Independent Financial Economist

Regeneration in London – next steps for policy

Financing Local Regeneration Schemes

Kate Gimblett, Policy Forum for London Keynote Seminar, 16th June 2016

I would like to talk about ideas for financing Regeneration because finance is a scarce resource in the context projects with social aims.

Most debt finance for development is difficult to obtain because development is inherently risky, and regeneration is usually perceived to be at the high end of the development risk spectrum. Every stage of a development or regeneration project is characterised by an array of risks and the providers of debt and equity for regeneration projects require returns commensurate with those risks.

A study that I worked on with IPD attempted to quantify development risk. We examined the distribution of returns that were achieved on nearly 3,500 developments over the 26 year period from 1983 to 2008. These developments were the holdings of UK investors and there was a record in the IPD database of each development’s capital expenditure throughout the development period along with the achieved completion valuations and associated lettings.

It turned out that the development projects completed in the 26 years we examined had a median IRR of only 7%, i.e. half the projects had returns below 7%. Furthermore, 25% of the developments in the data set had returned less than -3%. This tells you that losses are frequent and development returns are surprisingly low - typically well below the 15%-20% hurdle rates generally expected of them. The investments we analysed were commercial buildings, but if you look at the past behaviour of returns to housing development you will no doubt find a similar story.

For all of these reasons, regeneration aimed at social targets cannot wholly rely on the private market for finance without some form of downside protection or credit enhancement to reduce risk – and that applies to schemes that benefit from sites contributed by public entities. A number of successful projects have been delivered by public private partnerships but the business models they have used tend to limit the number of potential regeneration schemes relative to current and projected needs. So, an additional approach is needed that reduces the risks and upfront costs of regeneration, while widening the potential number of projects.

The approach I would like to advocate is a vehicle that I have decided to call a ‘Regeneration Real Estate Investment Trust’, or more simply, a Regeneration REIT. Equity investors are very familiar with the listed shares of Real Estate Investment Trusts (REITS,) but the Regeneration REIT vehicles that I am advocating would not be listed – at least not at the outset.

The Regeneration REIT is a special purpose vehicle (SPV) wrapper in which to place both private and publicly owned sites and properties so that they can be regenerated and used to provide long term income streams without selling public assets in a one-off transaction.

The objective is to enhance the value of existing underutilised public wealth to create substantial amounts of new housing for rent, superior public realm, cultural spaces and workspaces for micro businesses and SMEs.

As all the new assets created will be generating long term income streams, Regeneration REITs can enhance public wealth and revenues alongside private wealth and revenues. Regeneration REITs would be a new and different form of public-private partnership.

One of the many advantages of a REIT-type structure rests on the opportunity that it would offer for private site owners in a target regeneration area to exchange their property assets - many of which are likely to be underperforming or obsolete structures - for shares in the Regeneration REIT. The exchange of existing assets for shares can be structured to be very tax efficient for these private site owners. Each shareholding could be valued in proportion to the market value of the site being contributed and additional measures can be put in place to compensate site owners for the loss of existing income streams for a limited period. The attraction of future profits from the REIT would reduce the number of regeneration projects that require unwieldy compulsory purchase orders for full site assembly.

Further shares could, and should, be offered to the citizens that live in the locality of the regeneration project. This would give communities the opportunity to have a stake in the project and help to reduce local opposition which so often causes planning delays.

The key to financing the full cost of the regeneration project(s) would be the use of Catalytic First Loss Capital provided by a public body or other entity with social aims. This can either be ‘on balance sheet’ finance, or ‘off balance sheet’ finance, e.g. through the use of a First Loss Guarantee for any debt finance raised in the private sector. Since the REIT structure would be employed as an SPV wrapper, any debt finance would be the liability of the Regeneration REIT.

If the Catalytic First Loss Capital guarantees are properly structured they can reduce risk sufficiently to attract institutional investment funds to provide debt finance, by which I mean pension, insurance and foundation funds. Institutions are increasingly investing in private debt due to the very low level of bond yields available in the market. Hence an increasing amount of institutional money is flowing to real estate finance through vehicles such as real estate debt funds. The debt funds seek real estate debt that meets particular risk profiles in order obtain higher incomes than the low yields available in the bond market. A Regeneration REIT, backed by credit enhancement such as a first loss guarantee, could provide institutional investors with private debt investments that offer the risk/return profiles over the long time horizons that they seek while at the same time financing much needed regeneration.

If Regeneration REITs are successful at generating attractive cash flows some could become listed in the future. Whether listed or unlisted, Regeneration REITs could foster the generation of long term public returns from existing underutilised public wealth in partnership with private finance while meeting urgent needs for affordable rented housing and small business space.

Thank you. Kate Gimblett

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