The great town hall property buying spree
April 9 2017 | by Oliver Shah @ The Sunday Times
Cash-strapped authorities have become real estate investors to raise funds.
Councils are using a loophole in Treasury borrowing to pile into real estate ““”Šand create a tower of debt.
After a career as an investment manager at HBOS, the bank that had to be bailed out by Lloyds during the financial crisis, Donna Jones became leader of Portsmouth city council in 2014. It was a time of belt-tightening, with the prospect of government funding for local authorities drying up altogether by 2020.
“It was clear to me we had to start running councils like businesses,” said the 39-year-old Conservative councillor. “To survive during the austerity programme, the only way to protect high-quality public services was to go out and generate income. We’re not moving to fortnightly bin collections or closing any libraries, swimming pools or museums.”
Prized property: BP in Sunbury
She has been true to her word. The council is now selling back-office facilities, such as human resources and IT support, to charities and smaller councils. It has leased the naming rights to the Spinnaker Tower, the city’s 560ft-high landmark, to Emirates airline.
Portsmouth’s local authority has also amassed a commercial property portfolio “” most of it many miles away from Fratton Park football stadium, HMS Victory and Southsea Castle.
Using £110m of debt, Portsmouth has so far bought properties including a DHL distribution centre near Birmingham, a Waitrose store in Somerset and a Matalan warehouse in Swindon. In December, it sold a long lease on the Wightlink ferry terminal to the insurer Canada Life for £73m. The proceeds will be used to raise the portfolio’s size to more than £180m.
Jones said the deals were already producing £4.9m of annual income after interest. Combined with other measures, that means only £900,000 of the £9m budget cuts that Portsmouth must implement in the coming year will have to be passed on to residents through service reductions, she said.
Across England, other councils are doing the same. Empowered by the 2011 Localism Act and funded by cheap loans from an obscure subsidiary of the Treasury, 49 local authorities went on a £1.3bn property buying spree last year “” spending far more than the £142m recorded in 2015.
However, there are growing concerns in the private sector and parts of Westminster that government grant cuts, coupled with generous lending by the Public Works Loan Board (PWLB), are encouraging councils to take risks they do not properly understand “” in an asset class that is more volatile than many realise. Most of the property deals have been 100% funded with debt, leaving both councils and the Treasury exposed to immediate losses if values fall.
William Hill, the former head of property at the fund manager Schroders, warned in January that councils were “behaving like hedge funds exploiting a financial arbitrage”. He questioned why the government was lending to local authorities “to buy real estate on terms that make bank lending to the property sector before the [great financial crisis] look positively conservative”.
THE TOP FIVE MOST ACTIVE COUNCILS LAST YEAR BASED ON VOLUME DEALS
- Spelthorne£394m
- Surrey Heath£104m
- Canterbury£80m
- Portsmouth£78m
- Stockport£75m
Sam Resouly, a partner at the investment firm Trinova Real Estate, said the trend had caused “distortion” in the market, with the PWLB giving councils an advantage over other bidders. He added: “If they buy 10 years income, they have to accept that as 10 years goes to zero, they’re going to get a rapid deterioration in the value of that asset. At some point they’re going to have to spend money to get it up to standard, and what happens to councils’ accounts then?”
One management consultant, who did not want to be named, said: “It’s hard to see why councils aren’t just the dumb money in the property market.”
The borough council of Spelthorne, a patch of the Surrey commuter belt that is home to 95,000 people, had the dubious honour of doing Britain’s biggest local authority property deal last year.
BIGGEST DEAL
- £360mAmount Spelthorne council paid for BP’s office campus in Surrey
It boasted of outbidding “national and international” investors to buy BP’s Sunbury office campus for £360m. The complex has been leased back to the oil major for 20 years, yet Spelthorne financed its purchase with a 50-year fixed-rate loan from the PWLB.
Although the council is paying down the loan year-by-year “” unlike most other PWLB borrowers, which pay interest only “” the mismatch raises the possibility that Spelthorne will be on the hook for repayments on an empty building in 20 years, when BP’s lease runs out.
Terry Collier, deputy chief executive of the authority, said it had taken out a 50-year loan because “it was just the way the financing worked best for us”.
He said BP had been on the site for 100 years, and was an important local employer, but added: “We wanted to secure a key site within the borough which was 3½ miles from [Heathrow] Terminal 5. Regardless of what BP do long term, that’s a valuable site, and we obviously did our options analysis around various scenarios.”
Spelthorne took confidence from the fact it was advised by Cushman & Wakefield, a well-known property agent. Cushman, however, is likely to have received a seven-figure fee, based on typical industry contracts, meaning it was hardly incentivised to advise against the deal.
Of the 76 council property transactions last year, 58 involved authorities buying within their own geographic area, according to a report by the consultancy CBRE. Spelthorne’s purchase added £3m a year to its annual £13m income after interest costs, but also gave the council control of what it called a “strategic” local site. Similarly, Canterbury council in Kent spent £79m on 50% of the city’s Whitefriars shopping centre, with the dual aim of generating income and improving the mall, and Surrey Heath bought up a chunk of Camberley town centre for regeneration.
