160-year leaseback deal holds key to future of social housing finance

It has been dubbed the "holy grail" of housing: institutional investment in affordable housing has been cited by a long line of politicians, thinktanks and commentators as the elusive catalyst for new development.

London mayor Boris Johnson, the Liberal Democrats and the Royal Institute of British Architects (Riba) were among the many voices to last year claim that pension funds could hold the answer to our housing crisis. Johnson pledged to "bang heads together" to prompt investment, with the Lib Dems planning to use the funds to triple the current rate of housebuilding. Riba's future homes commission meanwhile proposed that local government pension schemes could provide a £10bn housing fund which could boost housebuilding to as much as 300,000 homes a year over the next two decades.

These lightbulb moments are nothing new; institutional investment has been targeted by policymakers for years. Yet ambitious proposals often fall short when the fundamental principles of investment are applied to the housing market.

Institutions such as pensions funds typically look for their investments to make a return of between 7% and 12%; an optimistic return on build-to-let property in London and the south-east – the most attractive market for any investor – peaks at around 6%. A survey of 100 local authority pension funds conducted by the Smith Institute found that none would be prepared to accept lower returns in exchange for achieving social benefit. So how can you make up this shortfall to present an attractive investment option to funds with a duty to protect their members' money?

"This is people's pensions we are talking about," says Ian Greenwood, former chairman of the Local Authority Pension Fund Forum, in response to Riba's calls for investment. "If this goes wrong and the councils are called on to provide more money, it will ultimately affect retirement incomes."

However, political faith in institutional investment remains strong. The government-commissioned Montague report, which proposed a number of measures to unlock land for developers to encourage institutional investment in the build-to-let market, was released as a "blueprint" for the private rented sector by former housing minister Grant Shapps. The calls of his successor, Mark Prisk, for a bigger, better and more professional rented sector is also dependent on large-scale build-to-let developments, which may rely on institutional investment to get them off the ground.

There is now fresh hope for the arrival of a new income stream. Local government pensions funds are faced with rising deficits as rounds of redundancies have reduced income and turned many contributors into beneficiaries of the funds. And with returns in some other investment areas suffering, it is hoped investors will look to broaden their horizons. But there are hurdles to overcome to make the investment more appealing.

In November 2012, the London borough of Islington invested £20m in a residential property fund and in January 2013 the Greater Manchester Pension Fund invested in the construction of 240 new homes after reaching an agreement with Manchester city council, sparking hopes about the long-awaited arrival of big investors into the sector.

Ben Jones, fund manager of M&G's secured property income fund which holds a property portfolio worth over £1.35bn in the UK, says: "In terms of institutional investment, the biggest hurdles are managing a lot of short-term tenancies and the costs of doing that. And getting the volume of investment to get a decent-sized portfolio to make it worthwhile."

M&G recently finalised a £125m deal with Genesis housing association for the Stratford Halo tower block in east London. The sale and leaseback agreement will see M&G purchase 401 properties for private rent inside the tower and lease them back to Genesis to manage for the duration of the 35-year leaseback period, throughout which the housing association will make inflation-linked payments to M&G.

The innovative deal offers longer term benefits to the investor too. "Why this deal is particularly different is that under a traditional sale and leaseback at the end of the leaseback period the asset would usually go back to the original owner for a pound or a peppercorn," says Richard Kerse, executive director of resources at Genesis. "But under this deal it doesn't come back to us. It stays with M&G."

M&G hold an 160-year lease on the properties, and it is this long-term stake in the property market that has added the extra value to the investment. "The fact we've got a long-term leaseback from Genesis for 35 years with an annual inflation-linked rental payment is attractive," says Jones. "But also what interests our clients is having long-term ownership interest in residential real estate."

The deal releases £125m tied up in the development and Genesis will use the money to deliver 3,000 new homes over the next three years, including affordable rent and shared ownership homes.

Kerse believes the organisation's early foothold in the market rent business was crucial in securing the investment. "The fact that we have a strong track record [in managing market rent properties] definitely comes into it," he says. "Housing associations with private rented sector experience are going to be lower risk. There are a lot of associations that are starting to go into it. One the one hand they think, quite rightly, that it's an extension of what they do but to do it successfully requires a slightly different mindset."

Jones says the deal provides the financial returns that institutional investors look for: secure income from a strong counter-party, inflation-linked payments and a long-term stake in a strong property market – and if these criteria can be met then more institutional investment would be forthcoming. M&G is already in talks with another housing association over a similar agreement.

"The transaction provides a workable template to institutional investment in this sector," he says. "We're in the process of another transaction with another housing association at the moment. We've got significant capital to invest into additional projects on this sort of basis. We're certainly looking to do more.

"The demand is there if you can deliver it in a format that suits investors. Pension funds are very keen to invest in those sorts of assets, but as soon as you introduce too much risk or other factors, the level of demand drops away."

Join our panel of experts to discuss pension funds and investment in affordable housing, live on the Guardian Housing Network from 12-2pm on Monday 4 February 2013. Click here to go to the discussion

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