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Credit FAQ: Sharing Is Caring: U.K. Shared-Ownership RMBS Explained


Albeit rare, shared-ownership (SO) mortgages are not entirely unseen in U.K. residential mortgage-backed securities (RMBS) securitizations. However, given their social angle--they facilitate ownership to those who would otherwise not be able to afford to live in certain areas--and the unrelenting barriers to first-time buyer affordability, SO mortgages are rising in popularity. We have also observed an increase in interest in both the securitized pools of SO mortgages and securitizations of the rental streams of SO properties owned by a social landlord/registered provider (RP). This Credit FAQ explains some of the credit considerations and challenges to securitizing both portions of an SO arrangement.

Frequently Asked Questions

Market Overview And SO Frameworks

What is a shared-ownership mortgage?

In general terms, an SO is where a borrower owns a percentage of a property, via a combination of a deposit on day 1--typically between 5% and 10% of the property's total value--and mortgage financing from an eligible lender for the rest of the portion. An RP (generally a housing association) owns the rest of the property, renting it to the borrower at a contracted rate.

Historically, building societies have been particularly active in the SO lending market as mortgage lenders. Although the share that the borrower acquires on day 1 is not narrowly prescribed, affordability constraints means that it is not typical for it to be more than 50% of the total property value. As housing policy is devolved to the four countries of the U.K., specific rules differ by region.

Chart 1


From a legal perspective, the SO is a fixed-term assured tenancy with an RP on a dwelling. The fixed term is at least 99 years (with the latest framework offering 990 years). The SO renter/owner pays a premium for the lease on the share they own, which is usually funded by a mortgage. So, the mortgage lender's (ML) security is the lease granted by the RP.

Is there a typical SO property type?

SO property, except for resales, tends to be newly built. Additionally, many new housing developments have requirements to provide SO houses--not just flats--as part of planning consent. That said, different RPs will have different business models and commercial strengths when it comes to acquiring property earmarked for SO from new build developers.

Who can buy an SO property? And what does this mean for the risk profile?

To be eligible for SO, a household must earn £80,000 or less (£90,000 in London) per year. Secondly, the borrower must be either a first-time buyer, former homeowner who cannot afford to buy now, or an existing shared owner. Individual RPs may have additional eligibility criteria or specific regional biases that may alter the risk profile further.

This means SO mortgages are likely to have biases that are absent in pools of standard mortgage loans. For example, SO mortgage loans are likely to have higher-than-average exposures to first-time buyers and lower-than-national average income. Given generally lower affordability, SOs are also categorized by high loan-to-value (LTV) ratios, which can affect both default and loss estimations.

Are all SO schemes the same?

SOs have evolved and rules that govern important aspects--such as who is eligible to purchase, who can act as an RP, and rights and obligations in the event of a repossession--have changed. Generalizations of credit considerations that apply to all SOs are therefore difficult to make.

Table 1

Comparing The SO Frameworks
Feature Previous framework (up to April 2021) Revised framework (as of April 2021)
Minimum initial purchase (%) 25% OMV 10% OMV
Lease length 125 years 990 years
Minimum staircase (%)* 10% OMV 1% OMV first 15 years, 5% OMV thereafter
Maximum no. of staircase increments* No limit 1% OMV once yearly, 5% unlimited
Essential repairs Renter First 10 years of essential repairs are the landlord's responsibility
Sale nomination period 8 weeks 4 weeks
Note: The U.K. government has stated that approximately 50% of affordable housing delivered with grant funding will be SO for 2021-2026. *For staircasing, please see below. OMV--Open market value.

Who's responsible for costs and repairs?

Following consultations, between 2019 and 2020 the government introduced a 10-year initial repair period. During this period, the RP is responsible for up to £500 a year toward certain repairs and maintenance. For legacy SO renter/owners, all costs are their own responsibility.

Underwriting And Servicing

How does underwriting an SO loan compare to a standard first-lien U.K. mortgage?

An SO mortgage is regulated from a consumer perspective in the same way as any other mortgage loan, and the responsibilities of the lender to the customer and the lender's considerations about the security on the loan are generically the same as a standard loan. Below we compare key elements of the underwriting process between an SO mortgage and a standard first-lien U.K. mortgage loan.

