Many councils which bought commercial properties are in big trouble

“The timing couldn’t have been more perfect. At a debate over the role of councils in the commercial property market, held by retail landlord Ellandi in central London last month, one notable panellist was conspicuous by her absence.

Karen Whelan, chief executive of Surrey Heath council, had been due to argue against the motion that local authorities were “absolute beginners” in the property investment game, but her attention had been diverted by a more pressing issue. That morning, the struggling department store chain House of Fraser had announced its intention to shut 31 shops through a controversial insolvency procedure known as a company voluntary arrangement (CVA).

The Camberley store was among those earmarked for closure. Surrey Heath had paid £17.6m for the property only 18 months earlier, following its £86m purchase of Camberley’s main shopping centre, The Mall (since renamed The Square). House of Fraser’s imminent departure left Surrey Heath staring at a loss of rental income and a destruction of the property’s investment value.

Whelan and the council’s leader, Moira Gibson, issued a joint statement saying they had bought the House of Fraser store “as part of the wider regeneration of the town and not as an investment”. They said they were “disappointed” by news of the CVA but added: “Because Surrey Heath is in control of the freehold of this site, like other sites we have bought, it enables us to continue our regeneration proposals.”

Critics of councils’ increasing forays into commercial activities found the response laughable. Just over a year ago, The Sunday Times raised questions over the boom in commercial property deals being struck by local authorities. Empowered by the 2011 Localism Act and funded by cheap loans from an obscure subsidiary of the Treasury, local authorities ploughed £3.8bn into industrial parks, offices and shops between 2013 and last year, according to consultancy Carter Jonas and landlords’ group Revo.

To say that town halls have a questionable record in commercial ventures is something of an understatement. Hammersmith & Fulham in west London came close to cataclysm in the early 1990s when it amassed £6.2bn of risky derivatives bets (it was saved only when the House of Lords ruled them void).

Concerns about councils’ dealmaking go beyond property. In recent years, their pension funds have started to take a much more active approach to investing in infrastructure, allocating more of their spending to assets ranging from ports to power networks — seen as an ideal match for their long-term liabilities. Yet with that new approach has come greater risk.”

In November, a City fund poured tens of millions of pounds of councils’ pension money into projects run by the outsourcer Carillion — weeks before it went bust. Pensions Infrastructure Platform (PIP), which invests on behalf of councils from Strathclyde to the West Midlands, paid £400m for 10 private finance initiative contracts from Standard Life Aberdeen. Among those assets was a 50% stake in the unfinished Royal Liverpool Hospital. PIP was left nursing heavy losses when Carillion’s collapse in January halted the hospital’s construction. Work has yet to resume.

Councils are under huge financial pressure as they prepare for the withdrawal of central government grants by 2019-20. Last year, the Local Government Association warned they faced a £5.8bn funding gap by 2020 — even if they cut costs by closing all children’s centres, leisure centres, libraries and museums, and turning off every street light. By borrowing from the Public Works Loan Board (PWLB) at 2% and using the money to invest in properties yielding 5% or more, local authorities generate a profit that can be redeployed on front-line services.

Some private sector operators have accused them of behaving like primitive hedge funds exploiting an arbitrage, predicting dire consequences when the property market cracks and the Treasury is left on the hook for deals funded 100% with debt.

Surrey Heath’s experience with House of Fraser could be seen as one of several canaries in the coal mine. A wave of administrations and CVAs by retail tenants such as Select and Poundworld has punched holes in shopping centres’ rental incomes. Even the most sophisticated operators — British Land, Hammerson and Intu — have admitted to feeling the effects of retail insolvencies in recent weeks. Councils, who lack expertise and the scale to move tenants around their portfolios, could find the changing environment far harder to deal with.

Lord Oakeshott, chairman of the property fund manager Olim, said local authorities such as Surrey Heath were “completely failing to face reality”. He said: “The professionals see them coming a mile off and, sadly for council ratepayers and taxpayers generally who are lending them the money, most councils haven’t a clue. They are often the only buyers of their local struggling shopping centres and in a collapsing market they’ve been paying well above last year’s prices. You couldn’t make it up.”

While local authorities such as Portsmouth have ventured beyond their boundaries and struck deals purely to generate income, most have bought assets in their immediate area with a view to running or redeveloping them.

Gibson said she still felt that Surrey Heath’s purchase of its House of Fraser store had been “the right thing to do” because otherwise the council would have been a “hostage to fortune” in terms of deciding the future of the empty site. She said the council had filled holes left by insolvent tenants at The Square by moving in the local museum and creating a table tennis room.

“A year on, we have a lot more retail experience than we started with, and to be fair, I don’t think we can do worse than some of the people in retail at the moment,” she said. “We’re used to dealing with difficult budgets.”

There are instances where council intervention appears to have worked. Gerry Clarkson, leader of Ashford council in Kent, said he grew so tired of receiving complaints about the local shopping centre after taking over in 2013 that he instructed his staff to buy it. Clarkson, a former chief executive of the London Fire Brigade, said the council then revived Park Mall by offering six-month rent-free periods to independent retailers. Ashford is also working on a separate £75m development to build a Picturehouse cinema and a Travelodge.

“We were well aware of the government’s attitude to cutting funding for local authorities, and rather than cry into our beer, we started a strategy of becoming like a business,” he said. “In time, we will redevelop Park Mall and put flats above it, but for now, it’s thriving.”

Agencies such as Cushman & Wakefield and Knight Frank have earned significant sums for advising councils on deals. Charlie Barke, head of retail capital markets at Knight Frank, defended the prices some were paying for properties.

“These guys don’t have the luxury of waiting for what might be the bottom of the market,” he said. “Councils need to take action now, while there’s still some footfall and life in these town centres.”

Barke said the super-low interest rates offered by the PWLB mitigated some of the risks of tenants leaving, as the average shopping centre’s rent income typically covered the interest cost by two or three times. He said councils could mitigate risk further by paying down their loans over time, setting aside excess cash in a “sinking fund” and using professional advisers to manage the assets day-to-day.

Among local authority pension funds, the appetite for infrastructure assets is only growing as they seek to slash the fees they pay to external fund managers.

Last summer, a group including the £14.3bn West Midlands Pension Fund bought the Isle of Wight ferry company Red Funnel for a rumoured £320m — well above the expected price of £250m.

Councillor Ian Brookfield, chairman of the West Midlands Pension Fund committee, insisted it took a prudent approach. “It’s not just a bunch of guys sitting in a smoke-filled room any more,” he said. “We have some of the best advice you can purchase. We’ve done our proper due diligence and looked at the risk factors. It gives us a good, stable return.”

Brookfield added: “Red Funnel was our first direct investment and we are actively looking for more.”

Pension funds chase returns

While councils have been gambling on properties to address funding pressures and the need to regenerate town centres, their pension funds have been ploughing cash into infrastructure assets in a desperate hunt for yield.

For years, overseas counterparts, such as Ontario Municipal Employees Retirement System and Australia’s IFM Investors, snapped up water firms, power networks, ports and airports. They were keen to buy assets that matched their liabilities and delivered healthy returns.

Quantitative easing and the dive in gilt yields have forced council schemes to look beyond bonds for returns. Restricted on the amount of risky assets they can hold, they have turned to infrastructure, However, cheap debt and huge pots of money chasing a finite supply of assets have pushed values to eye-watering levels.

Westminster has played a part in the spending spree. Keen to keep a lid on debt, the former chancellor George Osborne ordered the 89 local government pension funds in England and Wales to pool their assets — now £263bn — and plough the money into British infrastructure.

Source: Sunday Times (pay wall)