 years                                                   2.4%

20 years                                                   4.1%

50 years                                                   6.5%

101 years                                                  4.4%

Credit Suisse First Boston calculates that the nominal market risk premium during
theperiod 1918 to 2000 was 5.9% and 5.7% on a real basis.

Ernst & Young currently uses a nominal market risk premium of 6%, and being close to
therange of views outlined above, this figure will be used in the calculation below.

In order to determine whether a lending proposition adds to shareholder value, the cost
ofthe lenders debt needs to be included in the calculation of the lenders overall
WeightedAverage Cost of Capital (WACC). This is because a lenders capital base is not
composedpurely of equity. The calculation can be represented as follows:

Lenders WACC

    Risk free cost of debt + (market risk premium x Beta factor) = Cost of Equity

Risk free cost of debt + premium over risk free rate = Cost of Debt
Lenders Weighted Average Cost of Capital equals:

    Cost of Equity x Equity as a % of market value of total capital
+
Cost of Debt x (1 Tax rate) x Debt as a % of market value of total capital

Debt raised by the lender as part of its capital base to support its lending operations
carriesa tax shield because the interest payable on such debt is deductible before the
lenderstaxable profits for Corporation Tax purposes are calculated.

WORKED EXAMPLE (AS AT 28TH FEBRUARY 2002)

Cost of equity

    Risk free cost of debt = Gross Redemption Yield (GRY) on long gilt = 4.8%

Market Risk Premium = 6% see above

Beta for leading LSVT lenders (From London Business School) ranges between 0.80 and
1.11,so for the purposes of this worked example we will use 1.0

    Cost of Equity = 4.8% +(6.0% x 1.0) = 10.8%


Cost of debt

    Risk free cost of debt = 4.8%

Premium over gilts for long dated sub-ordinated debt for a leading LSVT lender(for
example HBOS or Abbey National)= 1.0%

Cost of debt = 5.9%


WACC

WACC for a leading LSVT lender assuming a capital structure of 66% equity/34% debt:

    Cost of equity x 66% = 7.13%

Cost of debt x (1 Corporation Tax rate) x 34% = 5.9% x (1 30%) x 34% = 1.40%

WACC = 7.13% + 1.40%= 8.53%

From WACC to hurdle rate
If the LSVT RSL lending proposition is not risk adjusted, this WACC would need to
beincreased by the credit risk attaching to the LSVT RSL. The extent of this credit
spreadwould need to be estimated, perhaps using the spread over gilt yields for structured
andunstructured capital markets issues for LSVT RSLs.
Appendix VI - Funders main observations on funding stock
transfers
BANKS/BUILDING SOCIETIES

1. Margins and pricing generally declined to levels that make loans to LSVT RSLs
ofmarginal or insufficient attraction given the long-term nature of the funding requirement.


2. Government support (housing benefit) and role of Housing Corporation as regulator
isvery important.


3. The consolidation of leading funders could be beneficial if it reduces the number
offunders and causes interest margins and pricing to rise.


4. Timescales are too short and funders are involved too late in the transfer process.


5. The standard of advisers and information is very variable.


6. PFI style repairs and maintenance contracts may be useful in poorer urban stocks
giventhe risk attaching to construction cost inflation.


7. Exclusive underwritten Banks/building societies deals are unpopular with funders
whoare not involved.


8. Political risk is significant and perhaps the largest risk to the sector.


9. The number of syndication participants has declined to a negligible number and
thosethat exist have relatively small capacity.


10. Minimal innovation has occurred apart from that promoted by funders.


11. There is a need to learn from the lessons of problem LSVTs.


12. Whilst LSVT transactions are seen primarily as cash flow transactions with
residentialproperty backing, asset cover is becoming an increasing problem.


13. The views on the potential implications of Basel II are variable.


14. Tenant controlled boards are unpopular.


15. Some funders would like a larger LSVT programme to increase funding
requirementsand interest margins receivable.


16. Land sale risk would be unacceptable to some funders.


17. The long-term financial viability of LSVT borrowers particularly in poorer urban
areasneeds to receive more emphasis in developing business plans.

INVESTMENT BANKS

1. Public sector could take more initial risk in return for further consideration later.


2. Creation of a central securitisation vehicle could be useful perhaps sponsored by
PUK,with other funders providing different layers of debt.


3. Partially funded transactions on the day of transfer are seen as too risky particularly in
amarket with a limited number of funders.


4. Bonds could be held by the public sector sponsor of the transfer and sold off later by
atender process.


5. Monitoring of guaranteed loans to LSVT RSLs taking more time than anticipated
bymono-line insurers.


6. Securitisation of bank/building society loans to LSVT RSLs should be looked at to freeup
capital.


7. As in health PFI schemes, LSVT RSLs with a funding requirement above a certainlevel
(say £150m) could be required to review the efficacy of bond finance.
8. A private bond market may be developing for sizes of £30m to £100m.
Appendix VII - LSVT generic illustrative risk matrix
RISK TYPE     RISK                     LIKELIHOOD OF THE RISK   IMPACT OF RISK OCCUR
                                              OCCURING

                                     HIGHMEDIUMLOWPROBABILITYHIGHMEDIUMLOWINCRE
                                                      %                      COS
                                                                           REDU
                                                                            INCO

INVESTMENT    Stock Condition
STRATEGY      information may be
              inaccurate.

              Investment
              strategies may not
              be coordinated with
              other strategies in
              the area such as
              urban renewal,
              education, crime
              prevention.

              Investment
              expenditure may not
              be sustainable ie,
              need to be repeated
              before the end of
              the expected useful
              life of building
              components.

              The investment
              strategy may not
              have sufficient
              flexibility to meet
              changing needs, for
              example in levels of
              demand, tender
              prices, tenant
              requirements. It
              may focus too
              closely on the short
              term and a static
              model of the
              housing stock.

              Delays may occur at
              preliminary and
              tendering stages
              which hold up the
              implementation of
              the investment
              programme.

              Investment strategy
              may not recognise
              the revenue
              implications of
              investment
              proposals.

              Full decant
              requirements may
              not be built into the
              business plan
              and/or investment
              costs, including
              buying out
              leaseholders.

              Leaseholders may
              share common
              areas with tenants
              and may not be
              willing to pay their
              share of repair
              costs.

              Investment strategy
              may not be
              appropriately linked
              to demand patterns
              thereby resulting in
              investment being
              undertaken on
              properties for which
              there is not long
              term sustainable
              demand.

PROCUREMENT Capital programme
may not be
delivered within time
and budget
therefore failing to
meet the
undertakings to
tenants and funders
asset value
requirements. This
may be caused by
one or more of the
following risks.

There may not be
enough contractors
in the area with the
experience to
deliver the large
scale contracts
required by the
transfer, this could
result in the
investment being
delayed or more
costly than the
business plan
assumptions.

There may be
insufficient project
management
capacity available to
the recipient RSL, to
ensure that the
required large scale
contracts are let and
operated efficiently.

Funders conditions
precedent to
drawdown may not
be met by recipient
RSL, causing cash
flow problems for
RSL.

The receiving
         landlord may be tied
         to contracts with
         direct service
         organisations if
         these organisations
         under perform they
         may expose the
         RSL to financial
         risks.

         The large number of
         contracts involved
         may result in tender
         price inflation above
         the levels assumed
         in stock condition
         surveys/investment
         programmes. Poor
         market intelligence
         may result in
         contracts being
         poorly packaged
         and let at prices
         which are higher
         than necessary.

         Contractors may
         experience financial
         failure resulting in
         an inability to deliver
         the full investment
         programme.

DEMAND   The demand
         analysis on which
         the business plan is
         based may be over
         optimistic, this may
         be caused by one or
         more of the
         following risks.

         Certain areas of
         stock may
         experience
         collapsing demand,
         for example as a
              result of changes in
              the economy or as a
              result of
              popularity/reputation
              issues, thereby
              reducing the income
              available to the
              recipient landlord.