There were 18 instances of councils venturing beyond their boundaries for deals, apparently driven entirely by the hunt for investment yield. Tony Martin, a director at CBRE, played down the significance of this, saying there was “only a very small number who will do it”, but the trend among the likes of Portsmouth seems to be accelerating. Some are even considering going overseas.
East Hampshire is one. It was the only authority in England to announce a council tax cut this month. The council leader, Ferris Cowper, a former director of the confectionery giant Mars, believes the authority could scrap the tax altogether within five years despite the loss of central government grants.
The leader of Portsmouth council, Councillor Donna Jones, believes councils will have to be run more like businessesANDREW MATTHEWS/PA
As well as making money selling services such as planning and regeneration advice, Cowper has built a £24m property portfolio that produces more than £2m a year after costs.
He is in the process of negotiating £200m of new loans, at least half of them from the PWLB, to ramp up East Hampshire’s activities.
Those borrowings would amount to eight times East Hampshire’s annual budget of £25m. “That will be for opportunities nationally and, depending on the yield and risk profile, internationally too,” said Cowper, who plans to remain a cabinet member to oversee the strategy.
At the heart of this property boom is the PWLB, a body set up in 1793 to lend councils money for sanitation works. It now gives them access to cash from the National Loans Fund for “capital projects” “” in theory, building and infrastructure “” and has a balance sheet of more than £65bn.
The PWLB allows authorities to raise finance at sovereign prices: according to its website last week, £100m from the PWLB over 20 years would cost a council just 2.2% annually. The equivalent private sector rate would be 4% to 5%.
The process is surprisingly simple. Since Sir Eric Pickles, the former communities secretary, abolished the Audit Commission, councils have set their own borrowing levels based on the Chartered Institute of Public Finance’s prudential code for capital finance without close supervision by the government.
Provided a council can assure the PWLB it is operating within its limit, which is agreed every year by the cabinet and signed off by its finance director, it can borrow as much as it likes without telling the PWLB the purpose of the loan. The PWLB lends to the council without taking security over the asset.
COUNCIL INVESTMENT IN PROPERTY IN 2015/16
- 2015£142m involving 20 transactions
- 2016 – £1.3bninvolving 76 transactions
Councils’ interest payments must be paid ahead of their other commitments, such as spending on services, although the current spread between the PWLB’s rates and property yields means they can service the debt and keep a profit.
A parliamentary report last year noted that changes to the PWLB’s early repayment charges meant that fewer councils were paying off loans early.
Henry Stannard, an associate partner at the strategy consultancy OC&C, said councils were exploiting a loophole. He suggested they were using a legal but circuitous route to “launder” money ring-fenced for capital projects into the separate part of their budgets set aside for spending on services such as adult care.
“This is not what the PWLB was set up for, and it’s not what it’s been funding for the past 200 years,” he said. “There has to be a better way of funding local government than these sorts of cheats.”
The Treasury is absorbing the PWLB and taking over its functions, although it said local authorities would “continue to be able to access loans as before”, and that interest rates would “continue to be the responsibility of the Treasury”.
For now, the multibillion- pound property gamble is set to roll on. In the words of Tony Travers, local government expert at the London School of Economics, councils’ attempts to make profits are an “intended consequence” of Downing Street’s plan to cut local authority grants by 2020 while protecting spending on defence, the NHS and pensions.
The next property market crash will test the wisdom of that policy.
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Councils spent £1.3bn on commercial property last year as they sought ways of generating income to make up for central government grant cuts. They are doing this with cheap loans from an arcane branch of the Treasury that is supposed to help pay for infrastructure investment.
MPs raised the alarm over the trend in November. The public accounts committee, chaired by Labour’s Meg Hillier, said the Department for Communities and Local Government appeared complacent about the risks from councils “increasingly acting as property developers and commercial landlords with the primary aim of generating income”.
The report noted that:
- councils’ spending power on services, based on government grants and council tax, fell by more than a quarter from 2010-11 to 2015-16, and is set to drop another 7.8% by 2019-20;
- councils’ spending on capital projects ”” building and infrastructure, but also property investment “” rose by 13.6% from 2010-11 to 2015-16; and
- a “significant” number were already having to use more than 10% of the money meant for services to meet interest payments on debts.
The MPs said the department did “not have good enough information” on the pattern of property investment. They pointed out that three-quarters of councils’ capital spending was grouped under one category “” hiding the shift from building libraries and museums to investing in office blocks and supermarkets for yield.
The Tory MP Richard Bacon questioned councils’ ability to build portfolios. “We all know plenty of examples of local authorities that could not run a bath or organise their way out of a paper bag,” he said, referring to the early 1990s interest-rate swaps fiasco in Hammersmith & Fulham, west London. The council amassed £6.2bn of risky derivatives bets and was saved only when the House of Lords ruled them void.
Last week, Moira Gibson, leader of Surrey Heath council, accused critics of “underestimating councils”. She said her authority used outside advisers, including Montagu Evans, to help run its £130m portfolio.