Local Authorities Hit Back At Accusation They Are Dumb Money In £3.8B Spree — But They Can't Hide From The Risks

Karen Whelan was the ghost at the feast.

Retail asset manager Ellandi had assembled a top notch panel to debate the controversial issue of local authority investment into U.K. commercial property, and for once the local authorities themselves and their advisors were sharing their side of the story.

Throughout a 45-minute debate, those involved gave erudite and eloquent arguments as to why, contrary to the perceived wisdom, the local authorities making a big push into commercial property are not dumb money paying top of the market prices, but, in fact, are following sound strategic logic.

And yet, one panellist had not been able to attend Ellandi’s annual Retail Rocks event. Whelan, chief executive of Surrey Heath Borough Council, sent her apologies, but she had a fire to fight. That morning, House of Fraser had announced its controversial company voluntary arrangement plan which would mean the closure of 31 stores.

One of those stores is in the Square shopping centre in Camberley, bought by Surrey Heath for a combined £103M in 2016. The 475K SF centre now has a looming 115K SF vacancy in it, in the form of a defunct department store.

Surrey Heath may not be a bad investor — but its situation highlights the risk and complexity councils face when investing in real estate.

Local authorities invested £3.8B into property between 2013 and 2017, according to data from retail property body Revo and agency Carter Jonas. The push has two strategic aims. In many cases local authorities are looking to supplement budgets cut by central government by making profitable investments in property. Many are also buying town centre retail schemes — like the Square in Camberley — in order to take ownership of and try to improve the property at the heart of their communities.

But such investment is risky given the prevailing trends in retail highlighted by House of Fraser’s struggles and that of myriad other retailers this year.

“People talk about the risk of investing, but at this point I think the bigger risk is not investing in our town centres,” Leader of Eastleigh Borough Council Keith House said. “The risk is that we worry about whether we are paying a bit too much at the top of the market, we defer investing and the decline in town centres continues.”

Much of the criticism of local authority investment into commercial property revolves around pricing, with tales abounding among agents of local authorities outbidding conventional investors by significant amounts, or several authorities competing for the same property.

But an advisor to several local authorities said the unique financial structure being used for these deals reduces the risk.

“Nothing is ever risk-free, but the competitive financing that they can access means that the risk of overpaying is severely reduced,” Knight Frank Capital Markets partner Charlie Barke said.

Local authorities can borrow at 100% loan to value at interest rates of 1% from a central body called the Public Works Loan Board, and invest in property at yields of 5%, Barke said. He added that the covenants are not strenuous if the value of the asset drops and that the excess income from properties can be used to amortise the debt over the course of its lifetime, which can be up to 50 years.

“I don’t know many investors who wouldn’t like borrowing terms like that,” he said.

Although Whelan did not attend the event, she did send over a statement responding to the question of what Surrey Heath had learned from its move into property investment and management. She did not address the demise of House of Fraser directly, but mirrored House’s view that the council’s strategy was about regenerating town centres for the benefit of local communities. The private sector had failed to do this so the public sector was obliged to step in, she said.

“By acquiring the freehold interest in many of our town centre sites, Surrey Heath did so as part of a wider regeneration of its town and not as an investment property.

“Local authorities have been investing in their towns for years but normally as a lesser partner. The problem with this is you are not in control and can only move as fast as the other investors can move. These then have competing priorities either to other areas or to their shareholders in terms of level of return they are committed to."

Whelan argued that, if anything, Surrey Heath's investment programme had been too slow.

“We wanted to buy [the town centre retail scheme] sooner and we should have forced the private sector to sell it to us so that we could get on with the job. What we know since we have been in control is we have moved far quicker on our major projects than we have ever been able to move.”

There has been some talk about whether the Treasury would move to ban local authorities from investing in property because of the potential risks, but House said: “I think Treasury are looking at this, but they are mainly looking at people investing outside of their own borough. They understand the rationale for investing in town centres.”

Camberely and Surrey Heath will now be a case study in how local authorities deal with one of the biggest but also the most predictable setbacks that could face an investor in town centre retail — a big department store vacating a large unit. Maybe they will be able to move quicker and invest more than a private sector owner with banks or shareholders to appease, or come up with a more innovative solution. Watch this empty space.