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 were intended to put a firm lid on buying commercial property for pure yield.
With the publication of the new PWLB rules and guidance on 25th November, many in local government are wondering if the days of local authority commercial investment are over.
Some finance directors had previously confided in me (in the expectation of the PWLB consultation) that they might simply reprofile the capital programme so that borrowing is only used on allowed projects, with internal borrowing used for commercial activities.
HM Treasury have thought about that, and found a clever ruse to stop that from happening. Capital spending plans will have to be submitted in advance, and if a local authority intends to buy commercial assets primarily for yield (even using reserves) then they will be prevented from taking any PWLB borrowing in that financial year.
HM Treasury have a difficult challenge. On the one hand they want to continue to make borrowing available for service projects, housing, regeneration and refinancing. But they want to prevent borrowing primarily for yield. They clearly believe they have come up with a way of doing just that.
The government has chosen to issue guidance rather than strict definitions because of the challenges of developing strict definitions that reliably give the intended categorisation when applied to something as diverse as local government.
These arrangements apply to local authorities in England, Scotland, and Wales operating under the prudential code. They apply to all capital spending, whether it is within the local authority’s borders or outside.
Each local authority that wishes to borrow from the PWLB will in future have to submit a high-level description of their capital spending and financing plans for the following three years, including their expected use of the PWLB. Local authorities will be able to revise these plans in-year as required.
The section 151 officer or equivalent will have to provide an assurance that the local authority is not borrowing in advance of need and does not intend to buy investment assets primarily for yield.
When applying for a new loan, the local authority will be required to confirm that the plans they have most recently submitted remain current and that the assurance that they do not intend to buy investment assets primarily for yield remains valid.
What are the authorised categories for borrowing?
The guidance sets out categories of borrowing that are authorised. These include
Individual projects and schemes may have characteristics of several different categories of course. In these cases, the section 151 officer or equivalent of the authority will need to use their professional judgment to assess the main objective of the investment and consider which category is the best fit.
What impact will this have?
The type of investment that might well slow down to a crawl, will be ‘out of area’ acquisitions. It will be very hard (although not impossible) for local authorities to justify these purchases on the grounds of the five approved borrowing categories.
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.
For those that remain passionate about the commercial investment and see it as a new necessity, how do they keep that going?
Will they be able to find a way around the clever HM Treasury rules?
What will be the next move for local authorities intent on continuing on their commercial property investment journey?
What can we invest in?
The answer to that is in how individual s151 officers will form their interpretation of the category definitions.
The Housing category is activity normally captured in the HRA and General Fund housing sections of the COR, or housing delivered through a local authority housing company. This does provide scope on the face of it, for continuation of housing schemes, including through LA owned companies, and does not appear to restrict the borrowing to social or affordable housing. Section 151 officers will place their own interpretation on that.
Things get really interesting when we consider the regeneration category. This potentially provides scope to ‘mask’ commercial activity, if individual s151 officers choose to do so.
Regeneration projects are described in the guidance as having characteristics that fall into one of four areas:
a. the project is addressing an economic or social market failure by providing services, facilities, or other amenities that are of value to local people and would not otherwise be provided by the private sector.
b. the local authority is making a significant investment in the asset beyond the purchase price: developing the assets to improve them and/or change their use, or otherwise making a significant financial investment.
c. the project involves or generates significant additional activity that would not otherwise happen without the local authority’s intervention, creating jobs and/or social or economic value.
d. while some parts of the project may generate rental income, these rents are recycled within the project or applied to related regeneration projects, rather than being applied to wider services.
Whether under ethical pressure or not, the proposed new guidance does leave gaps to be exploited, should the s 151 officer be minded to do so. No set of rules or guidance can ever be watertight, especially at the first iteration.
The key to the guidance is what the investment is primarily for, given that many projects will straddle the boundaries of the categories. If you have any projects that are primarily for yield then borrowing is simply not available to you.
But that does not prevent you from borrowing for projects that are primarily for other purposes, which also happen to generate a financial yield.
For authorities that wish to continue to generate commercial income in order to protect services, the challenge will be finding projects that deliver much more than financial yield, such that they cannot be accused of investing in projects primarily for yield. Any yield in any such projects will have to be secondary to another prime purpose.
Alongside that ‘masking’ of commercial intent, there remain a number of opportunities for local authorities to continue to dabble openly and deliberately with commercial property investment.
One option might be the ring-fence rents from a ‘yield’ project, recycling them either within the project, or applying them to other similar projects with related or similar project outcomes.
The requirement on the s151 officer set out in the guidance is to provide an assurance that the local authority is not borrowing in advance of need and does not intend to buy investment assets primarily for yield. It does not ask you to provide assurance that you are not investing in assets primarily for yield.
Where you already have yield based assets, you could ring-fence some of that existing revenue income to invest on that asset, or other yield bearing assets, to improve investment performance and yields.
This might be a case of looking at your existing ‘legacy’ property portfolio and spotting opportunities where an injection of investment could generate greater yields.
Because the guidance is framed around borrowing to buy and not borrowing to invest, there appears to be no restriction on borrowing to build new yield-bearing investments on existing local authority land.
Another option to consider might be buying ‘yield’ projects where you intend to inject further investment beyond the initial purchase price. This might be through refurbishing or re-purposing the acquired asset. This appears to be a perfectly legitimate borrowing category.
For example, you could buy an office building with the intention of converting it say into residential or other uses, for yield. Alternatively, you could buy a run-down industrial estate with a view to gaining vacant possession, demolishing it and then redeveloping the site to create a new business or retail park.
A neat way of recycling capital might be using PWLB to buy or build new service assets (eg a new administrative office building, or a new leisure centre) and then re-purposing the existing redundant building into a ‘yield’ asset.
A fourth opportunity is land assembly for development, which again appears to be a legitimate borrowing category under the new guidance. So if you are looking to bring about some development in your area to effect a regeneration scheme, then borrowing for land assembly appears to be quite legitimate.
Finally, and perhaps a little more obscure, is the opportunity to buy or form a property based company, rather than buying assets directly. This is something that at least one local authority has done in recent years.
Obviously every scenario needs to be looked at on a case by case basis, for you to satisfy yourself that whatever scheme or acquisition you have in mind, meets the PWLB rules or at least will not fetter your ability to access PWLB borrowing. This Blog can only provide general information, and you will need to secure your own detailed advice as you formulate specific schemes.
It seems to us that there are still opportunities to invest and to generate investment income. Authorities may need to be smarter. They may need to do a little more work on identifying investment opportunities beyond simply going to the market and buying investments off the shelf.
Any s151 that has read the consultation may already be hatching their plans. Some might be waiting for more certainty to arrive in property markets.
Will local authorities find some work arounds, and continue to buy commercial property investments in their area?
With the impact of Covid on local property vacancy rates, it may 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. The trick will be finding investment opportunities that are ‘primarily’ for things other than yield, or can be safely described as such.
Local authorities should expect that their auditors will review their internal decision-making processes around borrowing and investment, including the assessment of whether their plans are compliant with the lending terms of the PWLB.
Local authorities should make sure that these processes are robust. Auditors do not have the power to overrule the assessment of the section 151 officer or equivalent whether the LA’s plans are compatible with access to the PWLB. If auditors raise concerns about these processes, HM Treasury may contact the local authority to understand the situation.