Local authorities in the UK are seldom thought of as a significant group in commercial property investment. A steady stream of transactions has occurred over time but is often limited by volume and value. That changed dramatically last year.
In 2016 the volume of such investment increased, culminating in 82 purchases worth £1.3bn. To put in perspective, between 2008-2015 collective CRE investment by local authorities amounted to around £150m spread between 10 and 20 deals a year.
On first thought, this increase might appear dramatic. However, isn’t this about local authorities making logical investment decisions to counter the structural changes in income now facing them? Beauty may be in the eye of the beholder.
Local authorities have undoubtedly borne the brunt of the UK’s staunch commitment to austerity. After several years of funding cuts from central Government, there is a need to plug gaps in budgets and become more self-sufficient. Rather than continuing to cut funding for valued services, councils are increasingly making the decision to source new income streams, including in property.
Significant funding cuts have been coupled with the introduction of a new system of localised business rate revenue and all money raised by local authorities is now kept by them. Local authority income is consequently far more sensitive to the performance of the business rates tax base, furthering the need for a broadening of income streams.
So far, so good. However, as has been widely criticised, it is debt that is funding the majority of these assets as authorities have access to favourable lending terms through the Public Works Loan Board (PWLB). Looking at the nine largest local authority transactions last year, a total debt of £624m was provided against a combined purchase price of £673m with next to no equity being introduced.
The length of lending is often as long as 50 years (well in excess of the lease terms) and based on 90%-100% LTV. Interest rates also appear typically lower than you would pay a traditional lender, altogether encouraging higher risk whereby high levels of borrowing magnify the potential profits or losses that result from changes in the market value of the asset over the course of the loan, and stretched repayment profiles.
The approach has been described by some as reckless and the capability of the PWLB to adequately manage such borrowing requests has been questioned.
Whilst the risks outlined here are significant, it could be argued that many commentators have taken a short-sighted view of the situation, quick to condone without adequately analysing the benefits. Here we reason why.
Firstly, it is good to see local authorities becoming more entrepreneurial and more closely engaged with their local economies. Over 85% of the purchases that transacted last year were assets within the councils’ own administration, with only a few seeking assets on a national basis.
Secondly, there is an undue fixation around the capital value of the asset as opposed to the income produced. Borrowing at 2-3% to buy assets yielding 4.5-7.5% gives the purchaser a self-financing investment producing surplus income that can be used to support local services. The length of the loan keeps amortization as low as possible, allowing the council to maximise their income, but there are still generous repayments to reduce risk when considering the
underlying residual value. Thirdly, they are prudently taking advantage of the fact that the PWLB provides non-recourse lending and does not evaluate commercial real estate loans in relation to the risks of the underlying collateral, as would happen with specific asset lending. Consequently, authorities are not solely relying on the asset to repay the loan but can draw on all their income sources to repay it.
Many cynics argue that the PWLB is encouraging local councils to behave like entrepreneurial risk takers. However, many local authorities are buying multiple properties to diversify their portfolios.
There is consequently greater rationale behind the decision making than has been publically reported. The concerns are unsurprising given the striking uplift in the volume and size of these transactions but what is most important is that these decisions are based on strong local economic fundamentals and prudent investment advice. Local authorities are seeking professional counsel to ensure risks are considered, income is diversified and if executed and asset managed correctly, there is no evidence that CRE assets cannot be a shrewd investment for local authorities.
Beauty or beast, only time will tell but there is certainly more of a story behind the recent changes in their investment policies than first meets the eye.
Tony Martin is head of investment advisory at CBRE