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Local authorities' investments in commercial properties has been a feature of local government finance in recent years. Although local authorities do have clear powers of investment, it is the extent to which the investments are funded by borrowing which is attracting interest. Then, if the key driver is the generation of revenue, current debate is around the extent to which local authorities should be undertaking this type of activity.
The background of course is that public services are under tremendous stress amid ten years of austerity. Add to this a decline in government grants, it is unsurprising that local councils will tell us that having to look to new forms of income is itself a modern feature of local government finance.
When it comes to borrowing for commercial investments, the incentives for local authorities have been clear, as low interest borrowing has led to a sharp increase in acquisitions of land and buildings using capital finance. Although relatively stable at between £800m and £1.1bn from 2012 to 2016, there was a sudden rise to £2.8bn in 2016/17, and this trend has continued.
An investment of £4bn by local authorities into land and buildings this year is record breaking, taking their share of total investment in the commercial property market has grown from 0.2% to 3.4% between 2015 and 2018 according to Savills. There are a number of ways this trend is concerning.
The statutory investment guidance issued this year from the Ministry of Housing, Communities and Local Government (MHCLG), and CIPFA’s Prudential Code, which sets the governing framework for borrowing casts into doubt the extent of borrowing to fund investments for commercial return.
While allowing for flexibility for local authorities, both set out clearly as a matter of prudence 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.
Borrowing in advance of need purely for commercial purposes is not consistent with the Code or with the guidance. In fact fundamentally, it is the role of local authorities to serve their community, including protecting public funds. This means avoiding exposing them to unnecessary or unquantifiable risk.
Where a local authority has made such a decision to borrow, its investment strategy should explain clearly why the statutory guidance has been disregarded, what use will be made of the money, and what procedures are in place if the expected investment yield does not materialise.
This type of borrowing is also not consistent with the primary function of local authorities, which is the delivery of local services to the local population. It is important therefore to distinguish between borrowing to fund wider regeneration projects and purely for investment.
One obvious risk which local authorities face from these investments is a downturn in the property market, which could lead to lower rents or higher vacancies. This could mean that authorities will need to cover future borrowing costs from other funds. Fluctuations in property values in our history shows that this is almost a given, with the continuity of the boom, slump and recovery cycle of the market. With retail in turmoil while web based retailors march on, there are structural challenges as well as these cyclical ones.
Management of these assets can be complex too, and at times they will require significant vision as well as investment to maintain profitability. This is of course a relatively new area for councils to be stepping into. It remains to be seen how successful the long term management of these assets by local authorities will be. It will also be interesting to see the private sector response and how they react to any market distortion.
So what should local authorities do? Further guidance on this subject will be developed but there are three immediate actions which I would recommend.
Firstly, you should carefully review CIPFA’s recent statement. The statement was specifically designed to remind users of the requirements of the prudential code, and their responsibilities to avoid the exposure of public funds to unnecessary or unquantified risk.
Secondly, the statutory guidance should also be carefully considered. Any departure from that guidance should be properly challenged and internal clarity sought as to why the Code and/or statutory guidance is not being adhered to.
Thirdly, the new requirement for preparation of a capital strategy provides the basis for a wider clarity to all borrowing and investment decisions. Those authorities who have completed or are in the process of completing their strategy will find it more challenging to justify some historic decisions but also add clarity to the basis for future borrowing and investment decisions.
If commercial investment does remain part of the future strategies of local authorities, it should not be one of the core pillars of funding. To do so ties public services to the property market, and the less proportional the borrowing which has occurred, the greater the risk will be.
This article originally was published in The MJ on 21 November 2018