              The contracts may
              not build in sufficient
              quality and
              commitment to
              continuous
              improvement, for
              example Egan
              principles.

FINANCIAL     Interest rate risk
MARKET AND    and counter party
OPERATIONAL   risk may result in
              increased costs for
              the RSL. Inflation
              risk may cause
              income to increase
              less than expected
              in the business
              plan.

POLICY RISK   Business Plans may
              be exposed to
              future changes in
              the VAT regime.

              Changes in Right to
              Buy (RTB)
              legislation could
              reduce income or
              reduce stock.

MARKET        Loan conditions
              imposed by funders
              are onerous in
              relation to delivering
              tenant guarantees
              and expected
              commitments to the
             local authority.

MANAGEMENT   Local authorities are
             likely to self insure
             many risks RSLs
             will not have the
             capacity to do this
             to the same extent.

             Any delays in
             excess of that
             assumed in the
             RSLs business plan
             in processing
             housing benefit by
             the local authority
             will impact on the
             RSLs income.

             Void levels and/or
             arrears may
             increase above the
             levels assumed in
             the business plan.

             Rents may not be
             set at an
             appropriate level to
             ensure continued
             demand and
             affordability.

             Receiving landlord
             may fail to meet the
             priorities of the local
             authority, resulting
             in lack of
             commitment from
             the local authority.

             Management
             structures
             established
             (including
             subsidiaries) may
             fail to meet the
             balance with
              economies of scale
              and governance
              requirements.

              The receiving
              landlord may not be
              able deliver on
              regulatory
              standards, for
              example in relation
              to energy efficiency,
              health and safety,
              and meeting decent
              home targets.

              The receiving
              landlord may be
              required to take on
              existing contracts
              which it has not
              negotiated, the
              terms of which may
              not be
              advantageous, for
              example in relation
              to asylum seekers.

CHANGE-OVER   Handover data in
              relation to rents,
              stock and costs may
              be inaccurate, any
              split of stock may
              introduce additional
              risks.

              Staff skills may not
              match the profile
              required by the
              receiving landlord.

              Receiving landlord
              may fail to meet
              registration
              requirements.

              The board of the
              receiving landlord
may not have
sufficient skills to
efficiently and
effectively manage
the organisation.

Pre transfer
settlements with the
local authority may
be onerous, for
example on RTB
receipts or arrears
resulting in too high
a purchase price
being paid by the
recipient landlord.

Information on
additional property
forming part of the
transfer may be
inadequate (for
example
commercial
property, garages,
roads and
footpaths), causing
the RSLs business
plan to
underestimate the
costs of future
maintenance.

Funders due
diligence may
uncover further
liabilities for the
recipient landlord.

Title to the stock
may not be clean
leading to delays
and additional costs
and also potential
difficulties with
implementing the
investment
                programme.

                Receiving landlord
                may fail to develop
                a package which
                balances an
                attractive tenant
                package and
                prudent business
                planning.

ENVIRONMENTALLand contamination
             may be discovered
             beneath or close to
             transferring stock or
             development land.
             This can be a
             significant risk
             which the recipient
             landlord is unable to
             absorb. These are
             generally covered
             by a warranty from
             the vendor local
             authority who may
             arrange specialist
             insurance to cover
             its liability under
             such warranty.
Appendix VIII - Leaseholder risk to LSVT RSLs in poorer urban
and large metropolitan stock transfers
INTRODUCTION

The purpose of this appendix is to outline the risks to transfer organisations in assuming
theobligation for repairing and improving properties, which contain both leaseholders
(otherwiseknown as owner occupiers) and tenants. The implications for recipient RSLs of
decantingboth tenants and leaseholders, particularly in blocks of properties earmarked for
demolition,are considered. It also examines potential mitigation strategies that stock
transfer RSLs maybe able to pursue in order to reduce the risks associated with properties
involving leaseholders.

BACKGROUND

Tenants in Council property have the right to purchase their property at a discount to the
openmarket value, related to the number of years of residence. There are now around
200,000properties throughout England where a local authority or transfer RSL is the
freeholder(included in this number is a significant number in urban and large metropolitan
areas).This means that responsibility for the cost of repairing common (shared) elements of
theproperty lies with both the Council (or RSL in the case of a stock transfer) and the
leaseholderswithin the block.

Most owners of flats, which were formerly Council property, will be leaseholders. The
Councilwould retain the freehold, which would be transferred to the recipient RSL in
transfer of thehousing stock. Ownership of the freehold will provide certain rights to the
landlord. Thesewill normally include the ability to levy reasonable service charges to cover
costs related torepair, maintenance and communal services such as landscaping and stair
cleaning. Thefreeholder will then be responsible for the provision of these services. The
lease with eachleaseholder will determine the rights and responsibilities of each party. If
the freehold istransferred to the RSL as part of the housing transfer it is highly likely that
these rightswill also transfer.

Whilst elements of the repair and improvement of the property subject to service chargesto
leaseholders depend on the terms of individual leases, but can include roof repair
orreplacement, insulation, works to the common stairs and similar works.

Recipient landlords will face a number of issues in relation to the leasehold arrangements:


  The leaseholder may only be responsible for certain types of work and may not be
   responsiblefor payments relating to improvements to the property, or may only be
   responsible incertain defined, circumstances.
  The landlord may be required to provide an estimate of future service charges to
   tenantsconsidering becoming leaseholders under the Right to Buy. Leaseholders
   cannot becharged more than this amount during the first five years after purchase.
  Leaseholders will generally have the right to consultation, before contracts with
   contractorsare placed and work commenced.
  These issues will mean that recipient landlords will have to assess how:
They will fund the full cost of improvement works.


They will deal with repairs to properties where some leaseholders have bought withinthe
past five years.


They will manage the programme to ensure their obligations to tenants during
theconsultation phase are met.

LEGISLATIVE BACKGROUND

Section 20 of the Landlord and Tenant Act 1985 currently requires landlords to
consultleaseholders before carrying out works costing more than a prescribed amount,
where thecosts of the works would be met by leaseholders through service charges. The
prescribedamount is currently the greater of £1,000 or £50 times the number of
leaseholders who arerequired to pay service charges. These amounts can be varied by
secondary legislation, butthe formula cannot.

The above legislation sets out detailed requirements for the consultation process.
Differentrequirements apply where there is a recognised tenants association (RTA). In all
cases atleast two estimates must be obtained by the landlord for the proposed works, and
at leastone of these must be from a contractor who is wholly unconnected with the
landlord. Wherethere is a RTA, the landlord must supply a full specification of the proposed
works and theRTA has the right to ask the landlord to invite alternative contractors to
provide estimates.The landlord is required to have regard to observations put forward by
leaseholders or a RTA.

If a landlord fails to comply with the requirements of Section 20, any costs in excess of
theprescribed amount cannot be recovered through service charges, although a county
court mayoverride this restriction if it is satisfied the landlord had acted reasonably in a
particular case.

The formula for determining the prescribed amount relates to the total cost of the job
ratherthan the amount payable by individual leaseholders.

The requirements only apply to specific works and would not catch contracts for the
provisionof ongoing repair and maintenance contracts. Landlords are currently free to enter
intolong-term contracts for the provision of works which could cost leaseholders
considerablymore than the prescribed amount over a period of time, without giving the
leaseholders anyopportunity to comment.

For RSLs taking stock transfers of poorer urban and large metropolitan housing stock,
theremay be risk mitigation advantages to be gained from long-term repair and
maintenancecontracts, particularly for large estates including tower blocks.

LEASEHOLDER CONSULTATION

Following the report Rethinking Construction by Sir John Egan, there has been a
growingtrend towards long-term partnering approaches.

The requirement to consult leaseholders on particular works under Section 20 can
causeproblems with long-term maintenance contracts, which as a means of reducing the
risk oflong-term maintenance costs, can be useful to RSLs undertaking transfers of poorer
urbanand large metropolitan stock. If the RSL has entered into a contract with a private
sectorcontractor to carry out future maintenance costs, it would not be able to accept
anyalternative estimate to satisfy the observations of leaseholders.