Table 2

Underwriting Process: Key Elements
Standard first-lien U.K. mortgage Shared-ownership mortgage
Affordability Affordability of the mortgage is assessed using verified borrower income. Living costs, including payments on credit obligations, are netted against income. Typically, lenders assess the impact of interest rate rises on affordability. The affordability calculation works in much the same way as a standard mortgage. The nuance is that rent is payable on the share the borrower does not own. So, the affordability calculation would consider the affordability of both the borrower's mortgage and the rental commitments under the agreement. Although a borrower only has a share of the ownership, they are generally liable for all maintenance and repairs. Ultimately, this is much the same financial commitment that an outright owner of any property has.
Valuation Third-party valuation, usually including a full internal and external inspection. Third-party valuation, usually including a full internal and external inspection.
Further lending (staircasing) Both the valuation and the affordability assessment would be redone to see if the borrower can afford the new loan and security is appropriate. Both the valuation and the affordability assessment would be redone to see if the borrower can afford the new loan and security is appropriate.
What is the relationship between the rental portion and the owned portion? Can default on one trigger default on the other?

Yes, defaulting on one of the two components can trigger default on the other and trigger repossession and sale of the property. So, for example, if the borrower is in arrears on the rental portion but not the mortgaged portion, the RP could enforce on the security, and vice versa. Therefore, we would consider the combined LTV of both the owned and the rental portion when estimating default risk.

However, in practice, the interaction between the RP and ML in the event of either mortgage or rental arrears is more collaborative than the strict legal position.

As highlighted above, an SO ML has the lease on the property as security. Because the lease can be forfeited if the borrower does not pay the rent on the RP's portion of the property, the SO lender is incentivized to pay rental arrears and capitalize them by adding them to the mortgage balance. This arrangement is common in standard mortgages where a borrower does not pay service charges or ground rent on a lease-hold property. To maintain its security, a lender would pay the outstanding ground rent and service charges and capitalize them to the mortgage balance. However, the amounts that an ML--and therefore a transaction--may need to pay to preserve security will likely be higher than those on a typical lease-hold mortgage. The ML's capitalization of unpaid rent will increase leverage and increase the LTV, while its first-lien means that the ML is typically prepared to take on the extra payments.

It is market practice for the RP and mortgage lenders to discuss rental arrears and the borrower's position before making any decisions on appropriate action, including the possible sale of the property. Although both parties are often pragmatic, the RP can disagree with the ML's view of a sale price and sell the property on the open market.

Chart 2

What happens upon enforcement of the security?

If the lease is breached, it can be forfeited. In this scenario, and unlike a lease on a non-SO property, the SO renter/owner is not entitled to any distribution from the resale of the lease even if that sum is enough to clear the rental arrears and any pending costs. In other words, the owner/renter risks losing their equity contribution, and any upside from the increase in the lease's value. In cases of borrower hardship where there is positive equity, the borrower would be incentivized to cooperate to preserve their equity stake and any upside from property price increases.

How does the repossession process work and how are sales proceeds allocated between the respective parties?

Since it is standard market practice for the ML to clear rental arrears (by capitalizing them), arrears on the mortgage are the most likely trigger for repossession. Therefore, it is typically the ML who initiates and controls the repossession and liquidation process.

Under the model lease's terms, in a repossession, proceeds are allocated to the ML first (including accrued interest and capitalized rental arrears or service charge arrears). Once these are paid, proceeds are allocated to the RP. This is known as the mortgagee protection clause. So, in practical terms, the SO ML enjoys a first-lien position with the RP holding a second-lien position. The ML can initiate a repossession hearing even if the RP does not agree.

SOs originated under the Homes England Model Lease permit 100% staircasing, which is an important mechanism in repossession scenarios. The ML can acquire the property outright and therefore remove the property from any restrictions the RP may have about who can acquire the property, effectively giving the lender the ability to sell the property on the open market.

Are there any restrictions on the resale of the property?

Older versions of SOs may have different rules, but generally limitations on recent SO iterations are not significant. However, the RP has a "pre-emption right", which allows it to have the first refusal to purchase the property at the market value for eight weeks. If the property has been staircased to 100% ownership, the pre-emption right disappears. So, although the process has differences compared to selling a standard property, an ML is not constrained after the eight-week pre-emption period. Some older iterations of SO leases prevent borrowers from staircasing to 100%, in an attempt to prevent dwellings exiting the SO sector.

Securitizing The SO Mortgage

What are the analytical considerations for staircasing?

Data available indicate that staircasing in the initial years following the loan's origination is relatively rare, and averages less than 1% per year. This is logical as the profile of a SO borrower means that they are unlikely to have significant cash available to staircase in the initial period after a loan's origination. However, there is not enough data available to conclude on the likely propensity of staircasing later in the life of the mortgage.

When it does occur through additional borrowing, staircasing is like a further advance, which is not uncommon in RMBS transactions. In practical terms, the ML is advancing further funds to the borrower, which are secured against the value of the property. Ratings assigned to any transaction containing a material amount of SO properties would consider how the credit characteristics of the pool may change owing to staircasing.

