Commercial Property Investment Update Mark Swallow

Local Authorities have owned commercial property for many years, holding them on the balance sheet as investment property, but the activity of buying to generate yield has increased recently and the practice has fallen under intense scrutiny from Central Government and other key stakeholders particularly as we await the outcome of the recent PWLB consultation.

Traditionally most transactions have either been concentrated within the authority’s local boundary, in an economic sector or both. Concentration risk is therefore a key consideration for local authority property investors. Would you invest all your surplus cash in one bank or would fear of default cause you to diversify? If you answered Yes to the question of diversification is buying property in one area or economic sector sensible especially if you have borrowed to fund that purchase?

Local economies are subject to different regional pressures and whilst one area could be thriving another may be more economically challenged, and this puts commercial investments at risk. Not all stores in a national chain operate at the same margins and some may be at risk of closure. Look at the recent news regarding John Lewis for instance: who would have thought the flagship store at Birmingham Grand Central Station would close?

By contrast Property Fund investors spread their risk. CCLA, a fund that our clients use to gain exposure to commercial property investment, ensure that their property holdings are spread via location and by asset and market type.

For instance, as at the 30th June 2020 the fund which is valued at £1.1billion was split across the following sectors:

  • 36% Industrial Warehouses
  • 34% Offices
  • 10% Retail Warehouse
  • And a small proportion (3%) in Retail Shops

This was split across locations including London, the South East Midlands and the South West.

Similarly, the Aviva Lime Fund with £2.7billion under management had an even more diversified portfolio and was invested in industrial assets, offices, supermarkets, healthcare, leisure and education which were geographically diversified across London, the South East,  the South West, the North, the Midlands and Scotland, so again a broad exposure to regional economic trends.

Some high-profile local authority landlords have recently announced that they had collected 95% of their rents which is a good news story in the current climate. 

However, “good names” can be stressed financially and struggle to pay rent on time and even a well-diversified portfolio is at risk of non-payment of rent.  The large investment funds can absorb this and can reduce the amounts that they distribute but even that impact is diluted across a large number of investors. Can a local authority with a small and concentrated exposure to commercial property deal with the impact of non-payment or reduction in rental levels?

These property transactions should be entered into in accordance with the spirit of the relevant Investment Guidance. In England the MHCLG Guidance states that local authorities should outline in their investment strategy how they have assessed the market that they will be operating in via commercial property investment, the nature and level of competition they will be exposed to and how they think that the market will evolve over time.

As with any long-term investment decision we would recommend a full and detailed due diligence exercise is undertaken on each commercial property transaction and on the leaseholders that will be paying the rent. This analysis shouldn’t be limited to being carried out at the outset of the property purchase but should be carried out at regular intervals to try to spot when a tenant might become stressed financially and put the rental stream at risk.

Company Voluntary Arrangements (CVA) are being used by commercial tenants on a more regular basis particularly in the retail sector to help them restructure debts and liabilities. Our recent insight ("Potential Sunburn for Commercial Property") provides more detail on this process but essentially the benefit of a CVA is that the tenant can continue to trade whilst paying back an agreed portion of monies owed to its creditors over a period. The problem for a Landlord is that the proposal will normally result in a substantial reduction in the rent being paid. Also, a raft of measures has been implemented as part of the Covid-19 pandemic which give more protection to tenants than landlords.

So, if the rent received on your commercial portfolio is at risk of being reduced, and you have limited rights to do anything about it, there will be costs that cannot be renegotiated and this will cause issues with the general fund budget putting additional strain on already stretched local authority finances;

  • In most cases property investments will be funded by long-term borrowing from the PWLB. Interest costs will still need to be paid irrespective of the income being received from the tenant. Early repayment of loans is expensive. Premiums can be spread but will be an ongoing cost that will not be fully offset from rental income.
  • Capital expenditure needs to be financed. MRP which is a revenue cost needs to be considered as part of the investment appraisal. If income falls MRP cannot be reduced unless it can be argued that this is being Prudent, which is doubtful.
  • Ongoing costs of ownership will continue to be paid even if rent is not being received.
  • Ultimately the sale of the asset might be required. The value will be impacted by the quality of tenant and current trading conditions will also be considered so capital losses may be recognised.

This final point above is important to note as going back to the MHCLG Investment Guidance it is clear that:

  • Where the fair value of a commercial property investment is no longer enough to provide security against a capital loss (i.e. its value is less than the debt outstanding), then it should be made clear what mitigating actions would be taken to protect the capital invested. And remember fair value is the market value of the asset not the price you would receive, so this may be a lot worse in a forced sale situation.
  • Where a loss in the fair value is recognised then an updated Investment Strategy should be presented to full Council detailing the impact of the loss and any revenue consequences that are expected so full disclosure is required and that means increased public and press scrutiny.
  • And the Investment Strategy should also state the local authority’s view of the liquidity of any commercial investments that it holds, recognising that assets can take a considerable period to sell in certain market conditions.

So, in summary whilst commercial property investment looks good at the outset there are a lot of other things to consider beyond the yield quoted in the sales prospectus. The ability to purchase new investments may become more difficult in the future if the PWLB remove the ability to borrow to fund such investments, this may also make it harder to sell assets if that is your revised strategy. Current economic conditions may also make existing investments illiquid and your commercial property investments may become a source of ongoing costs instead of the regular income stream that you had hoped for.