Stronger spotlight - Council commercial property scrutiny

Thursday 23 April 2020

Councils were already vulnerable to a downward trend affecting their commercial property investments, then along came COVID-19 and a country-wide lockdown, which has shut many of the businesses that are commercial council tenants.

In February the National Audit Office (NAO) reported on local authority investment in commercial property. Conclusions from its findings are direct and concerning.

‘The scale of investment of public funds in this activity in the last three years, the concentration of this activity in a relatively small group of authorities, and the use of borrowing to finance such investments is striking. The benefits from this investment therefore must be considered against the potential financial sustainability and value‑for‑money risks that have emerged.’

Access to cheaper borrowing through the public works loan board (PWLB) has resulted in many councils buying commercial properties in recent years, with the rental income helping to stretch their budgets. This is not the core intention of the PWLB, and the Government is looking to address its use. A future lending terms consultation document was published on 11 March 2020, which may restrict access to this source of finance in the future.

According to figures from the Chartered Institute of Public Finance & Accountancy (CIPFA), after being relatively stable at between £800 million and £1.1 billion from 2012 to 2016, council investment in commercial property rose sharply to £2.8 billion in 2016/17 before hitting a record-breaking £4 billion in 2018.

Shifting property focus

Although commercial property ownership isn’t a new venture for councils, the type of property currently being targeted for investment is markedly different. The focus on return means commercial properties like distribution centres, office campuses and large shopping centres have become council investments.

Rundown and dilapidated buildings are also found in council’s commercial property portfolios. The potential for higher returns once they are renovated makes them attractive. In addition, whereas most councils would have stuck to commercial properties in their own area in the past, the push for return means this is no longer the case. Savills’ research shows that 39% of investments by councils were outside their operational area.

Risky venture

Financial pressures may have forced councils to seek these additional income streams but there are significant risks inherent in investing in commercial property, especially where it’s underpinned by borrowing. CIPFA highlighted these risks in November 2018, stating that councils: ‘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’.

Certainly, some scenarios could leave councils struggling to cover loan repayments. Following concerns about the increase in council borrowing, HM Treasury sent out a warning in October 2019, restoring interest rates to levels available in 2018. As a result, the margin that applies to new loans from the PWLB has increased by one percentage point on top of usual lending terms.

The extreme economic impact of the Coronavirus emergency is already showing and the longer-term effect on the UK economy will hit council budgets. Even before the pandemic, the last figures on the UK economy showed no growth in the final three months of 2019. The ONS figures showed the economy grew by 1.4% in 2019, marginally higher than 1.3% in 2018.

The continued Coronavirus lockdown is having a deleterious effect on an already struggling retail sector in the UK, on which many council investments rely for income. We have seen the recent failures of Laura Ashley and Carluccios, with Debenhams closing many of its stores. 

Higher levels of defaults and vacancies are already making it harder to generate income from commercial property. The retail sector has been under pressure for some time and landlords were already having to reduce rent for companies trying to avoid collapse.

There can also be issues from an insurance perspective. For starters, it may not be possible to add these new investment properties to existing council commercial property policies.

To find out more about insurance issues and risk challenges, download Winter stronger for the rest of Alison Goodwin’s Commercial property concerns article.

Alison Goodwin, Public Sector Practice Leader, Aon (alison.goodwin@aon.co.uk)

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