There has been a lot of media covering the financial challenges faced by local authorities over the past five years. Central government grant funding has been cut by an average of 36.3% in real terms between 2009/10 and 2014/15, whilst council tax revenues have only grown modestly over this period. Taken together this has resulted in an overall reduction in council funding of 19.9% in real terms over this period, placing significant pressure on service delivery (this article explores the opportunities available to local authority to react to the significant funding cuts).
Despite this cut in funding, local authorities have coped well in maintaining local services and have achieved many of the ‘quick wins’. However, with further austerity announced in the Spending Review last autumn further challenges lie ahead. Councils are going to need to turn every stone to establish what additional savings can be achieved and whether alternative revenue sources can be exploited.
Non-operational property is an area that is often overlooked, but is one that could make a meaningful contribution to the bottom line. This article provides an overview of some of the issues often associated with these portfolios and the opportunities available that can enhance financial performance.
All local authorities own and manage a non-operational property portfolio. These typically comprise a mix of assets including car parks, industrial estates, offices, business centres, retail parades, shopping centres and surplus development land to name a few. These investment assets provide an important revenue source for local authorities. The value of these portfolios can run into hundreds of millions of pounds, but often generate a relatively low income return relative to the capital invested. As the need for revenue becomes ever more important, Councils need to be taking a closer look at these non-operational assets to see how they can contribute further to plugging the gap in funding
local government services.
Cushman & Wakefield has recently advised a number of local authorities on their non- operational property portfolios including Hull City Council, Basingstoke & Deane Borough Council, Haringey Council, Sandwell Metropolitan Borough Council and North East Lincolnshire Council. To varying degrees each of these authorities face the same financial challenges and were keen to understand how their commercial property
assets could help.
Some of the challenges we encountered include:
- Balancing socioeconomic and political objectives against financial performance.
- Justifying retention of assets against potential alternative investment opportunities or capital requirements.
- Considering an authority’s investment strategy and risk appetite and how well this is aligned with the existing non-operational portfolio.
- Achieving asset diversification covering both asset types, geography and ‘primeness’.
- Resourcing requirements in managing what are often large, varied portfolios.
Source: Institute of Fiscal Studies
This has led to the rationalisation of their operational estate, with particular focus on corporate office accommodation, libraries, leisure facilities and depots. We are now seeing councils turn their attention to non-operational assets.
Alongside socio-economic considerations, achieving an acceptable return on capital should be a central priority when making investment decisions on nonoperational assets. This return should reflect the level of risk involved and also the inherent illiquidity of property as an investment class. Through a combination of voids, a high proportion of ground leases and relatively high management costs, we have found that the returns achieved can often fall below expectations. This underscores the need to take a strategic look at these portfolios to ensure they are generating the best possible return and where this is not happening, councils should be looking to take action in achieving this.
With devoting sufficient resources to managing a portfolio, there is also often a need for a more strategic and commercial approach to asset management. Increasingly councils should look to run their non-operational portfolio as any other investor would, which inevitably means taking a more commercial approach when it comes to negotiating new leases, rent reviews, dilapidations settlements and in taking a tougher stance in dealing with arrears.
The need to look ahead at the future income profile is also of critical importance, especially there an authority is relying on this to help fund service delivery commitments. Where lease expiries are due within the next few months or years, authorities should be actively engaging with their tenants to better understand future intentions and where possible look to re-gear leases to protect future income levels and enhance commercial value. All of this requires good management information though; something that few authorities can claim to have a complete handle on. Knowing what you own and how much it is worth is the obvious starting point for any meaningful asset review.
Getting an acceptable return on capital that grows over time is what investment is all about. Local authorities are fortunate to be able to access capital relatively cheaply by way of Prudential Borrowing and this presents an opportunity to achieve enhanced returns through gearing property investments; in other words, achieving an enhanced return on capital employed through using a combination of debt and equity such that the equity invested generates a greater overall level of income than could be achieved without any debt element. This arbitrage is wholly consistent with a strategy of enhancing revenue streams as it potentially enables an authority to grow its investment income with less capital employed.
Aside from providing an income return, local authorities are also interested in seeing development and inward investment take place in their area. Councils are able to use their land and property holdings to help attract this inward investment through joint venture arrangements. This enables private sector capital and expertise to work alongside Council resources in achieving the desired outcomes whether these be a new office development, infrastructure projector business centre. This is a model that a handful of authorities have pursued in recent years including Northumberland County Council and Sunderland City Council, which have helped bring forward property investment and development on key strategic assets in their areas. These joint ventures inevitably involve sharing the returns achieved, but they allow authorities to access private sector resources and importantly they spread the risks associated with specific property investment projects.
The challenges facing the local government sector over the next spending review period are undoubtedly significant. Optimising the performance of non-operational property portfolios will be one of the levers available to councils in facing up to these challenges. Those authorities that take an active approach in this area stand to weather further funding cuts better than most. This will take time though and much work will be needed to achieve the desired performance improvements.
This post was first published in The Authority Autumn/Winter 2015 and has been edited.