Guidance counselling: addressing the commercial property borrowing craze

Strongly worded statements and additional guidance might not be enough to wean councils off their addiction to borrowing to fund property investments, says David Green.

Local authorities must not borrow more than or in advance of their needs purely to profit from the investment of the sum borrowed, we were reminded again by the Chartered Institute of Public Finance and Accountancy (CIPFA) last month, in a tone reminiscent of a public health advert.

The warning comes in the wake of news that, despite the issue of strengthened government investment guidance and an updated Prudential Code for Capital Finance in Local Authorities in the past 12 months, some authorities continue to drink from the punchbowl and borrow to purchase commercial property.

The problem with repeating this prescription is that, according to the new prudential code, commercial property still counts as “need” rather than “investment”.

The key indicator of prudence in the code is that, except in the short-term, debt should remain below the capital financing requirement.

This requirement is described as the “underlying need to borrow for capital purposes” and defined as including the value of all property whether it is held to deliver services, for rental income or for sale.

Investments, on the other hand, are defined as including treasury management investments and shareholdings – but excluding all directly owned property.

So, months after publication of its prudential code and mere weeks after the release of the accompanying guidance notes at a cost of £1,000 per authority, CIPFA has announced it will be publishing even more guidance.

Alternative cures

If we are to avoid a Nightmare on High Street where local authorities are forced to attend continual guidance therapy until their addiction is cured, then I suspect that some more fundamental surgery will be required instead.

Government, of course, has more tools at its disposal than CIPFA, providing it is willing to soften its approach to localism.

Most concern appears to be expressed over the use of cheap and easy Public Works Loans Board (PWLB) cash to purchase commercial property, as private sector lenders tend to be more discerning in how their cash will be used, and therefore ask more searching questions before lending.

The PWLB could request confirmation that its loans will only be used to support the eponymous public works rather than investment, or charge a higher interest rate for the latter.

But policing that will be difficult, given the fungibility of cash and the complexity of local government finance.

I doubt PWLB loans will come in suitcases full of marked banknotes for HM Treasury to trace through the system and see exactly what they are spent on.

Closing the PWLB and forcing the sector to borrow on purely commercial terms would be a drastic step.

But repurposing some of local authorities’ £30bn cash not already lent within the sector would fill the gap for a while. It might also resuscitate the Municipal Bond Agency.

The end of cheap and easy money would certainly force lenders and borrowers to focus more on risk management.

Primary legislation is another option for government to pursue.

There is a private member’s bill currently in the parliamentary queue that would prevent local authorities buying property outside their boundary without permission, or from borrowing to buy any property for non-core purposes.

But such bills rarely become law, and our current localist government seems unlikely to sponsor anything similar, especially given their other priorities for parliamentary time.

Existing legislation already permits the secretary of state to determine that certain items are not to be classed as capital expenditure.

This can be applied via regulations to all local authorities in England, or via direction only to the individual authorities that have irked Mr Brokenshire.

Unintended consequences

Classing investment property as not being capital expenditure would remove it from the capital financing requirement and hence limit an authority’s ability to borrow, while complying with its prudential indicator for prudence.

But it could come with unintended consequences – for example, non-capital assets do not need a minimum revenue provision (MRP) which could make them more attractive to buy.

On that subject, since 2008, MRP rules have also been delivered through guidance instead of legislation, allowing adventurous authorities to bend them to suit the business case.

But putting this back to a statutory footing, if only for commercial property, would be a simple step for government since secondary legislation takes up far less time than an act of parliament.

A flat 5% MRP charge like the current guidance for shareholdings, or maybe 50% of rental income, would certainly be a disincentive, and there could be transitional protection for purchases made before the recent guidance.

None of this medicine would be easy for local authorities to swallow, and given problems with defining investment property, they all risk either being ineffective placebos or poisoning sensible capital investment in public services.

But issuing informal guidance clarifying the guidance notes that explain the statutory guidance, or writing another strongly worded letter, isn’t going to cure the patient either.

David Green is Strategic Director at Arlingclose Limited