Councils have been criticised for putting money into property instead of spending on services – but James Gulliford, joint head of UK investment at Savills, says it’s a wise financial move.
The actions of one group of investors has garnered a disproportionate amount of UK media coverage in the past 18 months beyond all others: local authorities.
Savills data shows local authorities look on track to exceed 2017’s £1.85bn of spending this year, having already invested nearly £1bn in UK commercial property in 2018. However, they still account for only 3.4% of the total UK commercial investment market and therefore remain a very small piece of the overall picture; their activities neither provide it with a dramatic boost, nor expose it to a potential fall should they withdraw.
But most commentators aren’t really concerned with these investors’ role in the stability of the broader market. Instead, the debate focused on this group is principally around whether they “should” be investing in property when local authority spending is being tightened – should they be putting the money into public services instead?
This is largely a political issue, but the argument against it is rather weak, as the fundamental reason many authorities are investing in income-producing assets to begin with is to plug the gap created by the reduction in income from central government. There is no doubt that there are many areas of local government spending that would benefit from a cash injection in the short term, but a wise real estate decision could provide strong enough income returns to ensure they are funded in the long term, as well as potential capital growth as values rise. Preventing local authorities from making investments, and thereby reducing their income, at the expense of funding public services, is therefore not in anyone’s interests until funding streams for these services are secured from elsewhere. And such streams are few and far between in the current climate.
Long-term decisions
A better question to be asking is not whether local authorities should be investing, but whether they are doing it responsibly and making good long-term decisions. Again, in some of the media coverage, this comes down to a simple distinction: if an authority is investing in property within its boundaries, that’s acceptable; if it’s investing beyond its borders, then such an investment is generally perceived as being more of a risk and attracts criticism. However, as with many things in life, the distinction is seldom as clear cut.
The big advantage of a local authority investing within its jurisdiction is that, as well as an income return, the authority (and by implication the wider community) gets the benefit of a “social return”. A local shopping centre that is struggling, but which provides a hub for the surrounding residents and potential services that they cannot access elsewhere, for instance, is arguably in better hands if it is bought by its own local authority, which has a greater interest in securing its future than a property company or fund.
Indeed, this is what many local authorities appear to be doing: councils have been actively buying shopping centres over the past two-and-a-half years. According to Savills statistics, in the first half of 2018 local authorities were responsible for £187m worth of acquisitions of the asset class – accounting for 31% of total volumes. This followed investments of £208m across seven deals during 2017 and £386m in 10 deals in 2016. Prior to 2016, council investment in shopping centres was limited.
The rationale behind the recent concentration of activity on retail assets in particular is broadly twofold:
1) Shopping centres provide a strong source of income;
2) They provide significant regeneration opportunities.
The current income multiplier that can be secured on a shopping centre is very attractive compared with other property sectors such as offices and industrial. The average shopping centre yield to date in 2018 stands at 6.65%, against offices at 4.75% and industrial at 4%. This good return from day one, when combined with attractive lending terms, produces a strong source of income.
On the second point, shopping centres, and other good office assets, typically occupy large town centre sites, which provide numerous potential regeneration opportunities. These opportunities, some of which may have been investigated by the private sector but proven unviable, are more attractive to local authorities as they unlock the wider regeneration of their town centres. Furthermore, where the council owns the freehold of the site, the purchase of a long lease on an asset can unlock some marriage value.
Revitalise and reinvigorate
In the case of shopping centres, in worst-case scenarios where vacancies are increasing and a centre is less viable as a retail destination, the purchase of the scheme can revitalise and reinvigorate, breathing new life into the asset and the wider area, and possibly introduce other community uses such as libraries, doctors’ surgeries or education, in addition to student, hotel, leisure or assisted living.
These reinvigoration benefits should not be underestimated. An improvement of the retail offer will result in additional business rates being paid to the council, and increase local employment. This can in turn lead to greater positivity and snowball into external investment and residential development.
Additional housing also provides further income through council tax. In short, by improving a town centre a council can benefit from substantial additional income and investment; a strong rationale for a local authority to take the lead.
This “social return” advantage seems to be largely accepted. What then of the criticism laid at the door of local authorities who invest outside of their jurisdiction, when such a return is not accessible? Much of this negativity is centred on the perceived lack of expertise from the local authorities investing in areas they are not familiar with and making rash decisions to “jump on the investment bandwagon”.
Investing outside the operational area is still a minority move, with the vast majority of spending happening locally. From a strategic perspective, though, it makes sense as it spreads the investment risk among multiple markets. Experienced real estate investors seldom put their money into one market alone – why shouldn’t local authorities do the same?
The perceived lack of expertise within councils is also, in our experience, unfounded. On every occasion that we have examined where a local authority has purchased a shopping centre, they have taken expert professional advice from agents. This transaction advice, combined with the appointment of professional asset managers on the ongoing management of the assets, means that councils are receiving best‑in‑class intelligence. Having a local authority as the landlord for a local shopping centre may also reduce the risk that the asset will be vacated by retailers, compared with when it is owned by the private sector, as they recognise that such landlords are committed to the asset and worth forging a long-term, mutually beneficial, relationship with.
Overall then, investment in commercial property can deliver both an income return and a social return for local authorities. So long as it is well-informed, transparent, and benchmarked (which it is under the Public Works Loan Board) we see no credible argument for discouraging or limiting their investment activity in this sector.
Main image © imageBROKER/Rex/Shutterstock
All investment carries risk
Councils have always handled capital expenditure and have a long history of managing risk, writes Mike O’Donnell, associate director for local government at the Chartered Institute of Public Finance and Accountancy. All investment carries risk, but that is not necessarily a reason to avoid it. What is crucial is that councils understand the risk they enter into and apply the right level of due diligence. To do so, councils need the right commercial skills in place to evaluate, communicate and manage the risk.
Local authorities in England and Wales must follow the principles laid out in CIPFA’s Prudential Code for Capital Finance in Local Authorities and Treasury Management in the Public Services.
This provides the framework for ensuring capital expenditure plans are affordable, prudent and sustainable and that treasury management decisions are taken in line with good professional practice.
