Investing in commercial properties and borrowing in advance of need

05-11-2017

by Don Peebles, Head of CIPFA Policy and Technical UK

CIPFA revised its Prudential Code in 2017 to take into account the changing public sector landscape, and the increased commercialisation of local authorities. The Prudential Code was of course originally introduced in 2004 to allow local authorities, within a more flexible framework, to be able to take their own sustainable, affordable capital finance and investment decisions. A significant difference from the previous controls framework was that any local decisions taken would be in accordance with their service delivery needs, signalling a move away from centralised controls.

The Prudential Code is a part of the prudential framework for capital finance introduced by the Local Government Act 2003. It is based on a system of risk based, self-management and replaced a complex system of borrowing restrictions (credit approvals) which limited local authorities’ ability to take effective capital investment decisions.  

Since the inception of the Code and this ‘new’ flexibility, local government has been facing reduced financial resources and long-term austerity. Local authorities have had to take more commercial decisions to maximise the most of their limited resources, ensuring they can support service delivery and economic generation. CIPFA has also encouraged and indeed supports these types of initiatives, which were indicative of a more modern local authority.
   
However, increasingly there is a move towards investments in commercial properties, funded by borrowing, with the key driver of this activity appearing to be the generation of revenue. A look at the regulatory landscape rightly casts doubt upon such practices. Statutory investment guidance from the Ministry of Housing, Communities and Local Government (MHCLG) this year sets out clearly that local authorities need to consider the long term sustainability risk implicit in becoming too dependent on commercial income, or in taking out too much debt relative to net service expenditure.

The Prudential Code itself of course takes the same position as the statutory guidance, and it is clear that authorities must not borrow more than or in advance of their needs purely to profit from the investment of the extra sums borrowed. The Code sets out that local authorities should also consider carefully whether they can demonstrate value for money in borrowing in advance of need, and can ensure the security of such funds. CIPFA was aware that despite the existence of the statutory guidance and the Prudential Code, the practice of borrowing to invest in commercial properties to generate income has continued.

The Code has clear principles of affordability and prudence along with indicators to demonstrate, monitor and support these principles. Prudence requires local authorities to take into account their arrangements for the repayment of debt, (including through its minimum revenue provision) and consider both the risk and the impact, and potential impact, on the authority’s overall fiscal sustainability. Affordability should consider the financial consequences of those same decisions and ensure the sustainability of new borrowing over the life of the investment plans.  

CIPFA’s recent statement was specifically designed to remind users of the Prudential Code, and their responsibilities to avoid exposure of public funds to unnecessary or unquantified risk. Our statement was also a reminder that local authorities must use their powers in relation to their functions, and for the prudent management of financial affairs. The expectation is that powers are used reasonably, and in accordance with the primary function of a local authority, which is to deliver local services.

It’s difficult to see how disproportionate levels of borrowing solely to make commercial investment is consistent with the requirements of either the Prudential Code or Treasury Management Codes.

In practice both prudence and affordability have to be analysed and managed from a risk perspective, so in addition to the core issue of borrowing in advance of need, commercial property investment brings risks. Those risks could be very difficult to manage, or when taking note of this that prudence and affordability have been achieved. If there is reliance on investment income, this means that the potential failure or a downturn of the property market will have a direct impact upon local services. 

So local authorities need to decide how to exercise their borrowing powers, their duty to determine affordable limits, as well as their use of investment powers. I advise local authorities to carefully review CIPFA’s statement, and also have regard to the statutory investment guidance. In the meantime, further guidance on this subject will be developed. I would add even if powers can be identified, authorities will need to be able to demonstrate that it would be reasonable to use them. 

Legal precedents, concepts of fiduciary duty and the elements of the prudential framework should operate together to ensure that authorities differentiate properly between what they could do, and what they should be doing. Their primary function remains the delivery of local services to the local population. 

This article originally appeared in Room151.