Simon Goacher 04 March 2019

Councils shouldn’t be chastised for acting commercially

The National Audit Office (NAO) has confirmed that its inquiry into council commercialisation will be published later this year. The investigation follows a growing number of local authority commercial ventures attracting scrutiny. Spelthorne Borough Council, a high-profile example, put an end to its programme of commercial property investments when it was revealed it borrowed £270m from the Public Works Loan Board (PWLB) to make deals between 2017 and 2018.

Clearly, excessive borrowing should be challenged, yet there is a real danger that disproportionate restrictions will discourage local authorities from making potentially beneficial commercial investments.

Councils are currently operating under unprecedented financial pressure. According to the Local Government Association, between 2010 and 2020 authorities will have lost nearly 60 pence of every pound that central government used to provide for essential frontline services. Investment in areas such and commercial real estate - such as office buildings and retail space - and residential property, can boost councils’ direct revenue, from tenant rents, for example. But it can also increase income from council tax and business rates by making the area surrounding the venture more attractive to third party investment. It represents a significant alternative source of funding for councils, and the NAO should remember the government has repeatedly encouraged councils to pursue the opportunity through greater autonomy and extended borrowing powers.

The Local Government Act 2003 and Localism Act 2011 gave councils the ability to borrow money from the PWLB to make commercial investments without central government oversight. The PWLB is non-discretionary, meaning councils do not have to explain why they are taking a loan. They are, however, required by law to ‘have regard’ to the Chartered Institute of Public Finance and Accountancy’s Prudential Borrowing Code (PBC). The code lets councils set and report their own borrowing limits and capital strategies, but stresses they should be affordable, prudent and sustainable.

Critically, the PBC allows flexibility. But, it does rely on strong council governance and financial management. Local government leadership should view the NAO’s investigation as an opportunity to take stock of their approach to commercialisation. They should ensure the way they conduct due diligence on a potential venture is as robust as possible, but also geared to securing a lucrative long-term investment that’s in line with their constituency’s priorities.

Commercial property is a common asset class for local authority investment, and a good example on which to reiterate the principles of effective due diligence. Due diligence, first and foremost, ensures councils are not taking an unreasonable commercial risk. While an office development can create jobs, and attract further investment - in addition to generating direct revenue from rent. But if tenants are unreliable, or the developer has a bad balance sheet and no relevant experience, the opportunity could fail, or quickly become unprofitable. Engaging the development consultancy arm of a surveying firm that can not only help councils justify the financial impetus for an investment, but also guide on more intangible factors – such as the credibility of potential partners and the health of the commercial property market – is a crucial first step.

There is also the question of geography. Councils have faced criticism for investing in assets outside their own boundaries. Managing a commercial investment from a distance is more challenging, but more importantly, it means a council’s understanding of the regional market their investment exists within may not be as strong, something that must always be factored into the due diligence process. By leaning on their local knowledge and considering the needs of the communities they serve and the health of their regional property market, councils can make their rationale for a potential investment more robust.

From a legal due diligence perspective, the strength of the contract between all the parties involved in a commercial venture is paramount. The structure that ties councils, developers, advisors etc. together must be tried and tested. If a council is investing in an office development that’s already in progress, a contract that contains a development and leasing structure that’s been used successfully elsewhere is often the best option. When something more bespoke is required, for a project the council is spearheading to regenerate a local area, for example, it could be prudent to try and include a guarantor from a bank to safeguard the council’s investment.

In the current climate, councils have no choice but to grab the opportunity commercialisation provides with both hands. But, ultimately, local authorities are accountable to their constituents and any mismanaged investments will inevitably have a political consequence.

It means local government leaders must approach commercial investments from an informed, well-reasoned position. For policymakers and the NAO, any efforts to curb irresponsible investments should look to help councils do this, not criticise them for behaving entrepreneurially.

Simon Goacher is partner and head of local government at Weightmans LLP and Clive Bleasdale is a partner in the firm’s real estate team.

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