There may also be legal risks that come with staircasing. It important to understand whether the ML's funding of any additional acquisition of the property becomes an obligation, or if it's simply on a "best efforts" basis. If it is an obligation, then setoff risks may emerge if the lender cannot fund the additional purchase, whereby borrowers may be entitled to claim any additional costs securing funds. This risk may be passed on to the issuer in an RMBS transaction. To illustrate the point, the most comparable scenario already seen in RMBS transactions is that of a flexible mortgage, where the borrower has a right to redraw, and if funds are not available to readvance to the borrower, the borrower can offset the cost of alternative financing.

Are there any other specific considerations about SOs?

Although not all properties are flats, cladding risk would potentially be higher for a pool of SO properties. In addition, older versions of the model lease may have clauses that create additional risks. For example, older leases may contain clauses that prevent underletting, rendering gaining consent to let the property harder.

What would prepayments look like for an SO loan?

Prepayment of a loan is a complex interaction of factors, including borrowers trading up, house price increases, people moving regions/countries, and product features such as step-ups at the end of promotional loan rates. The same is true of an SO mortgage, but at a transaction level, consideration should be given as to what effect staircasing will have on prepayments. A borrower in a SO arrangement whose financial position has improved may choose not to move house or pay down a lump sum of their mortgage, but rather, purchase a further share of their property. At a transaction level, this would be the opposite of a prepayment as collected principal is used as a loan to the borrower of the funds to acquire a larger share of the property. In theory, given the long leases, the non-owned portion could remain outstanding until death and therefore could exist a lot longer than the mortgaged part.

Challenges For Securitizing The RP Share

What is the legal form of the RP's ownership interest in an SO property?

The RPs share in an SO transaction is the opposite side to that of the ML and represents a granular rental stream from a diversified pool of borrowers, similar to a buy-to-let (BTL) portfolio. However, there are material differences between RP rental streams and a standard BTL pool.

Typically, the RP is a freeholder of the property and grants a lease to the borrower. The borrower typically purchases between 25% to 75% (10% now possible under the updated national framework) of the property. Although they can increase their portion via staircasing, they don't own the property until they have the 100% share.

This means that the RP's interest is not a mortgage backed by security but the ownership of real estate directly, unless a mortgage or some other mechanism is created to overcome this issue. This complicates securitizing the cash flow and analyzing the relationship between the RP, the borrower, and the ML, and how that ownership dynamic is dealt with when a borrower goes through financial difficulty. Although the steps involved are more complex, we don't expect this to have any material impact on recoveries on defaults.

An additional consideration is the risk that if a residential provider is liquidated, the legal title would need to be transferred to another RP. If the legal title is not held by an RP, the borrower may be restricted from remortgaging their homes under the current regulatory environment. In practice, borrowers could require the housing regulator to step in and remedy the situation.

How do the cash rental flows from a SO arrangement differ from those of a BTL transaction?

The first thing to highlight is that an SO borrower is underwritten on their income as the source of funds from which the loan will be paid, rather than on a debt service coverage ratio basis. This is logical and reflects the reality that the only person who will pay the rent on a SO arrangement is the renter/owner, whereas in a BTL loan, the tenant may change multiple times, and if the tenant does not pay the rent they can be replaced by one who will. If an SO renter/owner does not pay the rent and the ML does not opt to pay and capitalize the rental arrears, then the lease will be forfeited and the property will need to be sold. Consequently, we would likely assume that the default probability of the RP rental portion is the same as that of the mortgage and would be calibrated using the combined LTV ratio calculated as (1-the borrowers deposit).

Secondly, rents are linked directly to inflation, rather than a market rate. Whether this is a positive or not is difficult to say.

What is the maturity of typical rental stream that is owned by the RP?

As highlighted above, the RP's ownership interest is not a loan secured by a property and as such there is no defined maturity of the SO rental stream. It will end the earlier of (i) when the renter/owner sells the property or (ii) death (SO leases cannot be transferred to a family member without consent of an RP).

What does SO mortgage performance data tell us about credit performance?

Credit performance information is limited. To date, the main provider of SO mortgage finances has been building societies and so data are not in the public domain. There is no industry wide data set that shows performance of the sector overall. The nearest publicly available proxy, which is rental arrears data on the RP's share, shows that significant divergence between RPs is likely skewed by the practice of rental arrears being capitalized by MLs. This lack of data may create analytical challenges when it comes to achievable ratings for pools with significant portions of SO mortgages.

Would the operational risks be different from a typical RMBS transaction?

Operational risks, especially disruption risk, could be materially different for a pool of SO rents when compared to a pool of BTL loans. The analysis would center on a hypothetical event of default of the RP and how cash flows would likely be affected it.

This report does not constitute a rating action.

Primary Credit Analyst:Alastair Bigley, London + 44 20 7176 3245;
Secondary Contact:Darrell Purcell, Dublin + 353 1 568 0614;

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