Austerity has left local authorities strapped for cash. By 2020 they will have lost 60 pence from every pound they were allocated by central government a decade earlier, according to the Local Government Association. Not surprisingly, they are struggling to provide basic services like social care.
Local authorities have sold off parcels of land to raise cash, but they have also turned to the property market in search of income. Using cheap financing from the government-backed Public Works Loan Board, local governments are pumping billions into commercial property with the aim of regenerating local high streets, producing an income, or both. The commercial property market is not renowned for its stability. To put it mildly, there are risks.
But in the last couple of years a different form of funding has also proved popular for property investments by public sector bodies. On the face of it, this structure fulfils both functions — regeneration and revenue generation — with the option of keeping the entire transaction off the council’s balance sheet. This is the income strip.
Here’s how it works. An institutional fund is looking for inflation-linked income streams for pension investors. It buys a local shopping centre — or other property asset — and leases it to the council, which commits to pay an inflation-linked rent to the fund. This rent is backed by the council’s strong public sector covenant, underpinned by investors’ assumption that the government will not let a local authority go bust. The council anticipates making a higher rent from tenants in the shopping centre, generating revenues for itself. At the end of the income strip period, provided the council has kept paying its rent, ownership of the shopping centre transfers to the council, often for £1.
Councils also hope that taking control over the centre itself will enable them to carry out renovations and pick tenants. If all this goes well, the council gets a long-term revenue stream, an improved shopping destination for locals, and a property asset at the end of it.
For example: Legal & General buys the Sovereign shopping centre in Weston-super-Mare for £21m and leases it to North Somerset council for 35 years. North Somerset commits to pay an annual rent starting at £717,696 a year, rising with inflation; those rises are capped at 4 per cent. That leaves a surplus rental income of up to £1.1m a year for the council, says L&G. At the end of the 35-year lease, ownership reverts to the local authority.
The head of the local Liberal Democrats is sceptical. According to Bristol Live, he said: “Retail is a volatile and fast changing market, with traditional retail centres struggling and there is a real risk that vacant units won’t be let and that anchor tenants will be lost — then what?”
A property agent says that in a regional shopping centre, a large store might pay around £200,000 a year in rent. If the retailer goes bust, the landlord (the council) obviously loses that income. It also finds itself on the hook for that store’s business rates bill. In so-called “secondary” locations the rates bill can equal the rent, potentially costing another £200,000. The landlord will also have to cover the insolvent retailer’s contributions to service charges and insurance. “You can easily get a £400,000 swing in the income on a centre,” says this agent. Put this way, the surplus income looks more vulnerable.
Meanwhile, depending on inflation, the rent paid to the institutional investor rises. In Weston-super-Mare, for example, if inflation sits at 2.5 per cent for the next 10 years, that will take the annual sum due from North Somerset above £900,000 in a decade’s time.
In Weston’s favour, it is worth noting that almost 30 per cent of the shopping centre’s income comes from its car park, which is set to benefit from the closure of other car parks in town, according to David Pasley, the council’s executive member with responsibility for asset management. He argues this makes the council’s future income more secure. On announcement of the deal, Mr Pasley said he expects the “significant annual income” to help “replace the funding we depend upon to continue essential public services”.
Pete Gladwell, head of public sector partnerships at L&G, said he would not do a deal like this if he believed the council to be taking on excessive risk. “We are really conscious of the risks they are taking or not — making sure we have assessed those in the longer term.”
Other income strip deals are more speculative. Rochdale made an £80m, 35-year deal for the construction of the new Rochdale Riverside shopping centre last year; the income-generating capacity for this development has not yet been tested. (Rochdale already has two shopping centres.) Gravesend Borough Council, looking even further into the future, signed a 50-year income strip on the regeneration of a local centre in June.
Local authorities have also used the structures to buy ferry terminals, car parks, cricket grounds and office blocks. Universities are turning to income strips to fund new-build student accommodation. Fine — as long as you can really be confident of your income from the asset a decade or three into the future.
Most income strips appear on the public sector body’s balance sheet, but in some cases they are structured to avoid appearing. That’s not the only reason for choosing them: they can be cheaper than PWLB borrowing, cost less upfront and can match well with properties where the rental income is inflation-linked.
Still, it is clear where the risk ultimately sits. Here is Coventry City Council rejecting an income strip structure for its Friargate business district development:
This method of funding … would lead to the council taking all of the risk of letting the building to tenants. It would also leave the council with the risk that the rent it paid to the funder would almost inevitably become higher than the rent it received from the tenants it let to.