Risky business?

With pressure mounting on councils to develop alternative streams of income, Mark Smulian asks if the current vogue for commercial property investments by local authorities could end in tears.

It is often said that 100% mortgages were a factor in piling up the debt that helped cause the banking crash of 2008.

These are though in effect what is fuelling another buying boom, only this time it is local authorities borrowing to buy commercial property. Such purchases have rapidly moved in the past year or so from occasional curiosity to the mainstream of councils’ efforts to increase income by buying properties with good rental streams and which are likely to increase in value.

More investment has gone from town halls into property since January 2016 than did in the previous 15 years. Council pension funds have long invested in property as part of their portfolios and councils have often bought land and buildings involved in regeneration schemes.

This bout of property purchasing is though neither of these things - it is councils directly investing for purely commercial motives.

It has attracted some criticism, with Liberal Democrat leader Sir Vince Cable, the former Business Secretary, saying: “This is not a wise and sensible thing to do” and recalling “local authorities have a long and inglorious history of gambling in financial and property markets,” such as the London Borough of Hammersmith and Fulham’s disastrous 1980s foray into interest rates swaps.

Eyebrows might indeed be raised by the sums going into property investments given councils’ habitual pleas of poverty, but for this at least they have a ready source of money. They can borrow on a prudential basis from the Public Works Loan Board (PWLB) - effectively from the government - which looks only at a council’s ability to repay the loan involved, not the viability of any specific property purchase.

PWLB lending is at very competitive rates, usually 2-2.5% and thus councils can access cheap finance limited only by the PWLB’s view of how ‘prudential’ they are overall and the availability of suitable properties.

An indication of the scale of such purchases is shown by Mansfield District Council having bought Travelodge hotels in Doncaster and Edinburgh, and Luton Borough Council an office building in Chatham.

Spelthorne Borough Council (see box) has spent £385.5m to buy BP’s 620,000 square feet research complex in Sunbury-on-Thames, together with a host of other commercial properties, while the London Borough of Sutton now owns Oxford Business Park, Canterbury City Council has bought part of the Whitefriars shopping centre and Stockport Metropolitan Borough Council has purchased the local Merseyway retail complex.

Research by property firm CBRE shows the largest council property investor by value in 2016 and the first quarter of this year was Spelthorne at £394m - largely the BP deal -  followed by Barnsley Metropolitan Borough Council with its £120m purchase of the local Glass Works retail centre.

Altogether, 16 councils invested £20m or more in property in that period, with Nottingham City Council having the highest number of transactions at eight.

We’ve got the power
For lawyers, the consequences of this buying boom are not so much issues of powers as whether councils know what they are doing in the property market and can cope with the consequences of things going wrong.

Freeths' partner Nathan Holden says: “A lot of local authorities are investing in property as a commercial matter because they are desperate to have a source of money after 2020 when government grant will disappear and they have to become self-financing.”

A succession of legislation has allowed them to do this, Holden says, starting with the 1972 Local Government Act, which allowed them to do things incidental to their functions but not to use that to generate income, although Section 120 (1) (b) of that Act allows councils to buy land including land outside their area for the benefit of their area.

The Local Government Act 2000 included a power to do anything to promote the wellbeing of the area, while the 2003 Local Government Act said that anything that generated income must be done through a company as otherwise councils would be at an unfair advantage over private companies by not being liable for corporation tax. Powers were widened still further by the Localism Act 2011 which allowed councils to do anything not specifically forbidden though it retained the requirement to use a company for trading purposes.

Holden says: “Some councils take the view that they should buy property through a company while others are investing directly, which is a bit less certain in terms of their powers, as they argue that buying property is not trading because they are holding an asset long term.”

Chris Brain, senior property adviser to the Chartered Institute of Public Finance & Accountancy, says: “The legality question has come up a few times and councils tend to cite all the powers they have with any bearing on this rather than focus on one, and there are quite a few.”

Trowers and Hamlins partner Chris Plumley also sees few issues over powers, but says: “There isn’t a specific legal risk, its more what type of vehicle are they creating and what type of property do they want?

“Loads of councils do it now as they need the money with the budget cuts and they see building a portfolio of property as a revenue stream. But it is a big cultural change, they get a strategic vision of what they would like to do but do not know how to go about implementation.”

Buying property successfully requires an options appraisal of commercial and legal issues and assembling the advisory team to get that done instead of drawing piecemeal advice from different professions, Plumley recommends. “There are brilliant councils trying to do something new but you have to have the advice in place,” he says.

“You need to know the timescale and what return you are after over what period as returns fluctuate a lot in the property market.

“It involves a cultural shift because councils have built-in short-termism as they are tied to electoral cycles, while property investment is a long-term operation.”

Casting a safety net
Property also comes with a set of risks with which councils may be unfamiliar, which can be summed up as ‘is the rental stream from this building as certain as it reasonably can be, and can I deal with the consequences if it goes bad’?

Alan Aisbett, real estate consultant to law firm Berwin Leighton Paisner, says: “Local authority pension funds have invested in property for years but the difference is that their regulators will demand that there is a balanced portfolio of investments to spread risks, so there is diversification if anything goes wrong.

“With direct investment it’s about income but there are risks in commercial property, which apply to the sector generally not just to councils.

“Tenants may go bust, when it comes to re-letting, the re-let rent may not be as high, and values can go down as properties get old. There will also be repairing obligations and the need for refurbishment to keep properties attractive to tenants in future.”

While Spelthorne is perhaps unlikely to see BP go out of business, this is a hazard that can affect landlords with less blue chip tenants.