However, it is important that leaseholders concerns about matters which may involve
themin significant costs are properly taken into account before decisions are made.
Leaseholdersmay wish to question whether the works are necessary or whether there is an
alternativeand less costly way of resolving a particular repair requirement.

Given that long-term repair contracts may be attractive to RSLs acquiring poorer urbanand
large metropolitan housing stocks, it is therefore important to ensure that the concernsand
rights of leaseholders can be met. ODPM is introducing revised leaseholder
consultationarrangements primarily designed to address issues identified in the housing
PFI pathfinders.

Section 151 of the Commonhold and Leasehold Reform Act 2002 would replace the
existingdetailed requirements of Section 20 of the Landlord and Tenant Act 1985. New
Sections20 and 202A of the 1985 Act envisage two stages at which consultation with
leaseholderswould be required. Firstly, where a landlord was proposing to enter into an
agreement ofmore than 12 months which would lead to costs being recovered from
leaseholders throughservice charges. Secondly, consultation would be required when a
landlord was proposing tocarry out specific works which would result in costs of more than
a prescribed amount beingrecovered from any leaseholder through service charges.
Detailed requirements would beset out in regulations. ODPM plan to consult on draft
regulations in August/September 2002.It is expected that the final regulations will be
published around February 2003 and will comeinto force three months after that.

Consultation of leaseholders on long-term agreements
Long-term contracts for the repair and maintenance of poorer urban and large
metropolitanhousing stock are in their infancy and could cover a wide range of risks from
the simple tothe complex. Section 151 of the 2002 Act enables regulations to make
provision generallyor only in specific cases and to make different provisions for different
purposes.

For contracts primarily intended to cover arrangements where all management and
maintenancefunctions relating to leasehold property are to be carried out by a third party,
the third partywill either carry out all the functions themselves or act as a main contractor
with particulartasks being subject-contracted.
The key features of this type of arrangement are that the contractor will carry out all
theworks and services as and when required, and that details of the works and services
forindividual properties together with the precise cost will not be ascertained in advance.
Thelandlord would be required to inform leaseholders of the proposed scope of the
contract(ie, the nature of the works and services that are expected to take place during the
periodof the contract). The landlord would be required to obtain bids from at least two
contractors(at least one of which to be wholly unconnected with the landlord).

Details of the bidders would be supplied to the leaseholders together with an
indicativeestimate of the costs applicable to their property over the period of the contract.
Leaseholderswould be able to make representations on these matters and the landlord
would be requiredto have regard to those representations. Where leaseholders specifically
request, the landlordwould be required to make available copies of the tender documents.

To avoid the need to consult on relatively trivial contracts where the cost to
leaseholderswould be minimal, consultation will not be required where the cost recoverable
from anyleaseholder during a 12 month period does not exceed a prescribed amount.
ODPM areproposing this amount should be £25.

Consultation of leaseholders on specific works
The ODPM proposes to adopt a common procedure regardless of whether or not there isa
RTA. The rights of leaseholders, individually or as members of a RTA, should follow
thecurrent arrangements for consulting RTAs in Section 20(5) of the 1985 Act, subject to
anumber of changes.

The requirement to produce at least two estimates and the right to nominate other
contractorswould not apply where the works were to be carried out by a contractor (who
carries outthe works or acts as main contractor) under an agreement of more than 12
months andwhere leaseholders had been consulted on the award of that contract.
Leaseholders wouldbe able to make representations about the detail of the proposed
works and suggest alternatives.It is thought that this should avoid many of the difficulties
experienced with partneringarrangements for the refurbishment and maintenance of
housing stock.

The trigger for leaseholder consultation should be the amount payable by any
leaseholderrather than the cost of the job, as at present. Where the proportion of costs
payable byindividual leaseholders varies, the threshold may only be exceeded for some of
the leaseholders.In such cases, all leaseholders should be included in the consultation
process. ODPMproposes to adopt the figure of £250 as the threshold for leaseholder
consultation under thenew arrangements unless there is a clear consensus in support of a
higher or lower amount.It is the intention that the amount would be raised from time to time
to reflect inflation.

Compliance with the consultation requirements would not, in itself, affect the
requirementfor service charges to be reasonable, or leaseholders rights to challenge the
reasonablenessof service charges at a Leasehold Valuation Tribunal.
Although ODPMs proposals for leaseholder consultation should address most of the
existingissues, leaseholders may still be able to frustrate the implementation of the
investmentprogramme by:


  some may not giving consent and this may delay or prevent the RSL from
   implementingits crucially important repairs and improvement programme management
   time involved;
  some may be unable to afford their proportion of the works and/or service charges
   ormay need assistance in order to fund them; and
  investment programmes may have to be rescheduled to suit the pattern of ownership
   inindividual blocks.

IMPLICATIONS OF REDUCTION OR A DELAY TO THE RSLSINVESTMENT
PROGRAMME

If the transfer RSLs is unable to invest in properties where there is mixed ownership
inaccordance with its Business Plan (B/P), a number of issues may arise. While initial
investmentcosts may remain unspent thereby reducing loan draw down requirements,
there may be anumber of very significant short, medium and long-term implications.

Limiting investment to internal works for tenants within mixed tenure blocks is likely to
becontrary to some of the primary objectives set for poorer urban and large metropolitan
stocktransfers and may impact on the ability to provide guarantees to tenants prior to
transfer orto fulfil guarantees post transfer. Since most structural repairs relate to common
elements ofproperty, such as roofs and walls, the condition of the property will continue to
decline. Inthis situation the long-term cost/benefit of internal repairs and improvements may
also haveto be questioned.

The deteriorating condition of some blocks may blight neighbourhoods and prevent
holisticand sustainable community regeneration which the RSL, government and
sponsoring localauthorities are seeking to achieve. The value of these properties may
decline creating anissue for the neighbourhood, the receiving RSL and for the owners
themselves. This cycleof deterioration would inhibit the creation of long-term sustainable
communities andhousing markets.

It is likely that the long-term effect for both the receiving landlord and the neighbourhoodin
general would be increased difficult-to-let properties; rising voids; anti-social behaviour;and
increased future repair and maintenance costs.

If true regeneration is to take place, and if tenant guarantees are to be met, these
leaseholderswill have to be involved in investment and maintenance programmes in the
initial stagesfollowing transfer and in future maintenance.

ISSUES

RSLs proposing to undertake investment in blocks (including demolition) where there
areboth leaseholders and tenants will have to consider:


  whether they have the legal right to repair or improve leaseholders properties
   inaccordance with the lease and relevant legislation;
  how to secure vacant possession of the leaseholders property in the case of demolition;
  how agreement to works must be obtained (for example through a majority vote
   byleaseholders);
  whether leaseholders can be charged their share of the cost of works, through
   servicecharges or through other means; and
  how such charges will be charged and collected.


The issues for a landlord receiving stock following a transfer will be to:


  Ensure that it can carry out the proposed investment programme across all
   properties,particularly in relation to any guarantees which have been provided during
   the ballot period.
  Avoid leaving owners with levels of debt which make it difficult or impossible for themto
   sustain home ownership.

DEMOLITION OF LEASEHOLDERS PROPERTIES

Some recipient RSLs will have identified properties, including those with
leaseholdersproperties, which do not justify substantial investment. This may be due to a
number offactors, including:


  The level of investment required is so large as to not represent good value for money.
  The block has already reached, or is approaching, the end of its expected useful life
   andwould require further investment in the relatively near future.
  The site of the block is strategically important and has a high alternative use
   value,which is important to the long-term viability of the recipient RSL.


In such circumstances the RSL will be seeking to decant its tenants and buy-out the
interestsof leaseholders. Compulsory Purchase Powers (CPO) may be required to secure
the interestsof leaseholders.

During the pre-ballot tenant consultation process, potential demolitions may be
identified.This may prompt some tenants to submit an application to exercise their Right to
Buy in theexpectation of making a sizeable profit in the prospective RSL seeks to secure
vacant possession.

