Councils as investors and property developers

Nathan Holden, Freeths, Nottingham

As the financial position of local authorities has weakened in recent years, they have increasingly had to find ways of generating new sources of revenue to make up for budget cuts.

One area local authorities have turned to is investing in commercial property. As Public Finance magazine reported ‘Guests staying at a Travelodge hotel in Edinburgh’s picturesque Learmouth Terrace might be slightly surprised to learn that it is the property of Mansfield District Council … Similarly, staff working at an insurance broker in Chatham, Kent may not be aware that their landlord … is Luton Borough Council’. This pattern is being duplicated across the country with local authorities snapping up shopping centres, car parks and office premises both in and outside their areas.

Local authority participation in commercial property deals goes beyond pure ownership to include:

  • investing jointly with the private sector to bring forward new development such as business parks;
  • turning around the fortunes of existing tired developments, including shopping centres which have lost ground to online retailers or newer competing developments; or
  • entering into a more speculative development arrangement harnessing a local authority’s good covenant, that is its creditworthiness, to secure capital investment that can be turned into a healthy long term revenue stream.

At least, that is the plan!

It is not all about the money!

Although income generation is an important factor it is not all about making money, as the Estate Gazette reported recently. It is as much about local authorities taking back the control of their town centres, for example acquiring a shopping centre from a pension scheme investor with limited appetite for new investment. ‘For a lot of local authorities they are taking centres that, after being bought 10 years ago, have been metaphorically stuck in the freezer.’ ‘…a lot of local authorities still value bricks and mortar, and retail space is often at the heart of their town or city. It’s a great way for them to improve the value of a town and persuade more private investors to develop there.’

What is the legal position?

Powers

Section 1 of the Localism Act 2011, the general power of competence, is widely cited as the relevant power, that is, the power to do anything any individual may do. However, it is worth bearing in mind that the general power of competence is not completely unfettered. Section 4 limits a local authority’s use of the power to act commercially where it does so through a company. You also need to be wary of any pre-commencement limitations on the use of the power. Although the use of the general power of competence may overlap with the scope of a pre-commencement power, it is limited to the same extent as the pre-commencement power is limited. For example, in the property context, the Local Authorities Land Act 1963 empowers a local authority to advance money to any person to acquire land, erect any building or carry out any work on land. However, this is conditional on the loan being secured by way of a mortgage. Any attempt to rely instead on the general power of competence for these purposes would likewise be constrained by virtue of the pre-commencement limitation referred to above.

Underlying public law constraints

The mere existence of a power is not enough to guarantee that a council’s decision to invest will not be free of challenge. Councils still have to exercise their powers reasonably. This includes having regard to the implicit fiduciary duty owed to their council tax payers. Recent research conducted by Public Finance magazine suggests there is a significant gap between local authorities’ ambitions and their ability to deliver them. In particular, there seems to be a lack of understanding as to what the market needs and the risks involved. In a buoyant market these risks are often hidden or downplayed.

Taking a punt?

A typical example of a more speculative approach to investing is the ‘income strip’ deal. In this scenario, a local authority agrees with a developer and their funder to take a long lease on land, say 40 years, whereby:

  • the rents are fixed subject to retail prices increasing;
  • there is no right to assign; and
  • at the end of the lease term the council has the option to purchase the freehold for £1.

The reason funders are keen to lend is because local authorities would never be allowed to default and therefore the debt is virtually risk free.

From the council’s perspective, this is attractive as it allows it to generate an income stream through the rent from the premises and potentially 100 per cent of the business rates from 2020 onwards as they relate to the premises.

However, the catch with such arrangements is that they are predicated on assumptions about the future. If the underlying economic circumstances change and the rental income were to drop, this could create difficulties. In the words of Warren Buffett, ‘you only find out who is swimming naked when the tide goes out.’ What had begun as a highly attractive and lucrative investment could become very costly very quickly.

Structures and options

Local authorities have two main investment options available to them. They can invest in a vehicle that purchases assets as a shareholder or purchase the assets directly. When adopting the latter approach, direct acquisition, if they are investing for a return then they could rely on section 12 of the Local Government Act 2003 and the accompanying statutory guidance issued by the Department of Communities and Local Government. However, according to the guidance, those powers cannot be used to borrow to invest solely to make a profit. Arguably, as the Local Government Act 2003 is pre-existing legislation, any constraints on its use cannot be remedied by relying on section 1 of the Localism Act 2011: the general power of competence. If the investment is in a vehicle, for example, as shareholder they could instead rely on section 95 of the Local Government Act 2003 or the Section 1 power.

State aid

Finally, the use of state resources must be applied carefully so as not to infringe state aid restrictions. Where a local authority is investing, for example in a property joint venture arrangement, it needs to be careful to ensure that the terms upon which finance is provided are equivalent to the terms that a private sector investor would lend or invest. In terms of lending, the EU Commission has issued guidance on the interest rates that a local authority should impose which are based on a combination of the lender’s credit rating and the quality of the security for the debt they provide.