Is commercial property one risk too far?

By Aileen Murphie | 27 May 2020

In response to substantial falls in funding since 2010-11, local authorities have made reductions in revenue spending on services. Increasingly, some authorities have also sought to offset funding reductions by generating new income through a range of strategies. A key component within these responses in recent years has been a rapid expansion in the acquisition of commercial property, often funded by borrowing.

The National Audit Office published a report on local authority investment in commercial property in early February looking at the nature and scale of local authority spending and borrowing relating to commercial property. It also focused on the role of the Ministry for Housing, Communities and Local Government (MHCLG) and the extent to which it has fulfilled its responsibilities as steward of the framework for council borrowing and investment.

Since we published our report the financial context for both councils and commercial property has changed due to the COVID-19 pandemic. Our report identified that individual local authorities face potential risks from commercial property investment. These include ‘specific risk’ associated with each individual property, such as the financial strength of the tenant. Local authorities also face ‘systematic risk’, which reflects movements in markets. The current pandemic clearly represents the materialisation of a substantial systematic risk. The impact this will have on the finances of councils with commercial property portfolios will be shaped by the risk mitigation and management measures they deployed in building their portfolios and establishing contingency arrangements.

Local authorities have invested in and held commercial property for a long time, but there has been a significant upswing in activity in recent years. In the three-year period 2016/17 to 2018/19 we estimate councils spent £6.6bn on commercial property, over 14 times more than in the previous three years (see chart). A further £1bn was spent in the first half of 2019/20.

mulative spend in the sector was accounted for by only 49 local authorities, with district councils being disproportionately active relative to their size. There is also a strong geographical skew: councils in the South East accounted for more than half of the acquisitions by value. Some 38% of all acquisitions by value were outside authorities’ own areas.

Borrowing has played an important role in supporting the acquisition of commercial property. For the £6.6bn spent on commercial properties we estimate that up to 91% was financed by prudential borrowing. Some councils have seen significant increases in their external borrowing and debt servicing costs linked to the acquisition of commercial property: the group of district councils that have been most active in acquiring commercial property saw their stock of external debt increase by £88.8m at the median, and median gross external borrowing levels as a share of spending power grow from 3% to 756% from 2015/16 to 2018/19.

The primary risk faced currently by local authorities with commercial property portfolios is whether tenants can continue to pay their rent. In general councils acquire commercial property to hold for the long-term and to generate a net return on the rental income, rather than to look to benefit from an increase in asset values over the short-term. A range of different types of business are likely to be struggling at the current time and rent payments are not a given. For instance, Spelthorne BC, which has a large commercial portfolio, reported in its recent evidence submission to the Public Accounts Committee, that 10% of its March quarter rents had been deferred by agreement. In its evidence submission South Somerset DC reported that by the end of April it had received 80% of its March quarter rent and was expecting to receive more in the current quarter. Ultimately, however, it is rent defaults rather than deferrals that will be the most damaging and, as with all landlords, authorities will be working with their tenants to avoid these.

The extent to which a local authority’s portfolio is exposed to rent defaults, and the implications for its finances should those defaults materialise, will be shaped by the risk mitigation work done by the authority. Our report showed that councils reported mitigating risk in a variety of ways including: accessing appropriate skills and expertise; undertaking due diligence for each acquisition; managing property risks by diversifying portfolios, which could be in terms of property type, location, lease length or yield; and establishing contingency funds to deal with falls in rental income, capital refurbishment at the end of leases or unexpected additional costs.

Our discussions with local external auditors did not indicate that they had acute concerns about these arrangements across the sector. However, they did identify areas for improvement, particularly in relation to the skills and capacity of smaller local authorities undertaking complex arrangements, and where councils with little experience had moved straight to large deals.

In terms of the risk mitigation by councils, there are some notable points. Firstly, portfolio diversification has not necessarily been a priority for all local authorities as their activities have not always been driven wholly by commercial objectives and principles. Some councils have acquired property not only to secure yield but also to deliver local regeneration or place-shaping objectives.

In recent years supporting the high street and preserving local shopping centres has become an important objective for some. This is reflected in the £2.3bn spent by local authorities on retail property in 2016/17 to 2018/19 (see chart). This has potentially exposed some councils to the pressures that the retail sector is currently experiencing due to the pandemic. In this context, the fact an asset has been acquired for place-shaping rather than yield generating objectives is not wholly relevant: if the acquisition of an asset has been financed by borrowing, which in turn is due to be serviced by rental income, then that debt has to be serviced regardless.

Secondly, some local authorities are in the early stages of developing their commercial portfolios. This implies that in some cases their contingency funds to cover rent defaults and other unexpected costs might also be in their early stages. Contingency funds are often started with a down payment, which is then added to annually, pro-rated to the size of the portfolio. Given that the pandemic has occurred so shortly after the recent spike in activity, some councils may still be building these funds up towards their target levels.

We do not have a crystal ball, so we do not know what the future holds for local government finance or the commercial property market. However, where local authorities hold commercial property portfolios financed by borrowing, these hold the potential to create additional challenges over the coming months to add to the myriad of others created by the pandemic.

As a consequence, the quality of the steps councils took to mitigate and manage risk in the development of their portfolios will be tested.

Aileen Murphie is a director of MHCLG and local government value for money at the National Audit Office, and honorary professor at Durham University Business School

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