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Local Authority investments in commercial property – are they cash generators or debt burdens?

Since the mid-2010s some Local Authorities have been building up portfolios of commercial property – from hotels and farms to shopping malls and leisure complexes – putting the profits that are generated into their revenue budgets. With Government now consulting on the lending terms of the Public Works Loan Board – a lending facility used by many Local Authorities to build up their portfolios – and the coronavirus pandemic leading many tenants to close and forgo rent payments; will Local Authority property portfolios go from cash generators to cash draggers and what impact might this have on public services? Jessica Sellick investigates.

Local Authorities have long owned buildings that could serve a commercial purpose. Indeed they often use commercial structures to advance their core activities of delivering public services, housing and regeneration for the benefit of their citizens. However, recent reports suggest some Local Authorities have started to use low-cost loans from the Public Works Loan Board (PWLB) to buy investment property for rental income. The Government is now consulting on ‘debt-for-yield’ activity – recommending that Local Authorities wishing to buy investments primarily for yield should remain free to do so but not be able to take out new loans from the PWLB to do it. What decisions over capital projects are some Local Authorities pursuing – and how are they financing them? 

How much can a Local Authority borrow? Local Authorities are required to distinguish between capital and revenue funding in their accounting. Borrowing and investment are matters of Local Government Capital Finance, with practice in this area governed by The Chartered Institute of Public Finance & Accounting’s (CIFPA) Prudential Code for Local Authority Finance. In addition, Local Authorities must take account of CIFPA’s Treasury Management Guidance for Local Authority funds and the Ministry of Housing, Communities & Local Government (MHCLG) guidance on Local Authority investments and on Minimum Revenue Provision (MRP). 

‘Capital expenditure’ is defined in the Local Government Act (2003) as “expenditure of the authority which falls to be capitalised in accordance with proper practices”. Government provides an annual allocation of capital funding to Local Authorities alongside the annual distribution of revenue funding set out in the Local Government Finance Settlement. While Local Authorities can access finance for infrastructure from a number of sources, the quantity of expenditure that is often required for capital projects means that most Local Authority capital finance is obtained through borrowing. 

Under part 1, chapter 1, of the Local Government Act (2003) a Local Authority may borrow for any purpose relevant to its functions or for “the prudent management of its financial affairs”. Every Local Authority must set a total borrowing limit for itself in accordance with the principles of the Prudential Code. This borrowing limit is related to the revenue streams available to a given Local Authority, and the extent to which it can repay debt. Local Authorities are prevented (by law) from using their property as collateral for loans. However, there is some flexibility in exactly how individual Local Authorities set their borrowing limits. The Prudential Code, for example, does not contain a formula for Councils to make an exact calculation of prudential limits; with Local Authorities relying instead on the judgement of their chief finance officers and on ‘generally accepted accounting practices’. 

The Prudential Code requires all Local Authorities to draw up rolling three-year plans for capital expenditure. These plans typically cover all capital spending apart from housing. While Local Authorities may borrow money from a number of different sources, they cannot breach the overall borrowing limit they have set. 

Under section 32 of the Local Government Finance Act (1992) Local Authorities are required to maintain an appropriate level of reserve funding. As per the Prudential Code, the judgement as to an appropriate level of reserve lies with individual Local Authorities – there is no standard formula for identifying the correct level.  

Guidance on Local Government investments issued by the MHCLG in 2018 requires Local Authorities to prepare an investment strategy annually (or include the required details in their treasury management strategy). Each strategy must explain how their investments (including commercial property portfolios) relate to their core purposes; and quantitative indicators to allow Elected Members and the public to assess a Local Authority’s risk exposure as a result of its investment decisions. Importantly, the guidance requires an explicit statement to be included in each strategy about the degree to which commercial income underpins the delivery of services – and that each Local Authority must set annual limits for the proportion of gross debt compared to net service expenditure as well as the percentage of net service expenditure that comes from commercial income. This follows up on the findings of a Public Accounts Committee (PAC) Inquiry in 2016 which found Local Authorities were investing less in physical assets such as libraries, museums and parks; and spending more on commercial investments such as property. The PAC called on the Department for Communities and Local Government [now MHCLG] to strengthen its understanding of the capital issues faced by Local Authorities, and to develop a cumulative picture of risks and pressures across the sector. This formed part of a call to change key aspects of the codes and governance in line with a view that Local Authorities should not borrow to invest solely for yield.  

