The Tale of Two Cash Flows
The short-term development cash flow includes the key, basic ingredients: the land, the build, and the fees. If you are building a large number of homes, you may need to borrow money from the bank, and therefore there is also an attached interest cost to the cost of the development. Combined, these elements become the total scheme cost, also abbreviated as TSC. In the private sector, the TSC can be deducted from the property sales to reveal the overall profit.
In the affordable sector, the process is a little more complicated. Firstly, the housing association may obtain some subsidies. These may come from the likes of Homes England or the Mayor of London. In the affordable sector, the TSC is deducted from any sales and the subsidy is also deducted from the sales. What developers are left with is the long-term loan. This is the key difference between the private and the affordable sector; we don’t sell everything we develop. The housing association’s social purpose is to hold onto properties and rent them out at affordable rates.
This is why we describe it as the ‘tale of two cash flows’, because we have the short-term development cash flow when we are building, and when we finish the homes that cost moves into a second cash flow, sometimes called the management cash flow. Year one is defined in the long-term cash flow by the year of the handover of the first units. In year one sits the long-term loan as well as the attached interest as we have not paid the loan off yet. To pay off the loan, we will collect rent from the homes we’ve built. From this rent, we first have to deduct our landlord costs, our management, maintenance, voids, and bad debts. What we are left with is our net rent which can be used to pay off the loan. Most housing associations prioritise paying the annual interest first, and anything remaining will chip away at the loan. Alternatively, a housing association may choose to use the annuity method, which is a fixed payment that eats away at the loan and the interest.
This cycle of gross rent becoming net rent which then pays off the loan is predicted to continue over 100 years. In an organisation’s business plan, they will have picked a ‘sweet spot’ during this period for when the loan will be fully repaid. In the past this point would sit around 25 years, now, however, it is most typically situated at about 40 years. The business needs to know whether it is plus or minus on its loan by this 40-year point, and to do this Net Present Value (NPV) is needed to understand the future money coming into the business. To bring this future money back to the present value we can use the NPV which will have an NPV discount period, such as the 40 years. The NPV discount rate can be calculated by using the interest rate on the long-term loan, which the company finance director may align close to the annual interest rate, possibly with a margin on top for risk factors.
This is what our software, ProVal, does. In ProVal, the interest and inflation will be added to the cash flow over the 40-year period. It then takes a prediction of the future money based on the rent, management, and maintenance costs for the property. Finally, it returns this figure to you at the same point in time when you started the cash flow, year one. In ProVal you can also set different discount rates and periods for different tenures, to allow you greater flexibility when planning developments. These viability models which can be built within ProVal tell your business when the homes will pay for themselves, and if the build is helping your overall business plan.
Strategy and Opportunity
Within companies, there will be a board, a cabinet, or a committee that develops the business strategy. This development strategy will tell you who you are going to build for, which tenures you will use, where they will be, when you’re going to build, and how the business will finance the build. This business strategy supports your business plan, which holds all of the finance projects and therefore defines the business. However, despite these clear-cut plans, we work in an organic world of development opportunities. These opportunities may be positive for the business plan, and others may be negative and fail to cover the building costs. Therefore, program management is required to manage how many of these schemes are brought into the business at any given time. To help businesses manage these new projects and track their financial viability, we would recommend using SDS Sequel.
In the affordable sector, finance directors are required to ‘stress test’ their business plan on a regular basis. This is because the Regulator or Homes England does not want to give grants to organisations that are not sustainable. Questions may include, what if there is a significant change in costs, or if the business income was radically reduced? Could the business sustain these changes? These stress tests may reveal that the company needs some additional financial support.
When does SDS view a scheme as viable?
At SDS, we would look at the development strategy, the cost to value relationship, whether the developer can repay its loan and add value to the organisation, and if there is a subsidy available when required, to assess whether a scheme is viable. Development schemes would also be viewed as viable if they do not adversely affect the business plan and if potential risks can be resolved.
ProVal can support your business in analysing the financial viability of a project by developing a financial appraisal. Within ProVal, templates can be used to project loan rates, and there is a stored library of different tenures.
New tenure – ‘First Homes’
First Homes is the new dwelling type being offered by the government. It is a discounted market sale home that, according to government guidance, will make up at least 25% of any affordable housing required by Section 106 on a large site.
These homes must be the appropriate size and price for first-time buyers in the area. Housing developers will take the hit for these discounted prices as part of the affordable provision. Moreover, this discount will be held in a state of perpetuity and be registered at the land registry for any future resale of that property. Interestingly, because it is a discount of around 30% of the market, these properties are exempt from CIL (Community Infrastructure Levy). There is currently a price cap on these properties after the discount has been applied: up to £420,000 in Greater London, and up to £250,000 outside Greater London. This price cap only applies to the first sale, not subsequent sales. The agreed discount, however, does apply to future purchases.
In terms of eligibility, the government has stipulated that these properties are for first-time buyers only. These buyers should have a household income of less than £90,000 in Greater London, or less than £80,000 outside of Greater London. Also required is a mortgage plan to fund a minimum of 50% of the discounted price. Finally, the government has included a Mortgagee Exclusion Clause for lenders, which stipulates that in the event of repossession, the lender can sell the home on the open market, and then compensate the Local Planning Authority for the loss of this property.
The Local Planning Authority can amend a number of these government guidelines. For example, there needs to be an ‘eligible’ purchaser and this may be subject to Local Planning Authority criteria as well as government criteria. The LPA may alter the maximum household income permitted as well as the percentage mortgage the purchaser requires. The LPA is also able to increase the discount available for purchasers, as well as the local price cap on sales. These changes must be evidenced alongside the local plan. It is worth noting as well that any changes to the discount rate available are fixed in perpetuity for future resales of these properties. Finally, the LPA may also run a local connection test, which is designed to prioritise ‘key workers’ when selling the properties. ‘Key worker’ has been defined as any person working in a profession considered essential for the functioning of a local area.
New development plans should be taking account of First Homes by 28 June 2021. However, sites are exempt from this new policy if they had full planning permission by the 28th of December 2021.
Based on a webinar given by John Stevens on 24/07/21. For similar content, please visit our SDS webinars page.
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