Housing associations utilising reserves for their objectives

First, some background information. In the UK, housing associations are independent, non-profit making organisations set up to provide low cost housing for people in need of a home. They exist in the gap between the private and public sector in the hope that they can combine the best elements of both.

Majority are registered charities

Today, the majority of housing associations are also registered charities, a status which bestows tax benefits and has cemented the independent nature of the overall sector. In England, this independent status has recently been challenged by the Office for National Statistics (ONS), but the practical implications are so far muted. In Scotland this is not yet a concern.

The economic slump has forced many social sectors and charities into survival mode, but housing associations have so far weathered the storm well, becoming a powerful economic force and influencer on a wide range of social policy.

Tens of billions of public money in the form of grants have made it possible for housing associations to attract even greater levels of private finance, and having no shareholders has allowed the organisations to reinvest, enabling further growth. Any trading surplus made is used to maintain existing housing stock or to help finance new homes.

A tipping point

Today, housing associations are at a tipping point. Britain has a serious and growing housing problem and both the private and public sectors are failing to build enough homes for true regeneration to take place. The shortfall is growing substantially every year. While the private sector is beginning to increase building activity, housing associations have lagged behind. The sheer size and influence of the sector invites scrutiny but, as with most aspects of financial regulation, the causes are complex and counter-intuitive.

Put simply, to build new houses, housing associations need either direct support from the Government or they need to able to borrow the money elsewhere, using their income streams to repay the debt. In England, direct support from the Government has fallen over the years and rents are also being controlled centrally, leaving many housing associations with few means to repair their losses.

This is especially following George Osborne’s announcement that rent paid by social housing tenants in England should be reduced by 1% a year, for four years. In Scotland, the situation is less dire but there is a concerning trend emerging.

The current system of government funding appears not fit for purpose, but an overhaul of the funding model will be years in the making and in the meantime there is a strong need to find alternative income streams. Perhaps a rather under-appreciated element of housing associations – their charitable status and considerable free reserves – can alleviate some of the pressure?

Making reserves work harder

The topic of reserves and policies on the management of reserves has remained low profile for housing associations, even as the number of housing associations registered as charities has steadily increased. It has long been a familiar conundrum for traditional charities which recognise the power of reserves to serve multiple functions.

Whilst every organisation’s financial situation is different, it is important to realise that there are few regulatory restrictions on the management of reserves for charities. The funds are required to be managed in accordance with internal reserve and investment policies but each charity has the ability to evolve these over time. Most charities with reserves of similar size to many housing associations have opted to invest some or all of their free reserves.

In 2014 the Association of Chief Executives of Voluntary Organisations published a very useful report called Good with Money. The report contained a wealth of data and technical advice for charities and revealed that charity reserves are used to generate an investment income of over £3.5bn each year. On average, around 6% of charities annual income comes from their investment portfolios, and in 2014 1,990 large charities with reserves over £5m accounted for nearly £2bn of charity investment income.

Why free reserves at all

For housing associations the best place to start is to identify underlying reasons for holding free reserves in the first place. This may seem obvious, but the business case for reserves often goes far beyond the traditional “rainy day” scenario. Common reasons include:

Risk aversion versus risk awareness

In the Institute of Philanthropy’s 2008 report called Investment Matters – In Search of Better Asset Management one of the key recommendations related to risk aversion as an impediment to performance. It went as far as to suggest that the Charity Commission’s guidance should be updated to decrease emphasis on risk aversion, while retaining the emphasis on risk awareness.

Many charities, and certainly housing associations, adopt a very conservative attitude when it comes to reserves, regardless of the underlying purpose of reserves. Rather than being an asset that needs to be managed to maintain its intended function, reserves are deemed to be simply a resource to be protected and preserved.

It can be a surprise to hear that strategies for reserves matter to charity regulators, whose remit includes ensuring the effective use of charities’ resources.

A high level of defensiveness may be appropriate for short term cash flow problems and emergency spend, but for housing associations closer scrutiny of the intended use of reserves may be beneficial. Often there will be a realisation that reserves are required to fulfil both long and short term objectives.

