Is the 'Risk Squeeze' increasing the risk?

There has been a great deal of debate in recent months about whether local authorities that pursue commercial income generating opportunities are a good thing or a bad thing.

Opinion is understandably split.

As far as HM Treasury and CIPFA are concerned, they appear to believe that it is a bad thing. They are putting the squeeze on what they regards as ‘risky’ behaviour.

How did we get to where we are?

How will local government survive this ‘risk squeeze’?

Will the actions of the regulators actually result in greater risks that they have not really thought through?

The Prudential Code came into effect in 2004, and it radically changed the borrowing environment for local authorities at that time. Everything went along pretty happily for a while. The pact with Government was that in being given the facility to borrow freely, Councils would use the facility wisely and would only borrow what it could afford to pay off.

Four years later though, the world was hit by the banking crisis which created a global recession. The UK Government intervention through quantitative easing sought to stave off the worst effects. But this all created a debt. And that debt had to be paid off.

This was where the period of austerity was born. A period which saw local government funding on average fall by around half over a ten year period to 2018. Something had to give. Local authorities were faced with a stark choice – either cut back on service delivery or find new sources of income to make up for lost funding from central government.

Investment becomes a necessity?

This is the point that Local Government’s head turned towards investing in commercial property. The process started very gradually. It started with a few pathfinders that stayed well below the radar. Pretty soon though, others in the sector heard about this shiny new source of income. Income that could not be taken away by anyone else, including the UK Government.

The snowball started rolling and before long the amount of money being invested in commercial property across the sector had reached very significant amounts.

The sad truth is that the messaging from Government throughout this period gave the sector little indication that this new commercial activity was frowned upon. In 2011 the Localism Act came into play which, alongside the Local Government Act 2003 (which introduced the concept of the Prudential Code), provided an environment where the sector was clearly being told it was fee to act, albeit that it should act sensibly.

The Ministry of Housing, Communities & Local Government (MHCLG) has overall policy responsibility for the prudential framework. I can recall sitting through several sessions over a number of years of the House of Commons Public Accounts Committee (PAC), watching MHCLG civil servants mentioning (even complaining) about the level of local authority commercial investment.

The PAC had started to raise concerns in 2016. Under questioning, MHCLG representatives would generally reassure the PAC that they were monitoring the situation closely. They would also stress that the majority of the sector are acting and investing sensibly, and that if there was ‘rogue activity’ it was isolated to only a handful of examples.

As early as their 2016 report into Local Authority Financial Sustainability, the NAO were observing that:

“The Department for Communities and Local Government takes its assurance from its devolved framework for capital, which provides assurance on financial sustainability at authority level, but does not provide a mechanism for identifying trends and issues across the sector. As a result, the Department has limited insight into broad changes in authorities’ capital resourcing and spending as well as associated risks.”

The evidence to PAC it would seem did not convince the NAO that MHCLG were on top of things at all. I must admit that when I listened to the MHCLG evidence I found it largely unconvincing. They kept repeating that the worrying incidents of commercial property investment were limited to maybe 2 or 3 at the most local authorities. I have heard representatives from CIPFA say much the same thing.

Everyone except MHCLG, it would seem, knew what was really going on. There is another possibility, that MHCLG knew exactly the scale of the investment across the sector but were reluctant to admit it.

The regulatory backlash creates confusion?

Fast forward to 2017 and CIPFA, having no doubt been in detailed conversation with MHCLG about this topic, publish a new Prudential Code. One of the reasons cited for the revised Code was the need to reflect the changing landscape in which local authority services are delivered.

One of these was the increased tendency of course for local authorities to seek commercial opportunities to make up for lost income from Government.

This commercial style investment – often termed ‘borrowing in advance of need’ – was put front and centre in the new Code. It was always something that CIPFA had frowned upon, and now the language was going to be beefed up to place more emphasis on what was regarded as rogue behaviour.

Unfortunately, the updated Code didn’t seem to make an awful lot of difference to local authority commercial behaviour. Not surprising in a way. The Code, did state that authorities must not borrow more than or in advance of their needs purely in order to profit from the investment of the extra sums borrowed.

However, in the same paragraph it said that authorities should also consider carefully whether they can demonstrate value for money in borrowing in advance of need and can ensure the security of such funds.

So, was borrowing in advance of need allowed or not allowed?

You could be forgiven for being confused.

At the same time as adopting a new Prudential Code, CIPFA also published an updated Treasury Management Code. Rather than using this document to frown upon commercial property investment, it actually acknowledged that local authorities might invest in property primarily for financial return.

That is a lot of mixed messages.