Who can a Local Authority borrow from – and how much are they borrowing? Local Authorities seeking to develop property portfolios do so using Statutory Powers that relate to their wider purposes – such as regeneration or economic development. 

Section 4 of the Localism Act requires anything done for a purely commercial purpose must be carried out by a Limited Company. However, if a Local Authority is using powers related to regeneration or economic development to buy a local shopping centre, for example, it is not acting purely in a commercial purpose and can own it directly. 

The Local Government Act 2003 permits Local Authorities to pursue certain forms of commercial activity through a company structure. The General Power of Competence, introduced in the Localism Act, permits a Local Authority exercising it with the (a) power to do it anywhere in the United Kingdom or elsewhere; (b) power to do it for a commercial purpose or otherwise for a charge or without charge; and (c) power to do it for the benefit of the authority, its area or persons resident or present in its area. Again, as Local Authorities are looking to manage commercial property as an adjunct to other functions rather than purely for financial gain a company is not required.  

Local Authorities can fund commercial property acquisitions using money from capital receipts, by using revenue funding, or through borrowing and meet debt servicing costs from revenue funding. Local Authorities are able to choose between different sources of external borrowing.  

In recent years the majority of loans taken out by Local Authorities have been supplied by the Public Works Loan Board (PWLB). The PWLB is located within the Government’s Debt Management Office (DMO), part of HM Treasury, and its funds are available at lower rates than the market. The PWLB publishes data listing borrowers, with the amounts advanced, the rate of interest, the term of the loan and length of time before the loan will be fully expended. 

Alternative borrowing mechanisms include:  

  • Tax Increment Financing (TIF) which permits Local Authorities to borrow money for infrastructure projects against the anticipated increase in tax receipts resulting from the infrastructure – for example, Local Authorities might borrow against their income within the Business Rate Retention Scheme or against the rate within a specific geographical area such as an Enterprise Zone
  • New Development Deals (NDD) where a geographical area is not subject to future levies and resets thereby creating an area and stream of revenue outside of the Business Rate Retention Scheme. 
  • An ‘earn-back scheme’ which has been enacted in some City Deals whereby Local Authorities can make investment up-front if additional GVA is created relative to a baseline. 
  • Through bonds, which allow Local Authorities to raise substantial sums of capital immediately, and repay it at a specified point in the future. Some Local Authorities have obtained credit agency ratings, allowing them to borrow on the open market; and for smaller Local Authorities through the UK Municipal Bonds Agency which is owned by 56 shareholding Local Authorities and has offered to obtain a competitive price for bonds at a lower rate of interest than the Public Works Loan Board. 

The MHCLG publishes statistics annually on Local Authority capital expenditure and receipts. The latest statistical release covers the financial year April 2018 to March 2019. This shows capital expenditure by Local Authorities in England totalled £25.9 billion in 2018-2019; an increase of £202 million (or 1%) in real terms compared to 2017-2018. When this figure is broken down by economic sector, acquisition of land and existing buildings totalled £4.4 billion, up from £326 million (or 8%) in real terms when compared to 2017-2018. The data also reveals how Local Authorities are financing a greater proportion of their capital expenditure from prudential borrowing and capital receipts rather than from capital grants and revenue resources. For example, the proportion of capital expenditure financed by prudential borrowing has increased from 22% in 2014-2015 to 38% in 2018-2019. Over the same period, the proportion of capital expenditure financed by capital grants has fallen from 45% to 35%.  Actual debt held by local authorities was recorded at £104.46 billion at the end of June 2019. At the beginning of 2017-2018 Local Authority external debt stood at £110.1 billion – but at the end of 2017-2018 Local Authority external debt stood at £118.3 billion (an increase of 7.4%). 