In order to secure the vacant possession of leaseholders properties, they may need to be
offeredacceptable alternative accommodation. In addition, they may need, along with
tenants, tobe offered disturbance and removal assistance, particularly if they are of
retirement age.

The recipient RSL needs to ensure that:


  these costs which may be significant for properties in urban areas are fully reflected
   intheir business plan and in the Tenanted Market Value determination of the
   purchaseprice payable to the vendor local authority;
  the programme included in its business plan for securing vacant possession of
   unitspending demolition, is reasonable and deliverable with a reasonable margin of
   comfortfor slippage;
  it has the necessary resources to efficiently and effectively manage the labour
   intensiveprocess of the decanting and demolishing such properties; and
  if the alternative use value of the site is important in ensuring that the RSL will meetits
   asset cover requirements to lenders, then sufficient time is included in the businessplan
   to achieve demolition, site clearance, site rectification for any contaminated landand
   securing any necessary planning permission for change of use.

LEASEHOLDER PROFILE

In general, leaseholders of former local authority property tend to be at the lower end ofthe
income spectrum. Leaseholders tend to fall into four main groups:


  Leaseholders who bought at a significant discount and are now of pensionable age.
  Leaseholders of pensionable age where near relatives have provided financial support
   tothe leaseholder to enable them to fund the purchase.
  Leaseholders who bought at a significant discount and continue to have an incomefrom
   employment.
  Leaseholders who bought the property on the resale market at full value, most of
   whowill have low to moderate income from employment perhaps with little equity.

PROPERTY PROFILE

In addition to leaseholder profile, which is relatively low income, property values
amongstformer Council properties also tend to be lower than those in the privately built
market andto show lower year on year increases in value.

This will present a significant issue where owners are required to fund the proportion
ofrepair costs, which may represent a significant proportion of the total value of the
property.This may also be an issue where, due to the ongoing investment requirements of
the property(particularly aging flats), service charges are expected to be significant for a
number of yearsinto the future. This problem will be exacerbated where the repairs do not
add significantlyto the open market value of the property.

FINANCIAL ASSISTANCE TO LEASEHOLDERS
Currently, the majority of assistance to owner-occupiers is provided by local authorities.The
Housing Green Paper, Quality and choice A decent home for all published in
2000estimated that £250 million was provided per annum to approximately 70,000
households.This funding is used for a variety of support mechanisms to owners, not just for
those in formerCouncil property. It includes grants for renovation, repairs to common areas
and home repairassistance, which provides assistance for small-scale repairs. It is unlikely
that the amountof assistance currently will be sufficient to meet the additional requirements
created by thelarge post transfer investment programmes needed in poorer urban and
large metropolitanareas, unless a significant proportion of total funding is ring-fenced for
that purpose.

RISK MITIGATION

The costs to the transferring landlord of not dealing with leaseholders will be significant.
Itmay mean a failure to meet the guarantees provided to the tenants in adjoining
properties,along with rising voids, unpopular properties, neighbourhood decline and
increased managementcosts. In addition, a failure to recoup costs from owners will reduce
income.

Receiving landlords will wish to ensure that they have sufficient mitigation against this
risk.This could be done in a number of ways as set out below.

Clearly establishing potential costs and sources of funding
The stock condition survey and investment programme must clearly identify the costs
toleaseholders of work, which will be carried out on common elements.

The transferring local authority should then establish the level of local authority grantwhich
owners can expect to obtain in order to assist with costs. This is likely to involvenegotiation
with the local authority to ensure that an appropriate proportion of the grantbudget can be
directed to matching the RSL investment programme.

The RSL should examine the extent to which other grants (for example in relation
toinsulation) can be obtained by leaseholders to assist with their service charge
obligations.

Establish legal framework
The legal documentation for each lease may be different and may differ between
differentblocks currently owned by the same local authority. The receiving RSL will need to
ensurethe extent to which:


  it can undertake repair and maintenance work to common areas;
  it can undertake improvement to property;
  charges can be made to relevant leaseholders for such works; and
  the level of consultation with leaseholder is required.
The answers to these questions will determine the extent to which this issue will affect
thepost transfer business plan and the extent to which further mitigation is required.

Additional financial assistance
The RSL, on its own or in partnership with the local authority, may wish to explore
schemeswhich would assist owners with raising the capital required to meet their
proportion of thecosts involved. These may include equity release arrangements including
second mortgages,easier access to low cost and low start loans, or savings funds.

These may be run either by existing organisations or on an agency basis. The
mechanismsto be used should be developed and agreed as far as possible prior to
transfer. In additionany assistance available may affect the interest programme
implementation and rate ofservice charge recovery.

Rate of recovery
Within the business plan the receiving landlord will wish to estimate an appropriate level
ofrecovery of service charges from leaseholders. This is required since the works to the
propertywill need to be undertaken whether or not leaseholders agree to pay so that
landlordcommitments can be met.

The assumptions in the RSLs B/P should take into account the level of grant and
otherassistance available and also any available information on existing levels of recovery
forsimilar work. Where a large number of leaseholders exist, the effect of any loss of
futureservice charge recovery may be so significant as to require a reduction to the initial
purchaseprice paid to the vendor local authority, thereby removing some of the risk from
the RSL.The assumptions for recovery should reflect a pessimistic rather than optimistic
view. In addition, the assumptions should also reflect the level of grant, which the local
authority isable to commit. Rates of recovery may be improved to some extent by requiring
a proportionof total cost to be paid prior to commencement of works.

Sharing the risk
If the number of leaseholders is significant as a proportion of the total number of
propertiesto be transferred, it may be appropriate for the vendor local authority to share in
the riskgiven the catch up nature of much of the early investment work. This may be done
partlythrough sharing agreements and through the assumptions contained within the
businessplan. If the problems are of a sufficiently large scale it may also be appropriate for
some riskto be taken by other parties such as central government, for example through
increasedgrants or through support to other schemes to assist owner occupiers.

CONCLUSIONS

Leaseholders will form an important stakeholder group in many poorer urban and
largemetropolitan housing stock transfers and in the ability of the recipient landlord to
efficientlyand effectively implement the investment programmes, which follow. Without
leaseholdersparticipation, investment programmes may be seriously hampered;
guarantees to tenantsnot met and holistic regeneration will not take place. It may also
cause the RSL to defaulton some of its financial covenants and ratios with its lenders.
The number of leaseholders in urban areas is likely to be more concentrated in flatted
propertywith shared common elements with tenanted property. Transfer landlords will
therefore haveto consider in detail the risks associated with properties containing
leaseholders and militateagainst them through thorough assessment of costs, legal
requirements, available grant andthrough robust assumptions in the business plan.
Additionally, they may seek to share therisk with the vendor local authority and potentially
central government, through the effectson the purchase price and through assistance with
grant and other financial support.
Appendix IX - Investment procurement risk to LSVT RSLs in
poorer urban and large metropolitan stock transfers
In poorer urban and large metropolitan stock transfers, the implementation of the large
initialinvestment programme is of critical importance. Not only is it very often the primary
reasonfor the transfer but it is central to delivering sustainable regeneration of the recipient
RSLshousing stock. In addition, the RSLs funders will be keenly interested to see the
efficientand effective implementation of its borrowers investment programme, thereby
achieving itsloan to asset value financial covenant requirements.

INTRODUCTION

The purpose of this appendix is to discuss the risks associated with the procurement of
investmentworks related to the large scale voluntary transfer (LSVT) of large urban and
metropolitanauthorities housing stock. The first section covers the risks and how they may
be mitigated.The next section gives a definition of procurement and identifies the broad
areas of risk.Before discussing the risks in detail, the particular features of large urban and
metropolitanLSVTs are discussed in order to set the context for the discussion of risks and
mitigations.