While cash strategies are sufficient and well suited to fulfil shorter term obligations, it is difficult to maintain the real value of reserves with cash-only strategies. This is of particular significance for housing associations which often need their reserves to function as insurance against spending liabilities that run far into the future.

Good reasons for reserves diversification

Strategies for managing reserves should align closely with the underlying reason for holding reserves in the first place. Often the understanding that that multiple strategies may be needed to best manage the overall pot of free reserves is key to this issue.

There are several good reasons to consider investing a portion of reserves:

Creation of useful income stream

The current low interest rate environment has persisted since the financial crisis and it is showing few signs of improvement. As a result, income from cash on deposit is minimal at best and often requires a willingness to lock of capital in term deposits. Housing associations which opt for arrangements involving lock-in periods are essentially trading liquidity for return and the risk/reward characteristics of this trade are not always beneficial.

Housing associations facing dramatically lower grants from the Government and a reduction in income from rents have the ability to create a more attractive income stream from reserves by diversifying away from cash-only options.

Risk diversification

Risk is a fluid concept, often hard to accurately define, and the best we can hope for often boils down to the familiar basket of eggs. Cash is a conservative option, but it is not risk free. Especially not for housing associations whose free reserves often total tens of millions of pounds. As a result of the sums involved, housing associations can find it difficult to effectively diversify counterparty/default risk and large deposits are often placed with a small number of banking institutions.

If a UK regulated bank fails (as happened during the financial crisis) and is unable to repay its deposits, the entire sum is at risk unless the organisation qualifies for the Financial Services Compensation Scheme (FSCS). If an organisation does qualify, the cover in question is currently only £75,000 per institution, far less than most housing association deposits.

Funds invested via investment managers are held in nominee companies. Holding investments in nominee protects the beneficial ownership of the investments, allowing the custodian to administer the investments. Investments held in nominee are ring fenced under separate legal title.

If the investment manager or the nominee company in question gets into financial difficulty there is no direct risk to the client’s investments. Above and beyond this structural difference in default risk, FCSC compensation up to £50,000 applies for qualifying underlying investments.

Choosing to devote a portion of reserves to non-cash investments involves the acceptance of market risk, usually defined as volatility. This is a trade-off that most large charities with significant reserves are willing to make as the income streams created help accomplish charitable objectives. Additionally, the long term horizon of most large charitable organisations make then well suited to absorb the volatility over time.

Investing a portion of free reserves can be a risk diversification exercise. Trustees opt to accept a level of investment risk, tailored to the underlying purpose of reserves, in exchange for lower counterparty/default risk.

Inflation risk

For most charities, reserves are held to assist with both long and short term fluctuations in income and spend. Cash is often the most appropriate option for mitigating short term risks, but £1 will not be worth £1 five years from now. If a portion of reserves is needed to mitigate long term risks then efforts to preserve the real value of reserves may be appropriate.

It may seem counter-intuitive, but often the most effective way of preserving the purchasing power of reserves involves an element of market risk. This principle is particularly important for housing associations which often have maintenance contracts and future expenditure plans that rely on the future purchasing power of current reserves and income streams.

Developing a reserves policy

Charities in general and housing associations in particular have a duty to balance the needs of current and future beneficiaries. One way of ensuring that future as well as current interests are protected is to develop a robust reserves policy, outlining both the intended purposes for reserves and the allowed strategies for managing them.

Within housing associations, there is a traditional view that reserves should not be invested but rather be kept as cash as this is considered the lowest risk option. In reality, housing associations and other large charities are often very well placed to accept a degree of market risk and their charitable objectives are often greatly enhanced by the additional, longer term investment returns.

At a minimum, reserves policies should aim to cover the following:

A three-pronged threat

Housing associations currently face a three-pronged threat to their financial position. Dwindling government grants in England, pressure to reduce current rental income and the Governments continued emphasis on the social tenants’ rights to home ownership are stark reminders of the need for non-government income streams. While partial investment of free reserves is only a small part of a complicated puzzle, it may be a viable start.

END OF ARTICLE

Return to top of page

NEXT ARTICLE