Back in January (seems like an eternity ago!) I questioned whether the recent lift in Public Works Loan Board lending rates would put the brakes on local government spending on commercial property investment, which had reached a heady £6.6bn in the three years to 18/19. Whilst there are no published figures yet for 19/20 it would be reasonable to expect a significant tail off, although for the last quarter it will be difficult to differentiate the impact of the PWLB rate from that of Covid 19 on investor appetite.
And for any local authorities still contemplating commercial property as the answer to their ever widening revenue gaps, we now have a Public Accounts Committee enquiry on 11th May, following on from a National Audit Office report in February which flagged serious concerns over the scale and extent of borrowing by a small but significant minority of councils, and the value for money risks especially around retail investments which have accounted for c.35% of purchases over the last three years .
The statutory guidance was changed in 2018 to include provisions against borrowing to invest solely for yield (e.g. through the purchase of “out of area” investments) and ensuring that members and officers have skills expertise and information to inform strategy. But the concern is that this has not gone far enough and here perhaps are some of the reasons why:
• The notion of a balanced portfolio becomes challenging where all investments are made within the same authority area or economic region, and sector weightings may be skewed by one or two very large holdings, for example a local shopping centre. The reality is that despite the spending spree, most local authority investment portfolios are too small to achieve anything close to an optimal balance and many are likely to be exposed to higher than average risk.
• I have commented previously that beyond the negative headlines, falls in capital value will be of less concern to authorities with long term regeneration plans, provided rental and service charge income is sufficient to repay borrowing costs and fixed outgoings. Most investment business cases will have made prudent assumptions about voids and tenant risk profile, but cannot have envisaged the seismic impact of the pandemic, particularly on the retail, hospitality, leisure and food and beverage sectors. Across the market, rent collection for the March quarter is at only 70% to end of April and June may be worse still. With most Council portfolio net yields estimated at below 2.6% there is the real possibility that some Councils will struggle to meet interest repayments and Minimum Revenue Provisions without recourse to their general fund.
• Most large strategic investment purchases will have been supported by detailed analysis by household name advisors (although even their worst-case scenario modelling and sensitivity analysis may not have foreseen what was ahead). But for smaller deals some Councils may not have appreciated the blurred line that sometimes exists between objective professional advice and brokerage, relying on little more than a valuation based on the backward looking evidence, optimistic assumptions on running voids and rents, and limited analysis of the range of risks. And many agents’ and advisors’ fee structures are still geared to price paid, acting as a perverse incentive to drive hard bargains with sellers.
So what can we expect to see next?
• More tightening of the rules – Following the PAC, the pressure will be on for MHCLG and Treasury to introduce even greater tightening of the statutory guidance and Prudential framework. Exactly what this means remains to be seen but could extend to fixed upper limits on borrowing, and/or the requirement for contingency funds to cover rental shortfalls.
• Some selling off and much reduced volumes of new investment – In the short term, some local authorities may come under pressure to reduce debt by selling off assets, with out of area investments under the spotlight first. Overall I’d expect new purchases to fall off significantly but for those Councils with sufficient borrowing headroom there will perhaps be more opportunities to acquire distressed assets that support long term regeneration and housing delivery, but with even more rigorous assessment of holding costs and risks around short term income.
• It will get political – For all its “black swan” characteristics, Covid 19 has delivered the ammunition for those ideologically opposed to Council borrowing. Expect to see some administrations who advocated ambitious commercial property strategies coming under sustained pressure from opposition groups to explain falling values and negative returns – especially if it starts to impact local service provision.
• Longer term, perhaps a revival of ideas for pooling local authority commercial property funds as a means of achieving critical mass, balanced portfolios, a spread of risk and lower management costs – although clearly there are huge statutory and other complexities in this, with existing Council asset portfolios at different points along the risk and return curve.
I’m watching with interest.