Cheap Local Authority Lending – Squaring the Financial Circle?

Without wishing to stray into politics, it is undeniable that Councils are faced with a clear challenge of covering growing financial deficits, whilst still delivering services for all, as a consequence of the financial austerity of recent years.

According to the Government’s ‘Local Authority Revenue Expenditure and Financing budget’, released in June 2018, the actual outturn of ‘centrally distributed income’ to Councils was £79.2bn (financing 75.9% of Council revenue expenditure) in 2010/11. This has fallen consistently towards a budgeted £47.98bn (50%) in 2018/19. With this snapshot, one can see the additional finance required from locally retained income, such as the Rate Retention Scheme or Council Tax, appropriations from Council reserves or by other means.

Local authorities are therefore scrutinising alternative ways to generate income and balance the books. An obvious option is the disposal of underutilised land and buildings, achieving the dual aim of reducing running costs and generating significant tranches of income. Indeed, apartments are springing up across the country where council offices once existed, quickly changing the dynamic of urban areas. Sales of such assets have increased following a rule change in 2017, dictating how such proceeds could be invested. The Chancellor, then George Osborne, clarified these funds could be spent in redesigning service delivery, providing synergies were realised, rather than solely employing them in to new capital acquisitions.

Whilst useful in balancing the books, this is clearly a stop gap solution, hence why interest in recent years turned towards leverage provided by the Public Works Loan Board (PWLB) across the country, a statutory body issuing loans to local authorities and other specified bodies, from the National Loans Fund. Such lending is now under the banner of the United Kingdom Debt Management Office (DMO), a government agency.

This finance is predominantly for capital projects and is made on a non-discretionary basis, meaning that providing the borrowing costs are affordable to them, local authorities do not require Government consent, albeit the Secretary of State can of course veto borrowing of any kind. Indeed, there is also no requirement to submit information to the DMO in respect of the reasons for the loan application, merely a recognition that responsibility for local authority spending and borrowing decisions rest solely with elected Council members. That said, the DMO must be satisfied that any lending is adequately covered by security, which is over the revenues of that authority, something laid down in statute.

Repayment options are available over fixed and variable rates determined with reference to gilt yields. Initial advanced fees for a fixed rate loan set at £350 per £1million drawn down, per Circular 159 of the UK Debt Management Office, released in May 2018. Of further appeal is that authorities can also select the loan term, of up to 50 years for a fixed rate lend. Access to this funding therefore appears to be relatively simple, swift, flexible and is clearly below market rates compared to alternative funding sources.

Such lending has attractively positioned local authorities to become more aggressive in the pursuit of alternative income streams. The result has been some £2.7bn in PWLB/DMO lending during the three years to June 2018, invested in property acquisition and development. Expectations are that this run rate has further increased since.

Local authorities are making a greater number of commercial investments, potentially through a corporate vehicle. These could be in office blocks or car parks or through lending to third party entities for social housing projects amongst other things. It seems reasonable that any local authority planning department may possess a wealth of knowledge over local land and property, leaving them well placed to identify the most favourable opportunities.

The theory behind this is of course that short term income from dividends and a rental yield, allied to long term capital appreciation appears ideal and should give rise to an enhanced return when compared to any bank deposit and most share portfolios, in the long term. A perspective on such behaviour could be that local authorities are seeking to control alternative types of property within their areas, such as retail spaces. A coherent strategy surrounding the regeneration of a town’s retail offering can drive further third-party investment and entice home owners back to the area, driving a multiplier effect which benefits the locality. This is what some would argue should be at the core of any local authority’s aims, so furthering the implied fiduciary duty towards the council tax payer.

The alternative view is that local authorities should not be competing with the private sector and potentially using what some may term as state aid to create an unfavourable playing field to their advantage, whether this be wittingly or not. This economic armoury enables local authorities to outgun much of the private sector in a bidding scenario, exploiting a clear gap between the yields on offer and the cost of capital.

The other obvious advantage of an elongated borrowing period is the potential to purchase strategic land parcels which can become the ransom strips of the future, as local authorities have enhanced flexibility to take a longer term view and, hopefully, generate a greater return.

Of key concern to many observers is the consequences of a change in the economic winds. If this perpetuated a downturn in the property markets, the implications for local authority finances and therefore public service delivery are worrying. Are councils able to fully understand the relevant market risks, which may be camouflaged to a degree by recent positive investing conditions?

Perhaps of more relevance is whether such deals represent a risk worth taking, given the quantum of the evidently growing funding gap which needs bridging, or rather a required risk? A required risk, as in that given the growing size of the funding gap they need to plug, perhaps they are forced to take the risk and move in to the commercial property market, when it isn’t really their skill set and that changes in the property market etc. could cause issues down the line. Finally, in returning to the suitability of local authorities engaging in such investment strategies, The Sunday Times reported earlier this year how the auditors of one high profile council had, in reference to the 2017 financial statements, commented that its property portfolio may be overvalued. The council in question rebutted this claim, but this strategic switch could pose questions throughout the country in future years.

One thing remains clear, the attractive lending arrangements now provided by the DMO do not provide the panacea to today’s local authority financial conundrum.

If you would like to discuss this with us in more detail or if you would like to speak with a member of our team, please contact Hannah Farmborough or call on 0207 429 4147 to be put in contact with your local representative.

This article featured in issue 12 of our construction and real estate newsletter series. Read the full newsletter here: Real Estate Matters – Issue 12