PROCUREMENT

In this context, procurement describes the methods, systems and processes used by an
LSVTlandlord to secure the services required to deliver the investment programme
contained inits business plan. The investment programme is likely to be the largest area of
cost incurredby the landlord and so, funders will be concerned to ensure that:


  The costs are accurate ie, that they address the sustainable investment requirements
   ofthe stock and are not significantly under or over-stated.
  The landlord can control the programme ie, that the risk of cost overruns, slippage
   anddelays is minimised.


There are three broad categories of risk which are worth exploring:


  Specification risk: the risk that the wrong work is procured or that the correct work isnot
   procured.
  Sustainability risk: the risk that the work procured does not maintain or increase
   thevalue of the stock.
  Delivery risk: the risk that the landlord cannot implement the investment programmeas
   planned.
These risks are described in greater detail below, but first of all the context for these risks
isdiscussed by looking at the large urban and metropolitan authority dimension.

THE POORER URBAN AND LARGE METROPOLITAN AUTHORITY
DIMENSION

Procurement risks apply to all LSVTs, but the scale and/or complexity of urban and
metropolitantransfers influence the likelihood of the risks occurring as well as the relevance
and utilityof the mitigation strategies which can be used.

The particular characteristics of these transfers which impact on risk are:

1. Demand: low or decreasing demand will manifest itself in higher turnover, longer
reletperiods and possibly even unlettable stock. The main financial impact will be on rents
andtherefore on the landlords ability to meet its financial commitments and funding ratios.


  The impact of changes in the labour market as well as the availability of
   alternativeaccommodation can have a significant effect on demand. For example, the
   trendtowards the relocation of major employers of low-paid workers to business
   parksand sites out of the city centre, could effectively exclude the tenants of
   certainareas from employment because of transport costs and/or difficulties. This
   couldlead to a decline in demand for these areas.
  Research has shown that most households prefer to buy rather than rent. This findingis
   supported by the success of many low cost homeownership initiatives. It is likelythat
   large urban or metropolitan authorities have a greater range of housing optionsthan
   other authorities and this could suppress demand for social rented housing.
  Where the reasons for low demand are to do with the property type or condition,this
   might be difficult for the landlord to address due to a lack of resourcesincluding
   developable land.
  The issue of demand will affect sustainability risk.


2. Scale and complexity: the greater the number of properties, tenants and staff
involvedin a transfer, the greater the scope for unforeseen issues to emerge which may
have anadverse financial effect. For example, a property defect that was not identified until
afterthe transfer, might exist in all similar properties and might be costly to remedy. On
theother hand, the scale of the transfer may mean that problems which would be major ina
smaller transfer are less serious. To take the previous example, 1,000 properties with
acostly defect to remedy would have a greater impact on the business plan of a
smalllandlord compared to that of a larger landlord.

The issue of scale and complexity will impact investment programme on delivery risk.

3. Stock condition: poor and defective housing tends to be more prevalent in urban
andmetropolitan stock than in shire districts. This creates particular issues for landlords
ofurban and metropolitan stock in that the stock requires greater investment and in
somecases, the investment cannot be certain to extend the useful life of the properties.
The issue of stock condition will impact upon all three broad areas of risk.

4. Low value: the tenanted market value of the housing stock is related to the conditionof
the stock. In urban and metropolitan areas, the value of the stock is likely to belower than
that of shire districts and might indeed be negative in value. This mightcause difficulties in
raising private finance and might also have implications for the longterm viability and
sustainability of the housing stock.

The issue of low value will impact upon investment sustainability risk.

5. Tenant profile: the profile of tenants has changed significantly over the past
twodecades. There are several main reasons for the changing profile:


  The right to buy and the improved availability of home ownership has removedrelatively
   higher income households from the social rented sector.
  Demographic and social changes have led to an increase in the proportion ofsmaller
   households, elderly households and households who require some form ofsupport to
   live independently.


This means that the nature of the housing management service that is required has
alsochanged. The impact of these changes is particularly marked in urban and
metropolitanareas where there are large concentrations of tenanted housing properties.

The issue of tenant profile will impact upon sustainability risk.

6. Social exclusion: in many urban and metropolitan areas, problems of social
exclusionhave emerged, requiring intensive management as well as cooperation with
otheragencies such as the police.

The issue of social exclusion will impact upon investment sustainability risk.

7. Management skills and expertise: most authorities who are seeking to transfer all
oftheir properties through LSVT do so to a new landlord, specially created for that
purpose.Most of the staff of the new landlord will transfer from the authority in accordance
withTUPE legislation, including the senior staff. Furthermore, the board of management
iscomprised of unpaid volunteers who might not have any relevant qualifications or
experience.

There is a risk that the organisation lacks the competence to deliver the business
planbecause of skill gaps and weak or poor management. There is also the risk that
problemsmight be more difficult to detect because of scale and complexity. In small
transfers, thesafeguards of regulation are likely to be more effective than for large
organisations, whereit might be more difficult to detect problems at an early stage.

The issue of management skills and experience will impact upon all three areas of risk.
Summary of risk effects
The following table summarises the issues applying to large urban and metropolitan
transfers and the areas of risk which they affect. It shows that stock condition and
management skills and expertise have the widest potential impact.

Issue

                                    Specification risk

                                    Sustainability risk

                                       Delivery risk


Demand




Scale & complexity




Stock condition




Low value
Tenant profile




Social exclusion




Management skills




& expertise




Taking the urban and metropolitan dimension into account, the remainder of thisdocument
explores the three categories of procurement risks identified earlier.

SPECIFICATION RISK
This is the risk that the landlord fails:


  to identify all of the works required;
  to programme the works for the appropriate time period; and
  to draw up accurate specifications for the work required for contractual purposes.


In areas where the stock is in particularly poor condition, or where there is a
significantproportion of non-traditional housing stock, this risk is increased. Both of these
conditionsis likely to apply in poorer urban and larger metropolitan stock transfers.

Mitigation

i) Stock condition survey

The main method of mitigating this risk is for the landlord to commission a stock
conditionsurvey. The survey is typically sample-based at the 95% confidence level and
may includespecialist engineering surveys. The survey serves two purposes: it provides
the new landlordwith reliable information about the current condition and future investment
needs of thehousing stock and it also passes on some of the risk to a third party ie, the
surveyors whowill warrant the survey against errors.

The survey should be sufficient for planning purposes, but because it is sample based
thelandlord should be aware that the actual investment programme is likely to vary.
Manysurveys provide annual investment figures for the first ten years and then group
figures infive year bands thereafter because of the variations that will inevitably occur.

ii) Pre inspections

In practice, the landlord will find that some elements might need replaced later than
thelifecycle schedules assume and conversely, some elements might need replaced
sooner. Theactual requirement will be determined through pre-inspection by suitably
qualified individualsbefore the investment works are specified and procured. This will help
to ensure that worksare not done in advance of need and that they are properly specified.

iii) Update business plan

The business plan projections need to be constantly updated to take account of actual
spend:if the landlord does not need to replace a particular item in the year originally
programmed,this might allow earlier investment on other items or it simply mean that total
spend in thatyear is reduced.

iv) Develop a standard

Drawing on the developing experience of housing PFI schemes, some landlords are
examiningthe option of developing a standard ie, an output based specification which
defines thequality and functional requirements of the physical property. This standard can
be used asthe basis of developing a whole life approach to asset management by linking
capital investmentto the quality of the revenue repairs service.

Because the standard is output based and does not specify how these outputs are
delivered,it allows scope for innovation and competition in the delivery method. This
creates thepotential for efficiency gains.

SUSTAINABILITY RISK

This is the risk that the investment does not add sufficient value to the housing assets
orthat the value is short lived. It also covers resources being spent on the wrong things.

For example, for some housing in low demand, investment will not improve its lettability
andso the landlord has to question the worth of investing in these properties at all. There
are manyexamples of substantial public investment in housing failing to make an area
more desirablebecause the factors affecting demand are more complex than stock
condition alone.

