Low-Cost Housing Development

Mon, 19 Apr 2010 10:46

An extract of a paper titled:Are the incentives offered by the Social Housing Programme attractive enough to ensure the participation of the private sector?

Authored by Trusler, K.A.L. and Cloete, C.E. (Department of Construction Economics - University of Pretoria)

The Aim

Since the introduction of social housing in South Africa, there is no record of a private sector for-profit company having engaged in the initiation, development and management of a social housing project. This stark fact prompts two suggestions, either the private sector is not well informed about the social housing programme or, the private sector is informed, but does not consider the incentives being offered attractive enough to want to participate.

Therefore, the aim of the research is to investigate the envisaged role of the private sector in social housing, including the rules for their engagement in the programme, and more specifically, the nature and extent of the incentives offered, and whether the private sector finds them attractive or not. Other surrounding factors such as market related incentives and risks that could influence the participation of the private sector in social housing, are also considered.

The research design makes use of four different methods of data collection, which includes an extensive literature review, semi-structured interviews, a structured questionnaire completed by selected private sector organizations, and the use of a financial model provided by the Social housing Foundation (SHF) to test the financial viability of a typical project given a number of different scenarios.

Findings show that while social housing is one of a number of programmes initiated by the National Department of Housing (NDOH), now the Department of Human Settlements (DOHS), to provide housing for all South Africans by 2014, one of the delivery agents able to initiate, develop and manage social housing projects is the private sector for-profit company. Recognising the value of their contribution, the social housing programme stipulates very specific incentives applicable to the private sector to encourage their participation. These include access to the restructuring capital grant, the freedom to distribute retained profits during the term of the project, and the Build Operate Transfer (BOT) model that enables the private sector to exit the project after 15 years and trade with the housing stock in the market place.

In addition, market related incentives such as positive reports on the rental housing sector, vacancy rates and trends, inefficient and expensive municipal services etc., would further influence its involvement.

The response of the private sector to a questionnaire, which introduced them to the concept of social housing and the incentives available to them, indicated that the sector is initially attracted to the incentives offered, but with some reservations. When given the opportunity to recommend changes, they chose to increase the internal rate of return (IRR) and reduce the term of the project.

When these recommended changes were applied to a typical project and tested in the financial model, the only way financial viability could be achieved was by reducing the contract period, the cost of the land and the buildings, the operating costs, and the cost of long-term debt. Innovation and careful decision-making would be required to effectively implement these adjustments made to the cost side of the project, as rental income, which is controlled for the duration of the project, cannot be adjusted at will to cover unforeseen costs.

The research was to gauge how well informed the private sector is about the incentives offered in the social housing programme, and whether or not they find them attractive or not. This information could then be used to make the adjustments considered necessary to ensure the participation of the private sector in the future of social housing.

On the positive side, the private sector believes that they should be involved in social housing and as such, are willing to engage in consultation with government to develop mutually suitable grounds for participation. The recommendation is that Government should take the initiative to invite the private sector to collaborate in a process that would result in the formulation of a mutually beneficial model that would address the social responsibility of the public sector to provide rental accommodation for low-income persons, and the objective of the private sector to achieve acceptable profits.

Field of Play

The national goal is to provide housing opportunities for all South Africans, and to eradicate informal settlements by the year 2014. While millions of houses have already been provided, about 2.4 million still need to be delivered, at a rate of about 500 000 each year. As a result, a variety of housing programs offer temporary accommodation, while others offer various forms of fully or partially subsidised ownership. Social housing on the other hand, offers the rental tenure option, which excludes immediate individual ownership by the residents.

Social housing is defined as: a rental or co-operative housing option for low-income persons, at a level of scale and built form which requires institutionalised management, and which is provided by accredited social housing institutions (SHIs) or in accredited social housing projects in designated restructuring zones. Accredited SHIs apply to not-for-profit private entities, whereas accredited social housing projects apply to for-profit private companies.

An accredited project is a project in which Government subsidises rental units, provided by the private sector, making them affordable to those eligible for social housing. The project receives accreditation through the Social Housing Regulatory Authority (SHRA). The notion of accredited projects allows private sector developers and rental management agencies to participate in social housing provision, which boosts capacity to achieve scale delivery.

The private sector for-profit company is perceived as having the potential to make a major contribution, therefore the Social Housing Policy states that, ‘social housing must encourage the involvement of the private sector where possible'.