Another factor is that property is “potentially an illiquid investment”, Aisbett says, where a council that needs to realise its asset may find no buyer prepared to pay the right price, potentially forcing a ‘fire sale’ at a loss.

In a normal property transaction a lender would pay close attention to all this before advancing any money, but for councils this safeguard - or restriction depending on one’s view - is not there.

Aisbett says: “The PWLB will lend 100% of the value and that is different from a bank that would only lend 50- 60% and carry out a lot of due diligence on the property itself.“The PWLB just looks at the council as a whole so it leaves it up to the local authority to do due diligence.”

It is certainly possible for councils inexperienced in property to come unstuck. Trowers’ Plumley says: “I know of a council that speculatively built an office block and then told the world it was fully let, which is true but it was on a lot of short term lets which is not a very good tenure as there is no investment value if you want to sell it on.”

“I’ve not found any unwise investments yet,” adds Nathan Holden. “But, as Warren Buffett has put it, you don’t see the wrecks until the tide goes out. It’s possible that if the economy tanks then some of them will prove to have been unwise.”

Winckworth Sherwood partner James Duncan, who deals with real estate and the public sector, says that while some councils have the skills to buy property they may lack the private sector’s agility.

“One issue I see is that local authority staff are very busy people and so even if they have the expertise they do not have the resources to move at the speed that property transactions do, and quite a lot of resource is taken up with large transactions,” he says.

“When buying property outside their area the issue is how much knowledge they really have of the place where they are buying. That is more of a concern than long-term property management, where agents can be appointed.”

Brain says buying property outside a council’s area can be a perfectly sensible part of a diversification strategy.He explains: “It comes down to the risk appetite of the s151 officer. If there is little investment opportunity in their area they will look further, though some like Mansfield and Portsmouth have poli cies of only buying elsewhere so that their investment decisions are not connected with local political decisions.”

It is, he says, a balance. Councils may have less knowledge of the market outside their area, but miss some good opportunities if they only invest locally.
Winckworth Sherwood real estate partner Andrew Kinsey thinks the funding gap councils face by 2020, when the grant system is due to end, is so daunting that they may look at the best available returns on property and be insufficiently cautious.

“It’s no wonder when they can borrow at 2-2.5% and get a return of 4-6%,” he says. “They have a large funding gap to meet and where they don’t have the expertise it’s worth buying it in.

“Some politicians like Vince Cable have raised questions about whether this will turn into a bubble like local authority investments in Icelandic banks did. But by 2020 local government has a £6bn funding gap and by then they will be able to keep all their receipts, so I do not think this will go away.”

Councils have come unstuck under past Conservative governments when they competed with private industry - notably with the restrictions imposed by the Thatcher government on direct labour organisations - and there are some signs that the private sector could be concerned about the sudden emergence of local authorities as, in effect, a publicly-funded competitor for purchasing opportunities.

Brain says: “I’ve heard some sour grapes about councils’ cheap borrowing from the property industry as unfair competition. Borrowing is cheap, but the council still ultimately has to repay the capital on top of that.”

Ian Fletcher, director of real estate policy at trade association the British Property Federation, says: “Local authorities will sometimes have strategic reasons for investing in commercial property in their localities, to support wider council objectives, such as regeneration – and this is generally welcome.

“The need, however, to generate income is leading more councils to consider investing in commercial property outside their borders. These councils will need to be careful participants in this market as competition for assets can be intense and more experienced investors in commercial property invest a lot of time and expertise to ensure they make the best investments to deliver a risk-adjusted, diversified portfolio.”

CBRE looked at councils’ activities earlier this year on behalf of the property industry in a report Local Authorities: The New Long-term Investor? This found the £1.4bn of property deals concluded by councils between January 2016 and March 2017 exceeded the total of the entire preceding 15 years.
Offices attracted the highest total of investment at £769m, followed by retail (£610m) and industrial (£200m).

CBRE concluded this sudden spike was driven by the government’s decision to allow councils to retain the money they raise as the grant system ends.
Combined with the PWLB’s generous interest rates, “the proposition that they should invest directly in commercial property has now become extremely difficult to resist”, it concluded.

And it will become even more tempting to judge by CBRE’s analysis of how councils paid for these deals.

It says at least seven of the top 10 transactions were funded with debt and the PWLB in all supplied £624m against a total purchase price of £673m.

Debt terms were very long at between 23 and 50 years and interest rates ranged from 1.66% to 2.72%.

Holden says: “There is a question of whether the government will turn off the tap since most of the money for this comes from the Public Works Loans Board and if they pushed up interest rates it would alter the dynamic quite substantially.

“But it is in effect a form of quantitative easing by the government, so I would think it will be happy to keep lending councils money, but not giving them money.”

It remains to be seen if government proposals to change the statutory guidance on local authority investments  [see box The Cost of Prudence, above, left] will have a significant effect. In the meantime, lawyers and their colleagues are set to continue having to grapple with priority deals, not least because, as Holden notes: “If I were a local authority I would be wanting to do this, as even if the government did turn off the tap I’d still have the assets, whereas if I waited I might have nothing.”

Mark Smulian is a freelance journalist

This article was first published in the February edition of Local Government Lawyer Insight, which can be accessed at http://www.localgovernmentlawyer.co.uk/insight Insight is published four times a year and is circulated free-of-charge to all Local Government Lawyer newsletter subscribers (click here to subscribe) in electronic format. A single hard copy is also circulated to all local authority legal departments in England and Wales. Additional printed copies are available for just £49.95 for four issues. Multiple copies are also available at £149.95 for five or £249.95 for 10. Payment can be made by purchase order/invoice or by credit/debit card. To order, please call 0207 239 4917 or email This email address is being protected from spambots. You need JavaScript enabled to view it..