1. MHCLG saying they are only worried about 2 or 3 local authorities…so this doesn’t apply to me.

2. The Prudential Code saying that borrowing in advance of need is not allowed…but if I do properly then it is okay.

3. The Treasury Management Code acknowledging that investment in property primarily for financial return is okay…so I can carry on so long as I apply Treasury Management principles.

As a local authority s151 officer, where did that leave you?

Who could possibly be surprised that commercial property investment has continued? Even now, it has only abated really due to the Covid-19 health crisis which appears to have dampened even the most passionate local authority investor at the moment. Firstly, because minds and energy have been elsewhere, and secondly because of the uncertainty surrounding the economic impact of the virus.

We are going underground?

Just prior to the start of the pandemic, HM Treasury began a consultation on changing the borrowing rules through the Public Works Loan Board (PWLB).

The changes are intended to put a firm lid on buying commercial property for pure yield. There will no longer be any ambiguity as far as Government is concerned. Like others I imagine, I am waiting to see if these changes bring about the reduction in commercial property investment that HM Treasury believe it will. I am not so convinced.

The reason I am not convinced, is that the financial pressures on local authorities means that such investment has become a necessity. If activity is dampened it is more likely to be the impact of Covid than the borrowing rules. It could simply drive the investment underground. A sort of property investment ‘black market’ where the publicly stated purpose of property acquisition is different from the real reason for investment.

Have risks increased?

With this comes a new, and perhaps unforeseen risk. For every action creates a reaction. The risk is that the performance management, monitoring and reporting of investment in property will not be as transparent as it needs to be. And if it is not transparent, then there is a real risk of reduced scrutiny. Where there is a lack of scrutiny, there is a risk of investment behaviour that is not appropriate, prudent or sensible.

Local authorities will easily find some 'work arounds', and continue to buy commercial property investments in their area. In fact, with the impact of Covid on local property vacancy rates, it will arguably become easier to make a case than it has ever been, as pretty much every local authority will be seeking to revitalise their local economy.

Where will investment stop?

The type of investment that might well slow down to a crawl, will be ‘out of area’ acquisitions.

It will be difficult for local authorities to justify these purchases on the grounds of regeneration and supporting the local economy. Some may succeed, where the local economic area goes beyond their authority’s boundary, but I am guessing there will not be too many s151 officers willing to put their name to many such business cases.

When yet another version of the Prudential Code hits the shelves in 2021, no doubt this will be more explicit around out of area investment. We may even find that the ‘2021’ Prudential Code moves from being advisory to mandatory.

This will be a two pronged attack on out of area commercial property investment. The purpose is purported to bring about a lessening of the exposure to commercial risk from property investment by local authorities.

As we have seen, it will most likely reduce out of area investment. If you agree with me, that investment itself will not stop, then the question is this. Which presents the greatest investment risk, only buying commercial property in a small geographic area represented by the local authority’s rather artificial and arbitrary boundary, or spreading purchases across a wider geographic area and markets?

Well, I suspect you know my view on that already.

If you have ever invested in the stock market, either directly or though an investment fund or Share ISA, you will be familiar with the concept of risk spread. Indeed, CIPFA’s own Treasury Management Code talks about Price Risk Management, ensuring that the authority is not compromised by market fluctuations. Investment in commercial property, it would seem does not need to be subject to the same investment principles.

When it comes to investing in property, the rule makers are going to ensure that wherever possible you ‘buy local’. We could well find that as a local authority intent on continuing to invest in commercial property, you are forced to take more risks with your money than you otherwise would have done. You will be effectively forced to buy in area. All your eggs in one property basket, you might say.

This of course brings us to the question posed in the headline to this piece. The rules changes that are happening, will of course change local authority investment behaviour. Of that there is little doubt.

The question is, will that change in behaviour reduce the investment risk or increase the investment risk? The regulators need to tread very carefully indeed. There could be some unexpected and unintended consequences to regulatory changes. They need to consider if they would be better off regulating the investment activity, so that investment is done properly.

The elephant in the room!

There is of course one final point that has to be made. It is the elephant in the room. And that is, why on earth are we having this debate at all? The answer to that goes back to that period of austerity mentioned earlier. Council’s need commercial income streams because other funding sources have reduced.

There needs to be a bigger conversation about what we want local authorities to be and to do. That conversation needs to address how we choose to fund local government in the future.

Without a firm funding foundation, that is robust and reliable, local authorities will have to continue to pursue other sources of income. Nobody in local government wanted to go down this commercial route. Many have tried to resist it, but eventually succumbed to the financial reality.