The future of local authority property investment

The trend of councils investing in commercial property originally stemmed from their desire to fund regeneration schemes and gain control over local assets to assist in the regeneration process. This has particularly focused on secondary town centres and those with obsolete high street offices or tertiary retail.

However, the motivation has increasingly switched to providing income for local services against a backdrop of reduced funding from central Government. Indeed, the Local Government Association estimates that councils have faced a reduction of nearly £15 billion in central government funding over the last decade.

Where investment has been solely for income, purchases have not been restricted to properties within the local authority’s boundary, and ‘off patch’ investments have become an increasing trend. For example, the National Audit Offices estimates that 47.9% of all acquisitions by value in 2018/19 were outside the boundary.

Councils have purchased a significant amount of commercial property over the last four years, totalling over £7 billion. Investment peaked in 2018 at more than £2.2 billion. Although investment levels have reduced over the last year, Q1 2020 still saw purchases totalling £325 million. The highest proportion of investment since 2016 has been in office property, accounting for 44% of the total, with retail accounting for 31%. Industrial accounted for 14%, with the remainder in mixed-use or other sectors.

The volume of property bought by local authorities has been buoyed by their ability to outbid other purchasers. This is primarily because they can access cheap government borrowing through the Public Works Loan Board (PWLB), with the rate for 50-year new maturity loans at just 1.81% until October 2019.

The Government has become increasingly concerned about the level of investment and potential for excessive risks to be taken. In its February 2020 report “Local authority investment in commercial property”, the National Audit Office highlighted a risk that some local authorities could have paid a premium above the market rate due to the low rate of borrowing available through the PWLB.

In October 2019 the Treasury responded to the increased level of PWLB borrowing to fund commercial property investments by raising the borrowing rates for PWLB 50-year new maturity loans by 100bp to 2.82%.

The Treasury is now undertaking a consultation on the use of PWLB lending by local authorities for commercial investment, due to close on 31 July. Specifically, the proposal would prevent local authorities from buying investments primarily for yield, whilst maintaining their ability to undertake regeneration and provide housing. A definition of ‘debt-for-yield activity’ would be developed, although it accepts that there will always be an element of judgement.

Once a new system is in place, it is intended to reduce the interest rate on new PWLB loans (subject to market conditions). It is important to note that the consultation does not cover investment using other funding sources.

Simultaneously, a Private Members Bill aimed at curtailing local authority commercial investment activity is going through Parliament. Officially titled the “Local Authorities (Borrowing and Investment) Bill 2019-21”, its second reading is scheduled for 23rd October this year.

Although the exact wording of the Bill is yet to be announced, should it pass into law, it could heavily restrict the ability of local authorities in England to purchase outside of their boundaries, limit their power to invest in commercial risk-taking enterprises; and limit their borrowing for non-core activities.

We do not think it likely that all investments will be banned, and it is therefore likely that any restrictions will still permit regeneration and purchases for economic development purposes. However, some sort of assessment criteria may be required before funds can be drawn down.

The impact of COVID-19 is likely to have a significant adverse impact on local authorities, as it will do for all commercial property funds, and it is not impossible that a number of local authorities could experience severe financial difficulties. In addition, local authority balance sheets are clearly vulnerable to a sharp fall in the capital values of their investments.

Loss of commercial property income will now be a concern to those local authorities who rely on this to help fund services. It is a particular concern for the retail sector, which has accounted for nearly a third of the value of local authority purchases over the last five years, much of it in secondary shopping centres (and much falling into the regeneration category rather than investments purely for income). However, office and industrial property will also be affected.

Some of the impact will be immediate as tenants cease trading or seek a rapid rebasing of their rent in order to remain a going concern. Other impacts will take longer to feed through as some occupiers choose not to renew leases on expiry or exercise break options.

In these challenging circumstances, local authorities should look to mitigate the impacts by reviewing their portfolios and identifying opportunities for added value or change of use which could enhance the income returns from their assets.

If investment in commercial property is restricted, what are the alternative investment opportunities for councils, assuming they are still going to need to generate income streams from somewhere? A number of property-related options could be considered:

• It is likely that investment for regeneration will still be allowed in some form, as politicians are unlikely to cut off a route of funding for regeneration, particularly given the Government’s ‘levelling-up’ agenda. Therefore, opportunities which assist regeneration are likely to remain on the table.

• Investing in sectors that are not likely to be prohibited – there are numerous green energy investments which could be classified separately to commercial investment, and MP’s are very unlikely to hinder those councils aspiring to meet their 2035 Carbon Neutral targets by withdrawing funding to this sector. Other opportunities could include strategic locations for Waste to Energy plants, for example.

• Sale and leasebacks – if a council wishes to liquidate some funds quickly, it could offer a sale and leaseback on a property in their portfolio. They could, for example, grant themselves a head lease on a 30-40 year term and sell this to investor for say 3%, thereby turning a 6% investment into a 3% one and doubling their receipt. There are still risks and uncertainties associated with this option, for example, who would be responsible for capex on the building during void periods? However, a sinking fund from the capital receipt of the sale could be used to offset these costs.

• A number of alternative sources of finance are potentially available:

• Local authorities could partner with property funds (who also need to generate income), and we are aware of funds looking to put together long loans at low yields. A potential problem is the need for the funds to protect themselves against inflation over such a long period, which could necessitate an inflation-linked or stepped interest rate.

• The PWLB lending rate is now similar to what is being offered through normal commercial lending channels, which remain available to local authorities.

• Inter-council lending through municipal bonds.

• Identifying where surplus receipts could be invested.

We believe that the overwhelming majority of investment has been undertaken prudently within the rules, and with good knowledge and advice on the risks associated with investing in commercial property. Indeed, it has been instrumental in assisting local authority funding.

It is almost inevitable that the ability of local authorities to purchase commercial property investments will become more restricted, although the details remain uncertain. Together with the broader uncertainty, local authorities should be considering the strategic implications of this, as well as the impact of COVID-19 on their existing assets.