This is a major area of risk for low value transfers of urban and metropolitan housing
stock.Properties which have problems of sustainability and demand in public ownership will
notautomatically have their problems solved by transfer, even if it is accompanied by
majorinvestment in the physical fabric of the housing stock. A new landlord organisation is
highlyunlikely to have the capacity or resources to cope with stock which has a limited life,
unlessthe transfer business plan has an effective strategy to deal with these issues in the
first place.Therefore, it is important that the business plan can demonstrate long term
sustainabilityto funders.

Funders are concerned to ensure that especially in the early years where debt is
increasing,investment improves the value of the asset by a greater amount, or at least, by
a matchingamount. Funders are likely to be keen to ensure that investment which does not
result inan increase in value is minimised. This may apply to non-essential or discretionary
investment.

Mitigation

i) Test sustainability pre transfer

One way of mitigating this risk could be to test sustainability before transfer proposals
areapproved by ODPM. The Housing Corporation provides guidance on assessing
sustainability,which can be used by landlords. Armed with demand information and
projected investmentcosts from the stock condition survey, the transferring authority and/or
the new landlord isin a position to rank areas or even property archetypes according to cost
and demand. Thiscan be represented in a sustainability matrix as follows:


                                               Demand
  Cost            High cost/low demand                      High cost/high demand

                  Low cost/low demand                       Low cost/high demand

Using this approach:


  low cost/high demand stock should be retained; and
  the other categories of stock should be subject to an option appraisal to determine
   theirfuture: retain in current use; refurbishment; demolition and new build; demolition
   andsite clearance. The option appraisal would take into account the potential for
   increasingthe sustainability of the area and property type through investment.


This is just one example of how to approach a sustainability analysis, but the important
pointis that the risk that the new landlord might fail to be a going concern because of
fundamentalissues of sustainability should be addressed before the transfer business plan
is produced.

ii) Develop a management strategy

The previous paragraphs describe how demand, stock condition and low values can
beaddressed in order to mitigate sustainability risks. In areas where sustainability is a
concerndue to one or more of the other issues previously discussed (tenant profile, social
exclusion,management skills and expertise), the new landlords business plan should
address howthese will be addressed in a management strategy, for example through
developing locallettings plans to avoid having concentrations of particular types of tenants
in locationswhere this would cause problems for all concerned.

DELIVERY RISK

This is the risk that the new landlord is unable to carry out the investment programme
asplanned because of:


  tender price inflation;
  cost overruns during the contract;
  delays in letting the contacts/starting the works; and
  delays in delivering the contract.


Tender price inflation
Tender price inflation may occur because of a general or local increase in the cost of
labourand/or materials. This may occur for economic reasons out of the control of the new
landlord,or it may occur because of an increase in the amount of work being offered to the
market asa result of the stock transfer. In urban or metropolitan areas, labour is mobile and
contractorswill compete for suitably qualified workers. This may have the effect of pushing
costs up becauselabour rates increase and because contractors can command a higher
price for their work.

Cost overruns during the contract
Cost overruns can occur for many reasons:


  labour and or materials inflation;
  unforeseen circumstances, for example the discovery of asbestos or rot once
   intrusivework commences;
  poor or mismanagement of the contract by the landlord and/or the contractor; or
  profit maximisation on behalf of the contractor, for example a contractor may bid lowto
   win a job and then seek additional fees to achieve the target profit level.


Delays in letting the contracts/starting the works
There may be delays in letting the contracts/starting the works due to a lack of
managementcapacity on behalf of the landlord or due to a lack of contractor capacity.

Delays in delivering the contract
There may be delays in delivering the contract due to:


  poor or mismanagement of the contract by the landlord and/or the contractor;
  unforeseen circumstances, for example the discovery of old mine workings;
  optimistic planning;
  disputes with the contractor about the contract; and
  major problems with the contractor organisation, for example liquidation.

Mitigation

i) Local market analysis

One way of mitigating this risk is for the new landlord to investigate the local market
whenthe investment programme is being prepared. The new landlord can assess the
capacity ofthe local contracting market by reference to information about turnover and
other statisticsheld by enterprise companies. It will be important to take into account any
other majorworks which is being planned by other bodies so that a suitable amount for
price inflationcan be added onto the costs.

Also, the new landlord could meet with contractors (individually or collectively) to
discusstheir capacity and to discuss procurement issues with a view to packaging the work
in acost effective manner.

ii) Use an appropriate procurement method
The procurement method will affect risk. In essence, there are three main methods
ofprocuring works.

    a) Term contracts

These are contracts for more than one financial year (usually for three to five years) for
smalland recurring types of work. They can be expensive to administer and are typically
used forhigh volume, low individual value works such as responsive maintenance. Works
costs areusually based on a schedule of rates which helps to simplify the administrative
process.

    b) Traditional lump sum contracts

These are contracts for specific works, which deal with the repair and or replacement
ofproperty elements. They are usually of less than a year in duration and are let on a
competitivetender basis. They can be let on a fixed price or variable price basis.

Although cost risks can be passed on through fixing the price and through
appropriateinsurances and indemnities, a new LSVT landlord would have to devote
considerableresources to managing a programme based on this form of procurement.

    c) Design and build

These are contracts for new build or major refurbishment works and last for more than
oneyear. They typically involve lump sum tenders based on the clients output specification.

Although the risk of cost inflation is passed on to the contractor, experience has shownthat
this type of contract can become adversarial as contractors seek to recover
unforeseencosts, resulting in disputes and delays.

iii) Partnering

First introduced to the social rented sector by the Egan Report in 1998, and now
promotedby the Housing Corporation for RSLs, partnering involves:


  Entering into a long term arrangement with a number of contractors for the provisionof
   repairs and replacements.
  Focusing on the tenant rather than the process by emphasising outputs rather
   thantraditional input based specifications.
  Introducing performance targets for improvements: reducing costs, improving
   productivityand efficiency and reducing defects.
  Integrating the design and construction process by involving the constructor
   duringdesign stages thereby increasing the scope for innovation.
  Replacing the lowest initial cost culture with a best value approach.
  Ensuring that resources are available when they are required by giving the
   contractorthe scope for resource planning.
  Capturing scale economies and maximising buying power.


Partnering is particularly suited to large urban and metropolitan LSVTs because:


  the volume of work in large transfers creates potentially complex logistics and difficult
   planning;
  the repetitive nature and common features of some of the work lends itself to setting
   upprocesses to streamline and improve efficiency;
  large labour resources are required to deliver the whole programme and a
   coordinatedapproach allows labour planning;
  multi-site contracting is a major management and programming task and the
   contractorsas well as the new landlord might have difficulty dealing with this individually;
   and
  it provides greater control and certainty to the new landlord than any other method.


In practice, the new landlord may use a combination of these methods to deliver
itsinvestment programme.

iv) Put in place appropriate control systems

As previously discussed, the scale and complexity of large urban and metropolitan LSVTs
aswell as potential weaknesses in management skills and expertise can impact upon
deliveryrisk. Therefore, it will be important for the new landlord to ensure that appropriately
qualifiedstaff are in place to manage all aspects of the delivery of the investment strategy
and thatthere are effective systems of control in place.

CONCLUSIONS

This Appendix has sought to identify procurement risks and the particular issues which
relate to large urban and metropolitan LSVTs along with appropriate mitigation strategies.
Three broad areas of risk have been identified. The following table summarises for each
risk, the particular issues and the possible mitigations.

Risk category


Specific risk


Urban/metropolitan


Mitigation
LSVT issue




Specification


Landlord fails to:


Stock condition


Stock condition survey




  identify all of the works required




Management skills & expertise
Regularly update plans


Set a standard




  programme the works appropriately




  draw up accurate specifications




Sustainability


Investment does not add


Demand
Test sustainability




sufficient value to the assets




pre transfer




Stock condition




Value added is short lived




Develop a management




Low Value
strategy




Tenant profile




Social exclusion
Management skills & expertise




Delivery


Tender price inflation


Stock condition


Local market analysis
Cost overruns during


Low Value


Use appropriate




the contract




procurement method




Management skills & expertise




Delays in letting/starting
Put in place appropriate




the contract




control systems




Delays in delivering




the contract
Appendix X - Management structures risk to LSVT RSLs in
poorer urban and large metropolitan stock transfers
INTRODUCTION

This section of the report considers the risks to RSLs taking the transfer of poorer
urbanand large metropolitan stock arising from management structures.