The data does not provide a clear indication of the type of acquisition made. Similarly, the PLWB does not currently keep defined records of the purpose of each of the loans it makes to Local Authorities.  

In February 2020 the National Audit Office (NAO) published a report on ‘Local Authority Investment in Commercial Property’. This estimated that Local Authorities spent £6.6 billion on buying commercial property between 2016-2017 and 2018-2019 – this figure is 14 times more than in the preceding three years. 40%-90% of spending between 2016-2017 and 2018-2019 was financed by borrowing. Local Authorities spent an estimated £3.1 billion on offices, £2.3 billion on retail property [including £759 million on shopping centres or units within them], and £957 million on industrial property. 38% of all spending between 2016-2017 and 2018-2019 was outside of the local area. The NAO found the increase in commercial property investment to be concentrated in the South East, and also amongst District Councils (comprising 51% of commercial property spending between 2016-2017 and 2018-2019). For example, 49 out of 352 Local Authorities accounted for 80% of commercial property spending between 2016-2017 and 2018-2019. 17.5% of all commercial property acquisitions by value in the South East between 2016-2017 and 2018-2019 were made by Local Authorities. 

Why are some Local Authorities investing in commercial property? Since the mid-2010s some Local Authorities have sought to build up portfolios of commercial property. Various reasons may account for this, including (but not limited to): 

  • A reduction in Government funding provided to Local Authorities. The National Audit Office (NAO) estimates a real-terms reduction in Local Authorities’ spending power [from Government funding and Council Tax] of 28.7% between 2010-2011 and 2019-2020. Analysis from the Local Government Association (LGA) found in one year, between 2016-2017 and 2017-2018, Local Authorities had to absorb a funding shortfall of £2.4 billion – with further analysis showing a potential funding gap of £7.8 billion by 2025. Government provides a Revenue Support Grant (RSG) to Local Authorities to finance revenue expenditure on services. According to MHCLG, while the RSG has declined since 2015-2016 this should be viewed in the context of increased funding from business rates retention and other grants such as the Better Care Fund
  • Changing approaches to asset management whereby some Local Authorities have shifted away from disposing surplus land and buildings towards using them as assets and as ongoing sources of revenue – with this approach facilitated through the Government’s One Public Estate programme and in some devolution deals.  
  • As Local Authorities have been given more flexibility and freedoms (e.g. through the Localism Act) this has fostered a more commercial culture amongst officers and Elected Members, leading  some Councils to be innovative and entrepreneurial in obtaining more money from commercial activities rather than relying on ‘traditional’ sources such as council tax and business rates. Interestingly a report on insourcing by APSE in 2019 suggested that a rise in insourcing was being driven by a desire to improve service quality and flexibility amid the need for greater control over allocating resources, including commercialisation in order to raise revenue.  
  • Local Authorities have purchased commercial property to support local regeneration and economic growth – bringing unused or underused property back into use for the benefit of their citizens.  

What are the benefits – and the risks? Some commentators highlight how Local Authorities have long held large property holdings which they have used for social, economic and commercial purposes; and that the annual return rates on commercial property, and the spread between the loan rate and the return rate on letting out the property, generates profit for Local Authorities to use for the benefit of their citizens. For example, a report by the Audit Commission back in 2000 described how “typical non-operational properties include high street retail outlets, markets, industrial estates and shops on housing estates, held primarily to generate income or to stimulate economic or social development” (page 7). Some Local Authorities have bought commercial property to use the returns to deliver new homes and infrastructure, to respond to private sector withdrawal or market failure (e.g. high streets), to support social enterprise and community business and/or for wider place-making. In many instances it is the spread between the loan rate and the return rate on letting out the property that enables the Local Authority to make a profit to reinvest in local services and activities.  

