Commercial property: sound investments
Where are councils investing and why?
14 January 2019
Local authorities are looking to commercial property investment to help plug their funding gap – and are taking a variety of different approaches, as recent research found
When local authorities started to invest in commercial property, with the principal aim of generating long-term income streams, some predicted it was a passing fad or even a dangerous game. With some councils now forced to borrow funds to provide core services, it is apparent that revenue generation from commercial property is not simply a discretionary activity favouring those who thrive on risk and reward.
The Local Government Association (LGA) voiced concern about the drying up of central government funding to councils in September. With cuts of a further £1.3bn from council funding proposed in 2019/20, the LGA predicted that more than half the local authorities in England would receive no central government financial support at all.
The retention of business rates is part of this deal, and councils may take a more relaxed view on granting consent for both commercial and residential schemes if these can ensure regular income streams, and potentially one-off bonus payments. But the prospect of a radical overhaul of ratings could stymie this.
A glance at Figure 1 reveals a spectacular upward trend in the amount invested in commercial property by UK councils over the past 4 years. What is even more striking than the clear upward trend is the proportion of total investment by councils this represents: it stood at 0.16% in 2014, but is now well above 3%.
Figure 1: Investment by UK councils in commercial property from 2014 to Q3 2018. Source
Investment in property to create an income stream is likely to remain part of many councils’ financial strategies into the foreseeable future. To the extent that direct investment gives councils significant control over their financial sustainability, and potentially a similar degree of control of local economic regeneration, it can provide multiple dividends. And while borrowing rates remain relatively low, business cases can often be made without having to consider more complex issues such as economic impact or the social value added.
Following a review of the annual investment strategies, investment board reports, treasury management strategies and similar documents across a range of councils, it is possible to identify distinct commonalities, but also wide disparities. Many councils adopt an almost identical approach to the evaluation of opportunities, in terms of the criteria to be considered and the weightings used. There are also some commonalities in terms of the ideal portfolio mix that can, in theory, spread risk. This perhaps contributes to the unfortunate scenario in which public money competes with other public money for the same investment opportunity. As one council’s commercial property investment strategy confirmed: ‘The property investment market is a crowded arena, particularly as local authorities … appear to be seeking similar investment opportunities in prime locations with long leases and strong covenants'.
Evidence also points to councils piling into the acquisition of both department stores and shopping centres just as the retail market is going through an enormous transformation and gurus such as Bill Grimsey call for a re-imagining of the traditional retail heart of towns and cities. As with all commercial property investments, councils are buying into the future business models and market dynamics of the occupiers as much as – if not more than – into the bricks and mortar.
The shift from physical to online retailing was front-page news in the Financial Times when it noted a distinct cooling-off for retail property, leaving landlords and investors with a ‘glut of unsold shopping centres’, and adding that councils seem to have been the only willing purchasers (Financial Times, 8 October 2018, p.1).
An overarching investment criterion set out by one district council requires that no town should benefit from more than 25% of the total investment exposure. This may be a case of portfolio theory and diversification as interpreted by the council overtaking what may make complete sense financially and economically. And if investing in only, say, 6 properties, is it really necessary to apply a spurious economic theory to spread the investment risk across sectors and geography?
This is where we see some significant differences in policy and strategy. Table 1 summarises the alternative approaches taken by a range of councils of different size with different local challenges.
Table 1: Alternative local authority commercial investment strategies
In some instances, it is recognised that a locally based investment might not provide the same direct return, but it could enable wider community benefits. One council provides for opportunities generating between 0% and 5% to be subject to a separate economic assessment if there is a belief that it could deliver modest financial returns coupled with wider local benefits to the community.
The likelihood of electing to only invest within a council’s area, or to prioritise investment in that direction, is directly related to the nature and scale of the investment opportunities available. As reported in a parliamentary research briefing from February 2018, half the councils responding to a survey acknowledging that they had invested in commercial property were district councils from the South East.
To that extent, it would be unrealistic to expect investment to be constrained to the local area in all instances, although there may be a substantive case for prioritisation. Other than the political dividend for councils seen to invest locally, there could be a wide range of peripheral benefits; some with a very direct and immediate effect, others with a longer gestation period over a wider area but nevertheless attributable to the initial investment. These include:
- short-term and immediate benefits: for example, direct employment of local people, procurement of goods and services from the local supply chain, direct support for policy objectives, increased footfall and consequential improvement in sentiment by many stakeholders in the community;
- longer-term and wider benefits: for example, increase in property values, investment in infrastructure, enhancement of rateable value baseline, new homes and any associated bonus, additional inward investment by businesses, increase in the town or city’s gross value added and the creation of a sense of place.
Implicit in assessing wider benefits to a community is that financial investment appraisal can be mixed with politics. Since councils are inherently political bodies, it is surely right that politics has a part to play in crucial investment decisions, providing that the right checks and balances are in place and there is good governance.
If there were an appetite – and perhaps an ability – to carry out more economic appraisals on local investment opportunities, perhaps many schemes that on face value appear unviable would be taken forward. In theory, this sounds as though it would be the right thing to do, but the flipside is that a reliance on longer-term, non-cashable benefits may not be enough to plug short-term financial holes in the budget.
There is no easy solution to this dilemma, and no single investment policy is right for all councils. However, I predict:
- commercial investment will continue its upward trajectory;
- the government will not intervene to limit investment to council areas;
- investment policies will become more sensitive to local circumstances;
- investment in the community will attract more attention and an increasing proportion of discretionary investment funds;
- the property profession and its local authority clients will become more adept at ensuring wider benefits.
Brian Thompson is director at realestateworks
- Related competencies include: Investment management (including fund and portfolio management)
- This feature is taken from the RICS Property Journal (January/February 2019)
- Related categories: Property finance and funding