In order for the private sector to engage in social housing projects, they would need to become familiar with a variety of aspects surrounding the projects, such as:

• Rental structures
• Building density and specifications
• Variety of units
• Target markets and their income brackets
• Housing quality to suit the target markets
• Structure of capital grants
• Project accreditation
• Financial viability

Incentives encouraging the private sector to participate in social housing can be drawn from three main sources, namely:

• Government incentives applicable to the social housing programme only
• Government incentives not limited to the social housing programme
• Market related incentives

Firstly, Government incentives in the social housing programme only, include:

• Access to the restructuring capital grant
• A Build - Operate - Transfer (BOT) model which enables the private sector company to exit the project after 15 years, after which it can trade in the market place with the housing stock at their disposal, for profit
• To sell the property before the expiry of the 15 year period, the company would require the approval of the SHRA, and would be liable for:
  • Repaying one fifteenth of the initial grant amount in respect of every uncompleted year
  • Paying interest at prime + 2% on the reducing amount of the grant in respect of the number of completed years
• Retained profits may be distributed during the term of a project
• Private sector companies are not required to build up, or reinvest operational reserves

Secondly, government incentives not limited to social housing include the Urban Development Zone (UDZ) tax incentive. This is an accelerated depreciation allowance that relates to investments in refurbishing existing buildings or creating new buildings in inner city areas.

Thirdly, market related incentives would include positive reports on the rental sector, especially with regard to current under-supply and over-demand conditions, and extremely low vacancy rates of 1% - 2%.

However, there are certain perceived risks associated with social housing, such as the management of evictions, inefficient and expensive services delivered by municipalities, access to government funding and debt finance, and the lack of suitably located, serviced and affordable land. Each of these could discourage private sector participation.

The Questionnaire

Response from the questionnaire shows that 60% of the private sector considered the opportunity to engage in a social housing project attractive; 20% were cautious, and 20% were not attracted at all. This indicated a willing, but cautious response.

When asked if they would be satisfied with an Internal Rate of Return (IRR) of 18%, 80% said no, and that an IRR above 20% was preferable. As much as 60% of the respondents did not consider a 15-year project term reasonable, preferring a term of less than 10 years. Both the preferred selections of the higher IRR and the shorter project term indicate that the private sector are not convincingly attracted to the incentives offered, and are inclined toward higher initial returns and shorter project terms.

80% of the respondents indicated that they were in favour of paying 10% equity (of total project cost) up-front. Similarly, 80% of the respondents indicated that they were satisfied with the prescribed minimum floor area of 30m2.

When asked about the prescribed subsidised rentals and rental mix, 60% said it was good, 20% said satisfactory and 20% said unsatisfactory. This response indicates that the private sector, although not fully in agreement with the prescribed rentals and rental mix, are prepared to work around them.

The response to regulation and compliance monitoring of the project by the SHRA was fairly positive, with 60% saying it was satisfactory and 40% saying it was good. The willingness of the private sector to work with low-income earners in the R1 500 - R7 500 pm range was positive as well. The sector's willingness to interact with government departments was satisfactory, illustrating they were prepared to endure a necessary process as a means to an end.

When asked about municipal services, the Rental Housing Act and Prevention of Illegal Eviction (PIE), as well as the political and economic climate, respondents generally agreed that each of these would have an important influence on their decision to engage in the long term. Since the general opinion is that municipal services are expensive and inefficient, the Rental Housing Act and PIE are negatively disposed towards the role of the landlord, and there is an element of uncertainty in the political and economic climate, these sentiments would negatively influence the private sector.

However, an encouraging observation, supported by 80% of respondents, was that the private sector firmly believes they should be involved in social housing and are ultimately keen to consult with the public sector to figure out how to make it work.

The Case Study

To use the financial model, a case study was prepared using accurate information obtained from a "greenfields" social housing project in Gauteng. A typical feasibility study was conducted, taking into account the requirements of the social housing programme and more specifically, private sector incentives.

Project Details (As at June 2008)	Total	Per Unit
Number of units (50 x Bachelor, 50 x 1-Bed, 200 x 2-Bed)	300
Floor area of units (Bachelor = 30m2, 1-Bed = 37m2, 2-Bed = 50m2)	13 350 m2	44.5 m2
Cost of land including transfer fees (23 156m2)	R 4 948 796	R 16 496
Total project cost (Including land & VAT)	R 83 308 571	R 277 695
Assuming 30% of units reach Primary Target Market and remainder are let under R2 500pm
Number of Primary Target Market units	90
Monthly rental at commencement (90 units x R750 + 210 units x R2 452) - 5% Vacancy	R 553 299	R 1 844
Monthly direct operating costs at commencement	R 92 198	R 307
Monthly overhead operating costs at commencement	R 83 564	R 279
Monthly utility costs at commencement (Recoverable)	R 85 500	R 285

This information was then fed into the financial model, which among other things, calculated the IRR of the project over a 20-year life cycle, and determined the minimum debt service ratio. In addition, the model provided the IRR at exit from the project after 15 years, and calculated the amounts that would need to be settled after those 15 years, such as the equity share capital, outstanding shareholders loans, and outstanding debt.