The case for transfer is not simply an investment case; it is a whole business case,
whichinvolves the management of the housing stock. Therefore, one of the risks
associated withtransfer is that the management structure, skills and experience of the
LSVT landlord mightnot be adequate to deliver the transfer and the business plan
efficiently and effectively.

This analysis looks at the risks arising from LSVT landlord structures including:


  group structure versus a standalone organisation; and
  a subsidiary of an existing RSL.


Before the advantages and disadvantages of these structures are considered, the
particularissues facing urban and metropolitan transfers are discussed.

URBAN AND METROPOLITAN TRANSFERS

In any large scale voluntary transfer it is important that the LSVT landlord has the
necessaryskills to deliver the transfer business plan and to deal effectively with any risks
that mayemerge during the transfer process and beyond. This may be particularly
challenging forlandlords who acquire housing stock from large urban and metropolitan
authorities.

Many urban and metropolitan authorities face problems of:


  low or declining demand;
  social exclusion;
  changing client groups and expectations giving rise to changing
   managementrequirements; and
  poor stock condition including significant proportions of non-traditional properties.


Internally, they face the issues of adapting to modern service standards, with an increase
inthe use of technology to make services more efficient at the same time as trying to
respondeffectively to the problems listed above. For some authorities, this is made more
difficult bythe presence of outdated working practices, as well as a reluctance to reduce
staff numberseven where the stock has reduced significantly due to the right to buy.

Although registration with the Housing Corporation provides a degree of assurance
aboutmanagement standards, it does not provide complete assurance that management
weaknesseswhich existed before transfer will not endure after transfer.

GROUP STRUCTURE VERSUS A STANDALONE STRUCTURE

Some transfers have involved setting up a group structure rather than transferring to
asingle landlord body. Usually this has been done to comply with the ODPM
requirementthat no more than 12,000 units may transfer to a single body. However,
compared to astandalone structure, group structures have the potential to offer additional
benefits:


  cost pooling and economies of scale;
  cross-collateralisation for loan security purposes: the assets of the group may have
   thepotential to support a larger loan than the loans which could be raised by
   thesubsidiaries individually;
  tax efficient sharing of resources: the subsidiaries and parent can provide each
   otherwith services without having to charge VAT;
  synergy of ideas and performance: opportunities exist for the subsidiaries to benefit
   fromthe experience and innovations of the other members of the group; and
  devolution to a local level to involve communities: the subsidiaries can have a
   localidentity with its membership and directors drawn from the communities it serves
   flexibility:there is scope for the individual members of the group to specialise, for
   example theparent might provide corporate services to all of the subsidiaries or each
   subsidiarycould specialise in a particular corporate specialism on behalf of the group,
   such ashuman resources or IT.


The possible disadvantages of a group structure are:


  poor performance of one member of the group could have an adverse financial effect
   onthe other members;
  it might be difficult to find enough good candidates for all of the boards; and
  tenants and others might perceive the parent as having too much control over
   thesubsidiaries.


These potential advantages and disadvantages apply to group structures in general, but
thereare other issues to consider if an existing RSL sets up a group structure with a new
subsidiarydesigned to take over the management of an authoritys housing stock. In these
circumstances,the financial strength, existing management expertise and experience of
implementingmajor investment programmes of an existing RSL, can be hitched to the
greater politicalacceptance of a new landlord.

OTHER ISSUES

There are a number of other issues related to management structures which are
worthconsidering. These are discussed below.

Appointment of senior staff
It is important that the Chief Executive and Finance Director are appointed as early
aspossible, preferably pre ballot, to direct and influence the RSLs business plan and
thepurchase price to be paid to the local authority. The appointment of these senior
executivesis generally undertaken post ballot. Given that the chances of securing a positive
ballot maybe lower than for shire transfers, appropriately qualified candidates may need to
be givenincentives to leave existing employment to join an organisation where its long-term
futureis uncertain.

Expanding the scope of the new landlord
Diversification could assist the new landlord to spread risk in such a way that the
risksassociated with the transferred stock are mitigated. This greater activity would
obviouslyneed to comply with the Housing Corporations regulation of RSLs diversification
intonon-core activities.

For example, the RSL could have greater freedom to act as a not-for-profit housing
business,with responsibilities to tenants and accountability to the local community for social
housingprovision, but with greater scope to manage assets, create value and diversify into
widerhousing markets. This could enhance the viability of the organisation as a whole.
Also, thenew organisation would have greater relevance to the whole community, rather
than justsocial housing tenants, and should be more attractive to potential board members.

Another example would be to set up the RSL as the primary regeneration vehicle for
itsarea, with freedom to undertake selective demolition, redevelopment for mixed-use
andmixed-tenure. This should make the RSL a much more relevant and interesting
propositionfor board members and senior staff.

Using the skills and expertise of established RSLs
Where the authority has decided to set up a new RSL for the transfer, it could consider
thesecondment of existing RSL Chief Executives and Finance Directors to the recipient
RSLfor the period from pre-ballot to say 6 to 9 months post-transfer.

For challenging poorer urban and large metropolitan stock transfers where the need
forspecialist skills at board level (for example project management, corporate finance,
andlegal skills) is particularly acute, the possibility of paying specialist board members,
may beattractive. This may be a useful mitigation strategy, particularly during the higher
risk initialinvestment programme. This is part of a much wider debate and is far from being
universallyacceptable within the RSL movement.
Appendix XI - Analysis of replies received from existing RSLs
E&Y received replies from 67 existing RSLs, of which 40 were from established RSLs and
27 from RSLs created by LSVTs, an overall response rate of 61%.



Established RSLs


LSVTs


Total


Number of replies


40 (60%)


27 (40%)


67 (61%)


Do you wish to


Yes 40


Yes 25


Yes 65


increase the size of
your holding through


No 0


No 2


No 2


stock transfers?




Partial or whole


Partial 2


Partial 2


Partial 4


stock transfer? (not
all replies specified)


Whole 1


Whole 1


Whole 2




Either 33


Either 19


Either 52


Would you target


Geographically local 19
Geographically local 18


Geographically local 37


particular types of




transfer? (replies


Urban/Metropolitan 7


Urban/Metropolitan 2


Urban/Metropolitan 9


may include more




than one of the


Shire 5
Shire 9


Shire 14


answers)




Any 21


Any 3


Any 25




Specialist area
Specialist area


Specialist area 6




(sheltered


(sheltered




accommodation/


accommodation/




regeneration) is


regeneration) is




important 3
important 3




What is your view on the amount of properties your organisation would be
interestedin acquiring?

ESTABLISHED RSLs

Numbers of properties


Number of RSLs


Wish to own a further


currently managed


in this category




0-4,999


8


0-4,999: 5




Depends on circumstances: 2
No answer: 1


5,000-10,000


11


0-4,999: 4




5,000-6,000: 2




12,000: 1




No view: 2
No answer: 2


10,000-14,999


11


0-4,999: 6




10,000: 1




14,000: 2




No answer: 1
Depends on specialist market: 1


15,000-19,999


7


3,000+: 1




6,000: 1




10,000: 2




12,000: 1




15,800: 1
1 or 2 per annum: 1


20,000+


3


5,000+: 1




7,000: 1




Depends on circumstances: 1


TOTAL


40




LSVT RSLs
Number of properties


Number of LSVT RSLs


Wish to own a further


currently managed


in this category




0-5000


11


0-4,999: 4




5,000-10,000: 4
Depends on circumstances: 2




No more: 1 0-4,999: 3


5,000-10,000


11


5,000-9,999: 2
10,000-14,999: 3




No view: 2




Depends on circumstances: 1
10,000-14,999


5


12,000: 1




14,000: 1




Depends on circumstances: 1
No more: 1




No view: 1


TOTAL


27
Appendix XII - Calculation of a recipient RSLs risk buffer
LSVT RSLS WACC

On the day of transfer most LSVT RSLs undertake a range of treasury management
activitiesto provide a degree of certainty in its future interest cost, particularly during the
period ofthe rent guarantee and the initial catch up repairs programme.

