“This looks like a huge punt to me.” The director of finance at one UK county council borrower did not mince his words when asked about a recent real estate investment by another such local authority: the £350 million purchase in December last year of the BP Business Park in Surrey by Spelthorne borough council.
The buyer is a local authority with assets of £38 million and reserves of £40 million as of the end of 2016. It borrowed £350 million at 100% loan-to-value to buy the business park. “Through one transaction they have turned themselves into a property company,” says one critic.
By any measure, this looks like a dangerous concentration of risk. Of more concern is whether or not it is a signal that there is trouble brewing in UK local authority finance. Local councils spent £1.3 billion on real estate investments last year. According to property consultancy Savills, by October they had spent £859.1 million, a sharp increase on the £148.7 million spent in 2015.
Savills also suggests that councils accounted for 2.5% of all UK commercial property deals in 2016 – up from 0.2% in 2015. They could be responsible for around one-third of regional property purchases in the country. According to property consultant Gerald Eve, local authorities bought 25% of all office investments in the southeast in the first quarter of this year. A recent survey by The Times newspaper suggests that £878 million has been invested in the first five months of 2017, which would suggest a full year figure approaching £2.1 billion.
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Tony Martin, CBRE |
"This is a logical thing for local authorities to do,” Tony Martin, head of investment advisory capital advisors – investment advisory at CBRE, tells Euromoney. “Changes in local authority financing mean that they are challenged to cut costs and find new ways of producing income. A lot of councils are doing this now, and the number will rise. This is something that we should keep an eye on as the increase in activity has been significant over the last couple of years and how it will influence the market isn’t always immediately obvious."
Local authorities in the UK have seen their funding cut by 40% since 2010, which has forced them to look for other ways to raise cash. Real estate investments are attractive because of the carry trade on offer as a result of their own borrowings. Local authorities in the UK can borrow from the Public Works Loan Board, an archaic institution that was set up in 1793 but is due to be abolished and absorbed into the Treasury.
The functions of the PWLB are currently overseen by its secretary, who is a civil servant in the UK Debt Management Office.
Councils can borrow from the PWLB at about 2.5% to invest in real estate, which can yield between 5% and 10%.
On announcing the deal last December, Spelthorne explained that the funding given to it by the UK’s central government will be withdrawn completely in 2017/18, a situation that is “forcing Spelthorne to find innovative ways to fund services and create new revenue streams”.
It explained that “after exploring several options and taking advice from a number of independent experts, we are confident that this forward-thinking agreement [the science park deal] represents a very sound investment for Spelthorne. It will be key in helping us to close the budget gap and protect the vital services which our residents and businesses need and deserve.”
I am worried about some behaviour in some areas, but context is hugely important. Local authorities, faced with austerity, have been encouraged to be more self-sufficient - County council director of finance
Local authorities have always raised money commercially, but their track record is not stellar. Some 127 UK local authorities had £954 million invested in Icelandic banks when they collapsed – although most of this was eventually recovered.
Spelthorne borrowed funds from the PWLB for the science park sale leaseback deal at 100% LTV for 50 years. Other recent investments by UK councils include Surrey Heath borough council’s £86 million purchase of The Mall shopping centre in Camberley; Canterbury city council’s purchase of half of the £79 million Whitefriars shopping centre in that city; and the £75 million acquisition of Merseyway shopping centre in Stockport by the local borough council.
“Local authorities have bought a lot of shopping centres,” points out the county council director of finance. “This is a challenged sector with infrequent valuations. Ninety five percent of local councils are well-run and well-managed, but the whole sector will be damaged if one or two fall over. I am worried about some behaviour in some areas, but context is hugely important. Local authorities, faced with austerity, have been encouraged to be more self-sufficient.”
He points out that “local authorities have been commercial for a very long time with few failures.”
The situation highlights the slow progress of the UK’s Municipal Bond Agency, which was set up in 2014 to provide cheap funding to UK local authorities via the public bond markets. Warrington Borough Council launched an £150 million public bond in August 2015, marking the first direct issuance by an English local authority in 10 years. The success of the MBA depends on the funding on offer being cheaper than that of the PWLB. That is often the case.
"Local authorities can borrow from the PWLB at 2% or 3%, dependent on the term,” explains Martin at CBRE. “Compare this with the recent issuance by Aberdeen City Council of a 38-year index-linked bond that is trading at a yield to maturity of -0.44%."
Aberdeen City Council raised £370 million in November last year in a bond issue linked to RPI.
Tougher scrutiny
Yet municipal bonds have not taken off in the UK. Perhaps the tougher scrutiny of the public bond markets is a deterrent for councils that seem to be able to raise funds from the PWLB largely on the basis that investments are deemed to be in the public interest.
A UK government that has been wedded to a programme of austerity for many years will also be expected to encourage investment by local councils in the UK to tackle their growing funding deficits.
"Last year £1.3 billion was spent by UK local authorities on real estate,” says Martin. “Some of this investment is about creating income streams, but some is about regeneration where they are tackling housing and other issues."
As more and more councils jump on this carry trade others in the market have even claimed that their bidding power is now distorting the UK real estate market.
However, Martin cautions against giving too much credence to this argument: “Most other bidders would be bidding on a non-recourse basis and won’t have the same lending covenants as the local authority – the style of lending is different. It is important to compare like with like."
Rob Whiteman, chief executive of the UK’s chartered institute of public finance and accountancy has said that “while, overall, CIPFA wishes to see greater borrowing freedoms, for example in relation to social housing, we are concerned to ensure that councils do not take higher commercial risk without the necessary improvement in commercial capabilities, enhanced governance and transparency as will be needed.”
That is something that everyone in UK real estate can agree on.
"If the local authority is going down the route of investing for income, they should do it in a prudent way,” Martin emphasizes. “If you have not managed the risks going forward then that is not wise. However, if someone is coming up with a properly structured investment portfolio to provide an income stream, then that seems like a sensible thing to do."
