Media commentary in early 2017 drew attention to claims of a new development in the world of local government: local authorities buying up substantial portfolios of commercial property. This is a rarely-examined dimension of local government activity, and this post looks at the benefits and risks involved.
What are councils doing and why?
In the present financial climate, councils are able to borrow funds at near-sovereign rates, typically 2-2.5%, from the Public Works Loan Board (PWLB). They are then able to use these funds to buy commercial property, either within or outside their areas. This can then be rented out at market rates, which may provide a rate of return of 5% – 10% or more. The spread between the rate of return and the interest rate on the borrowing allows them to make a profit from the rent, which they can use to bolster shrinking budgets for local public services.
Several councils have taken steps recently to develop property portfolios explicitly aimed at generating funds. There are two key drivers for this: austerity and opportunity. Local authorities have seen year-on-year reduction in central grants since 2010. Both the National Audit Office (NAO) and the Institute for Fiscal Studies (IFS) have estimated reductions of some 36% in grant funding between 2010 and 2015. Reports, such as PwC’s The Local State We’re In 2017 and the LGA’s Future Funding Outlook for Councils 2019-20, suggest that authorities are increasingly concerned that they will be unable to maintain statutory functions. In this scenario, there is an incentive for local authorities to pursue new sources of income.
How new is property investment?
Property investment is not a new activity for local authorities. Many have had substantial property holdings for decades, and have frequently drawn rental income from their use.
The Local Government Chronicle carried out an investigation in late 2017: of 265 responding councils, ten accounted for 60% of the reported spend. This implies that, under the headline figures, there may be a long tail of authorities which have not changed their practice significantly. Furthermore, the investigation revealed that many authorities had had very substantial property holdings dating from before 2010, when the current budgetary pressures emerged.
Statistics released in June 2017 showed a jump in acquisition of land and buildings to £2.8 billion in 2016-17, having fluctuated between £800 million and £1.1 billion during the previous three years. The statistics do not show what exactly these funds were spent on, but the statistical release said that “a key factor behind the increases in these categories is that some local authorities have made capital investments wholly or partially for the purpose of revenue generation”.
Is this a risky business?
Some commentators share the view of the Financial Times that “loans are not meant to become a source of local budget funding by way of a carry trade. Nor are local councils set up to function as investment managers…. The Treasury should put a stop to the local council credit bubble before it grows even larger”.
A number of local government commentators, though, have stated that local authorities should be able to manage the risks as long as sound investment decisions are made. There have been no reports to date of serious financial difficulties arising from these risks.
Risk assessment is an integral element of local authority financial management. The Chartered Institute of Public Finance and Accounting’s (CIPFA) Prudential Code, which governs local authority borrowing, says “In considering affordability, the authority needs to pay due regard to risk and uncertainty… risk analysis and risk management strategies should be taken into account”. The DCLG’s statutory guidance on investment states that local authorities’ investment strategies should make clear how the risk of different investments is assessed and managed.
Large-scale purchase of commercial property does carry risks. To mitigate these, many authorities have developed experienced in-house teams and/or sought detailed advice from property consultants. Potential risks include:
- Properties becoming empty for long periods: if no rental income was received, other sources of funds would need to be used to pay back the loan
- A fall in asset values: this could cause difficulties if a council needed to sell (for instance, if it was struggling with loan repayments). The risk here varies according to asset class
In November 2017, the DCLG launched a consultation on revising its statutory investment guidance and minimum revenue provision guidance, proposing a number of extra transparency requirements around local authorities’ use of commercial investment income.
Is property investment the future for local government?
Commercial property investments are not a free-for-all. Local government financial management is tightly regulated, via the Prudential Code, the Treasury Management Guidance and DCLG’s statutory investment guidance. The Prudential Code is under review at the time of writing, and a review of the DCLG’s statutory investment guidance is anticipated shortly. Thus the regulatory framework is aware of recent developments and it is likely to respond.
The Government has said little about its position on commercial investments. A Public Accounts Committee session on 10 October 2016 looked at the issue in some detail. During the meeting, DCLG officials indicated that they were content for local authorities to increase their commercial activities and to raise revenue through this route, and that this was an intentional outcome of the Localism Act 2011.
There are many obstacles to generating extra revenue from ‘traditional’ sources such as council tax, business rates, and local fees and charges. Given this, it is unsurprising that councils might see the security of ownership and rent income as a route to increasing their income.
More detailed information can be found in the Library briefing paper Local government: commercial property investments.