On the assumption that the LSVT RSL hedges 80% of its interest risk by undertaking
aseries of interest rate swaps for 3, 5, 7, and 10 years and the remaining 20% being left on
afloating rate basis, it is possible to calculate the recipient RSLs initial WACC. If we
assumethat the LSVT RSLs interest margin is a blended 40 basis points, we can use
interest rateswap rates to calculate the LSVT RSLs initial WACC.

As at 28th February 2002, interest rate swaps of the above duration were as follows:

               Swap               Margin                  RSLs cost of funds
               rate




3 years        5.25%         +    0.40%             =     5.65%




5 years        5.40%         +    0.40%             =     5.80%




7 years        5.40%         +    0.40%             =     5.80%




10 years       5.45%         +    0.40%             =     5.85%




3M Libor       4.10%         +    0.40%             =     4.50%

LSVT RSL Initial WACC = (5.65%+5.80%+5.80%+5.85%+4.50%)/5= 5.52%

An alternative approach is to assume that on the day of transfer the LSVT RSL
undertakesa 30-year interest rate fixture, by undertaking an interest rate swap. As at 28th
February2002, a 30 year swap had a strike rate of around 5.1%, plus the long term interest
margin ofsay 0.4%, giving a long-term fixed rate of 5.5%.

Alternatively on the day of transfer, the LSVT RSL could undertake a structured and
unguaranteedcapital markets issue. From capital market sources, E&Y consider that as
at28th February 2002 an LSVT RSL could undertake a capital markets issue at a margin
overthe gross redemption yield on the reference gilt of say 1.40% and with 30 year gilt
yields of4.75%, this gives an initial WACC for the LSVT RSL of 6.15%.

Clearly, a new LSVT RSL, (particularly large metropolitan stock transfers with a
largepurchase price) could undertake a blend of several of these treasury management
scenarios.However, given the current shape of the interest rate environment, such an
approach wouldnot significantly alter the analysis and conclusions.

LSVT RSLS REAL WACC

If the real WACC of the recipient RSL is compared with the real discount rate used by
ODPM to determine the purchase price of the stock being acquired, it is possible to get an
approximation of the level of recipient landlords risk buffer. To compare the LSVT RSLs
initial WACC to the REAL discount rates used by ODPM, one has to move the RSLs
WACC to a real WACC by taking account of inflation. Market projections for long-term
inflation can be derived from long-term gilt yields.

Yield on 30 year gilt (6% Treasury 2028)                  = 4.79%




Real yield on index linked gilt (2.5% Treasury 2024)      = 2.32%




Market projection for long-term inflation                 = (1.0479)/(1.0232)

                                                          = 1.024 ie, 2.4%



The calculation to move from the RSLs initial WACC to a real WACC is:

    RSLs WACC/Projection for long-term inflation.

The results of this calculation for the three treasury management scenarios outlined above,
are shown in the following table (assuming 2.4% inflation and using 6% and 8% as real
discount rates used to calculate the TMV):

                         RSLs WACC          RSLs real WACC           Risk buffer
Blend of interest         5.52%                3.04%                       2.96% to 4.96%

rate fixtures




Long-dated swap           5.5%                 3.02%                       2.98% to 4.98%




Structured capital        6.15%                3.66%                       2.34% to 4.34%

markets issue


THE RISK BUFFER

To accurately reflect the LSVT RSLs long term WACC, requires estimates of interest
rateswhen the swaps mature. This requires detailed analysis of the forward curve for
interestrates, and is beyond the scope of this assignment.

Notwithstanding the RSLs exposure to interest rates after the period of the interest
ratefixtures in the three calculations above, in each case the LSVT RSLs real WACC as at
theday transfer is substantially below ODPMs current TMV real discount rate of 6% to
8%.However, this calculation does not take account of the annual loan management fees
payableto lenders, annual commitment fees (if payable) and any security management
fees.

It is difficult to say whether the level of risk buffer is too high or too low. In some strongshire
district transfers it may be too high and the public sector could secure a higher pricefor the
stock by a more competitive process for the selection of the recipient landlord(including
new with limited profit models and structures). This is investigated in moredetail in Part 2 of
this report.

In the case of poorer urban and large metropolitan stock transfers the buffer may be toolow
in that it produces a purchase price which is unsustainable by the recipient
landlord,particularly if this landlord is newly formed with no reserves. The extent of the risk
bufferwill also be irrelevant if the purchase price is strongly influenced by the interest
breakagecosts on the vendor local authoritys housing loans.

The level of the risk buffer is not a simple issue particularly for poorer urban and
largemetropolitan stock transfers where the large initial catch-up repairs and
improvementsprogramme often creates negative cashflows in the early years of the TMV
calculation.Where negative cashflows exist the TMV methodology should use real
investment ratesduring those periods rather than real borrowing rates.
Appendix XIII - Alternative models for stock transfer
REGENT INTEGRATED HOUSING MODEL THE PROPOSALS

Regent Integrated Housing (Regent) is owned by Charlemagne Capital and has been set
upto develop innovative social housing finance solutions. Regent has worked with Miller
Construction,Depfa, Nationwide Building Society and Bank of Scotland in developing its
proposals.

The following points summarise Regents proposals, which are aimed at reducing the cost
offinancing stock transfers and hence increasing the opportunities for successful transfers
andfor increasing the purchase price received by local authorities for their assets:


1. The acquiring Housing Company would utilise structured finance to improve
financialterms available for stock transfers, with the financial partners (particularly
equity)controlling the management of the Housing Company to which the housing stock
istransferred. The Regent Model involves using competitive mortgage and capital
marketsfor procuring the majority of the debt finance. Regent sees risks being allocated to
thoseparties who are best able to competitively price the risk and positioned to bring gains
tothe Housing Company namely equity investors and motivated management. Regenthas
stressed that the management team must be incentivised. This is something that isnot
overly permitted with current RSLs.


2. The Housing Company is to be an RSL (accepted by the HC on the condition thatit
complies with all registration requirements). Regent has indicated that to attractcompetitive
finance the providers would need maximum confidence in the HousingCompany
management. Regents proposed Housing Company would give the financeproviders
ultimate control over the appointment of key managers.


3. The total return paid to investors would be capped on any excess profits covenantedto
the public sector via a Trust for which it is envisaged that the tenants and the localauthority
would make up the board of. As an indication of how this arrangement couldwork, Regent
indicated that once investors had secured an agreed rate of return, anyremaining profits
would be covenanted to the Trust. The agreed return would be determinedby competitive
bidding and so would vary between transfers reflecting market perceptionsof risk. Any
surplus generated by the Housing Company would be transferred to theTrust to enable it to
undertake wider social, economic and physical regeneration worksin the area.


4. The Housing Company would be able to use and develop the assets to provide,
undercontract, a flexible housing service to accommodate social housing tenants in
propertiesthat matched their changing needs. Regents model goes further than other
proposalswe have previously seen in that it might involve substantial flexibility in the
managementof the stock. Subject to their agreement, tenants could be decanted and
rehoused tofacilitate development opportunities : ie, the Housing Company would not have
toretain existing estates in the format in which it acquired them on transfer, if
alternativeacceptable accommodation was provided.


5. Regent also propose that a golden share be retained by the public sector and that
aBond could be taken out to ensure a smooth transfer of ownership to another landlordin
the event of the Housing Company getting into financial difficulty. These measuresare
designed to help protect the interests of tenants as well as the public sector investmentin
the stock.


The research examines the extent to whichfinancing for housing stock transfers offer
valuefor money, and identifies ways in which this couldbe maintained or improved in the
future.

								
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