In 2017 the Local Government Association (LGA) published practical guidance on how Local Authorities could turn their commercial plans into reality. The guidance described trading and commercial property activity as “a particularly specialist activity where advice should be sought, if necessary, from a range of experts such as lawyers, property experts and accountants. Councils considering investment activity should be clear around long term risk and benefit modelling, governance and what specialist capabilities may be required to support the activity. They should be aware of the accumulated effect of every decision they take as well as the risks of each individual decision” (page 36).

More recently, the NAO in its report referred to ‘specific risks’ associated with each individual property [such as the length of the lease or the financial strength of the tenant] and ‘systematic risks’ [such as movements in markets e.g. people shopping online leading to growth in vacancy and void rates of retail units]. 

Some of the key risks for Local Authorities using commercial property to generate revenue are around: 

  • A downturn in the property market – leading to falling rents, higher vacancies, falling property values and causing financial pressures. 
  • Any Government intervention setting limits on the commercialisation strategies available to Local Authorities. 
  • A lack of skills and expertise (commercial awareness) within Local Authorities about the market and making investments leading to poor acquisition decisions. 
  • Liquidity – if a Local Authority needed to meet immediate cash requirements, property cannot be as quickly realised in the same way as other financial instruments.
  • Local Authorities are legally required to set a balanced budget – if commercial income is underpinning the delivery of services does not yield the required return, how will they overcome these broader losses of revenue? 

On 9 October 2019 the Government announced it would raise the interest rate on new loans from the PWLB by 1% over gilts over and above the existing interest rates. This decision was explicitly linked to substantial borrowing for commercial investments: “Some local authorities have substantially increased their use of the PWLB in recent months, as the cost of borrowing has fallen to record lows”. For some Local Authorities the rate rise was seen as making some large-scale regeneration schemes costlier, unviable, or requiring more time to obtain a return on investment – with some commentators suggesting it may lead Local Authorities to seek alternative sources of finance (e.g. private sector lenders, Municipal Bonds Agency).  At the same time of the announcement Government increased the cap on the total amount Local Authorities can borrow from the PWLB from £85 billion to £95 billion.

Are we reaching a tipping point?The NAO has highlighted how some Local Authorities would be badly exposed in the event of an economic recession or property crash, describing how “in the last recession UK commercial property values and market rental values both fell. More recently, systematic risk is perhaps apparent in the performance of the retail sector with the shift to online sales, among other factors, leading to growth in vacancy and void rates” (page 41).  

Analysts point to past examples of Local Authorities suffering financial difficulties – the interest rate swaps in the late 1980s/1990s, investments in Icelandic banks in the late 2000s, and LOBO loans in the mid-2010s. However, these episodes affected a small number of Local Authorities and none generated long-term financial strain or losses even though they led to serious concerns in the short term. Nor did they require Local Authorities to raise Council Tax substantially to offset a lack of funds. 

Yet all of these episodes are very different from the novel coronavirus (COVID-19).  Emerging evidence highlights the impact of the pandemic on bricks and mortar.  Coutts reveals how the retail sector was already heading into recession before the pandemic due to the rapid adoption of online shopping and the change in shopping habits. They predict this downward trend in retail property is likely to continue with only retail-to-residential conversions and specialist event venues surviving; warehouses and logistical centres will continue to expand; and the period of people working from home may lead companies to change working practices and reduce office space. The real estate developer Hammerson revealed that it had only received 35% of second quarter rent from its outlets – and it had also received requests from tenants for rent deferrals, monthly payments and waivers. Coronavirus is expected to create a hole in Local Authority income as a result of lost revenues from commercial property. This is further compounded by the loss of other revenue streams (e.g. planning fees, car parking). 

