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Local authorities turn into Propco’s

The National Audit office calculates that central government funding to local authorities (LA’s) has fallen by around 50% in real terms since 2010. At the same time, their costs have gone up, in part due to an ageing population needing more social care (which falls in the council’s remit).

To cover the decline in central government grants and generate new income streams, increasing numbers of local authorities across the country are investing in commercial real estate.

Indeed, our figures indicate councils have purchased £3.6 billion of commercial property since 2016 (see chart below). The majority (£2 billion) has been in the office sector, with Spelthorne council alone accounting for £930 million. They hit the headlines in 2016 with the purchase of the £360mn BP Campus in Sunbury, and again this year with the purchase of a £285mn South East office  portfolio.

To finance this spending, councils are primarily using the Public Works Loans Board (PWLB). Established in 1793, its job is to lend cheaply to local authorities. LA’s can borrow for up to 50 years at less than 2%, making investing in income producing assets at 5%+ yields enticing.

During the last financial year, the PWLB lent councils 780 loans worth £5.2bn, a 42% rise from the previous year. Although not all of that was used for the purpose of investing in commercial property, it still represents a large rise. In total, local authorities now owe the PWLB £70bn.

The Spelthorne Council purchase of the BP Campus ticked many boxes when looking through the prism of investing in a secure income stream for LA’s. It was Grade A office space, within Spelthorne’s district, had a strong covenant (BP) with a long lease (20 years).

But the key question is how many LA’s can replicate such a deal? And have all the subsequent purchases met the criteria of a good quality asset with a secure income stream?

The main risks lie in the expertise and knowledge required in the some of the sectors they are investing in well outside their boundaries.

A majority of investment has been into offices which if they have long term income generally require minimal asset management. But a large chunk has also gone into the struggling retail sector (46 deals equating to almost £1bn). A sector undergoing profound structural changes with the emergence of ecommerce, it is higher up the risk spectrum. One of the most challenged sub-sectors within the retail space is shopping centres, with a recent report from the National Retail Research Knowledge Exchange Centre indicating that over 200 shopping centres across the UK are at risk of closure.

Local authorities have spent close to £400 million on shopping centres since 2016. The rationale for a lot of these purchases by LA’s is that many of these shopping centres form an important part of their town centres. By buying these assets, they can have a direct influence in regenerating their central district which have struggled since the financial crisis.

They are looking at these investments not purely in terms of financial returns and income streams, but in terms of positive social impact for their communities.

Many also see the current low borrowing costs as a once in a generation chance to buy these struggling assets which in other times they would be priced out of by the private sector. That said, requiring significant asset management expertise, shopping centres are a challenging proposition in the current environment with numerous retail chains heading towards CVA or already having gone under. Throwing money at an already declining asset might not solve the underlying problems.

The government is aware of these risks, and has published guidelines to dissuade councils from investing purely for profit. They have also indicated they are considering a ban on council purchases outside their boundaries, but nothing has materialised yet (one of the main reasons LA’s purchase property outside their boundaries is the lack of investable grade real estate in their district. Hence this potential ban could have the undesired effect of forcing councils into purchasing poor quality assets).

Consequently, councils need to make sure they have the relevant expertise and knowledge either in house or seek external advice. They must also bear in mind the cyclical nature of the property market which could leave them vulnerable during a downturn. Short of central government funding, sound acquisition of commercial real estate has the potential to fill the funding gap in many LA’s balance sheets.

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