Against this backdrop, 11 different scenarios were tested. Each scenario took into account the effect of the questionnaire responses, such as an IRR of above 20%, and project terms of 10 years and less.

Phase 1

Scenario 1, based on 30% of the units reaching and remaining units not exceeding R2 500 per month, fails the viability test. It met neither the capital grant qualification nor the minimum debt service ratio of 1.3. Furthermore, it did not meet private sector expectations of a 20% IRR after 15 years, instead reaching 18% after 20 years, and only 14.34% after 15 years. The private sector would also have to settle an outstanding amount of more than R20 million.

Scenarios 2 and 3, which consider 50% and 70% of the units reaching the primary target market, produce results progressively weaker than Scenario 1. Scenario 4, which looks at letting the remaining 70% of the units at market related rentals, produced the poorest results of all.

Scenario 1 was naturally the best option from which to work, so various adjustments were made with a compounding effect, resulting in Scenarios 5 - 9.

Phase 2

In Scenario 5, the construction period was reduced from 14 to 12 months, which only achieved a 14.8% IRR after 15 years. In Scenario 6, capital expenditure was reduced as well, by 7%, whose 15-year IRR fell short at 18.46% and failed to meet the debt service ratio minimum as well.

For Scenario 7, the operating costs were reduced by 8%. After 20 years, all hurdles were overcome, yet it still did not meet the private sector demands after 15 years. In Scenario 8 the debt margins were adjusted from 0 to -2, from a straight 0. The results were marginally better than Scenario 7 but still fell short of private sector requirements.

Scenario 9 assumed the municipality donated the land and finally the desired results were achieved. The IRR after 15 years was 23.64%, the debt cover ratio 1.61, and given the market value of housing stock, the settlement amount of R11 841 603 would be considered very reasonable.

The results show that all the adjustments would need to be made before the capital grant qualifications were met, as well as the private sector requirements. In the end, it is idealistic, and would require highly detailed investigation, innovation and careful decisions. Authorities may challenge the idea of donating land, and the private sector may balk at the idea of reducing capital expenditure and operating costs.

Further ways to increase the IRR could be achieved through:

• National Treasury increasing the capital grant
• Reducing the minimum floor area
• Renting out parking bays
• Including commercial development
• Taking advantage of competitive tender conditions in a quieter market
• Incorporating preferential tax treatment (such as UDZ tax incentive)
• Subsidising municipal services

Phase 3 - Experimenting

The researchers continued the experiment with Scenarios 10 and 11, by looking at 10 and 5-year project terms respectively. In Scenario 10 the IRR was 19.19% but the combined sum of settlements and penalty fees for exiting early add up to a hefty R69 334 123. Scenario 11 achieved a laughable IRR of minus 3.5% after 5 years, with settlements and penalties amounting to R60 265 048.

Observations from here suggest that leaving any project before 10 years are up makes viability almost impossible.

The Final Say

Essentially, the incentives offered by the social housing programme are attractive to the private sector on face value, but with some reservation. Private sector expectations, as far as IRR and project terms are concerned, would effectively draw returns in line with other private market-related projects. It would also introduce risk mitigation measures, such as higher IRRs cushioning unforeseen costs, and shorter terms reducing exposure to market dangers.

When the preferences of the private sector are tested in the financial model, achieving an IRR of 20% after 15 years assumes that 30% of the units are reaching the target market, while the rest are let at rentals not exceeding R2 500 per month. The construction period is 12 months, capital expenditure and operating costs is kept at a minimum, and debt margins are set at -2%. Furthermore, the land must be donated by the municipality. These variables are not easy to achieve. They require incredibly innovative thought, careful decision-making and a healthy working relationship with the municipality.

Further incentives for the private sector to engage in social housing include the UDZ tax incentive, recent reports indicating the significance of the rental sector, the unmet demand for affordable accommodation, and the extremely low vacancy rates.

Since there is no guarantee surrounding the assumptions made in the scenarios, it is possible that the incentives are not considered attractive enough by the private sector. However, in spite of this risk and other debilitating factors such as poor quality and costly municipal services, bureaucratic government processes, debt finance, government funding, the lack of suitably located serviced and affordable land and buildings, the political and economic climate, and a host of other impeding factors related to social housing, the private sector still believes that they should be involved in social housing. As such, they are willing to engage in consultation with Government towards this end.

This positive approach by the private sector should be taken very seriously. Government should take the initiative and invite the private sector to collaborate in a process that would result in the formulation of a mutually acceptable model to meet the needs of both the public and private sector.

To view the full paper, please visit www.rics.org