In March 2020 the Government announced £1.6 billion package for Local Authorities to respond to service pressures including increasing support for adult social care and services that support the most vulnerable; a £500 million Council Tax Hardship Fund of discretionary support to help economically vulnerable people and households; £3.2 million of initial emergency funding to reimburse Local Authorities for the cost of providing accommodation and services to rough sleepers; the deferral of £2.6 billion in Local Authority payments of the Central Share of retained business rates; and brought forward £850 million of social care grants. In April 2020 the Government announced a further £1.6 billion of additional (and un-ring fenced) funding to support Local Authorities to meet additional pressures arising from the pandemic and to help them to continue to deliver frontline services. 

While the impact of coronavirus on Local Authorities – including those with substantial commercial property portfolios – depends on how long the lockdown last for and the gradual steps to a ‘new normal’ that the Government will implement; scale really matters here. The bigger the spend, the bigger the borrowing, the greater the risk. And these risks become even greater where Local Authorities are dependent on income from commercial property portfolios to repay debt or fund services. They may also be tying up Local Authority money and resources that could be diverted elsewhere. 

Because we do not have a clear picture of the scale of investment of public funds in commercial property, where it is concentrated and how it is being financed, considering the implications for rural residents and businesses is difficult.  According to the Rural Services Network urban authorities in 2016-2017 received 40% more (£116) per head in the Government’s Settlement Funding Assessment compared to rural authorities. We also know that it costs more to deliver services in rural areas. What we do not know is whether this leads rural Local Authorities to borrow more than their urban counterparts, if and how much they are investing in commercial property,  what the income from this investment has been used for, and what impact COVID-19 will have on these portfolios and Local Authorities now and into the future. The longer the pandemic persists, the greater the chance of a more prolonged impact on the economy including commercial property markets. In the meantime, we need to improve the data and evidence base: what are the trends in capital strategies, buying out of area, the contribution of commercial income to service expenditure, the scale of contingency, and which Local Authorities are vulnerable and what can we do to manage the risks?  

When making any investment we are reminded that past performance should not be taken as a guide to future performance. The value of investments, and the income that we get from them, can go down as well as up and we may not recover the amount of our original investment. 

Affordability is a key duty underpinning the borrowing arrangements contained in the Prudential Framework. In practice, some Local Authorities have taken on general fund debt in high multiples of core spending power and viewed it as affordable because of the income their commercial property investments generate. The experiences of coronavirus, seen within the context of already sustained financial pressure, may mean that some Local Authorities (inadvertently) test the limits of compliance. 

As Local Authorities have built up their commercial property portfolios there has perhaps been a lag in governance and oversight from Government.  In March 2020 HM Treasury launched a consultation containing proposals to (a) require local Authorities that wish to access the PWLB to confirm that they do not plan to buy investment assets primarily for yield; (b) publish guidance defining activities that the PWLB will no longer support; and (c) standardise the information currently gathered through the application process for the PWLB Certainty Rate to confirm with Local Authorities that their plans conform with the guidance. The consultation runs until 4 June 2020 and you can submit responses here.  

As we have to get used to a ‘new normal’ Local Authority repayments to the PWLB and other borrowers may start to hurt. Will this lead some Local Authorities to increase taxes or reduce public services? Watch this space. 

Jessica is a researcher/project manager at Rose Regeneration. Her current work includes helping public sector bodies to measure social value; evaluating an employability programme; and working with 8 farming organisations across England on a Defra funded project on farmer resilience. She is also a senior research fellow at The National Centre for Rural Health and Care (NCRHC) and sits on the board of a Housing Association that supports older and vulnerable people. 

She can be contacted by email jessica.sellick@roseregeneration.co.uk, Telephone 01522 521211, Website -  http://roseregeneration.co.uk / https://www.ncrhc.org/, Blog - http://ruralwords.co.uk, Twitter - @RoseRegen

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