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Inside Spelthorne Council’s £1.2B Property Push

100 Cheapside in the City

There was plenty of noise when last week it emerged that Spelthorne Borough Council is set to spend another £300M on London and South East England office property.

If it does complete deals to buy Embassy Gardens in Nine Elms and 100 Cheapside in the City, that will take its total spending on commercial property to around £1.2B in about three years. That would be roughly a fifth of all local authority spending on property, making it the poster child for what many commentators think is a risky activity for councils to be undertaking.

Here is a deep dive into the numbers behind the Surrey council’s acquisition drive, and a video from the council defending its strategy.

Even before the new potential acquisitions, Spelthorne had faced criticism from those in the property industry and its residents about the scale and nature of its investment in commercial property. That portfolio would extend to 12 buildings in London and the South East if the two new deals complete and would be almost all offices, with a net area of more than 1.6M SF.

In August council Leader Ian Harvey and Portfolio Holder for Finance Howard Williams posted a (badly out of focus) video explaining the why and the how.

The why is pretty clear: Harvey said that without the income from property investment, the council would have to cut services. In a very helpful page on its website further explaining the strategy, Spelthorne laid out the maths.

At the end of 2018 its portfolio was valued at £914M. It said that portfolio generated around £50M a year in rental income. After costs it has about £10M of free cash from the portfolio, which makes up around 50% of its £22M annual budget.

“If we did not have this income we would be forced to cut half of the Council's services and put up charges to make up the difference,” the council said on the website.

Those costs include interest payment on borrowings, loan amortisation, advisory fees and paying into a sinking fund which pays for refurbishments and the cost of covering rental payments if tenants vacate. That sinking fund is £11M and will grow to £35M over the next five years.

In the video, Williams argued that the council is not “speculating” as some have accused it, but only buys high-quality assets with good income streams. Unlike some councils it is not buying retail assets and Williams said it has no intention of doing so.

“We walk away from 10 times as many opportunities as we look at,” he said.

Risk is to some degree in the eye of the beholder. The portfolio has a large exposure to one particular tenant, oil company BP. At the end of 2018 the company accounted for more than 40% of the income received from by Spelthorne's portfolio. That is down from 97% in 2016, and will reduce further if the two new deals go through.

But BP is the occupier of Spelthorne’s largest and most complex asset, an 800K SF suburban business park in Sunbury-on-Thames, which is  the company's HQ, but where it has been reducing its occupation over time by subleasing space. It has 18 years left on the lease. Spelthorne paid £360M for the asset.

Not all of the assets it has bought are fully leased. Embassy Gardens is 80% let to publisher Penguin. One of the assets in a three-building portfolio it bought for £285M last year is only 30% leased, according to Property Week.

A valid question in the current environment, particularly with the two new deals, might be why not wait to see what happens with Brexit? It is a question the council addresses on its website, albeit not in relation to the new deals.

“Clearly there is a great deal of uncertainty surrounding Brexit, and the Council has no better insight than any other commentator on what may happen in the next few years,” it said. “We are investing on a long-term basis and we fully expect to hold these assets through a number of economic cycles. We have made allowances for things such as refurbishment costs and void periods and we are building up sinking funds to ensure the money is there when we need it.”

One of the big drivers of councils buying commercial property has been debt, and Spelthorne is no exception. Local authorities are allowed to borrow from a government body called the Public Works Loan Board, and in many ways this investment drive by Spelthorne and others is a classic example of how people game the system. To stop them overextending, councils are not allowed to borrow to fund services, but they are allowed to borrow for capital investment. So they are borrowing to buy assets to fund services.

The economics of borrowing to invest are very, very good for councils at the moment, even better than in the private debt market. Interest rates on Public Works Loan Board Rates are 1.8% on a five-year loan, and only rise to 2.8% on a 50-year loan. The yield on Spelthorne’s portfolio is just over 5%, which is why it is able to generate that £10M a year cash flow even after costs.

Data from the PWLB analysed by Bisnow showed that Spelthorne’s borrowing as of March was at an average interest rate of 2.3%, and the loans it had taken out at this point have a range of maturities from this year to 2068. It has more than 100 loans, and the council said that taking out lots of smaller loans rather than a single loan against each asset had allowed it to save £14M on debt payments over the life of its borrowing.

The figure that has caused some alarm is the loan-to-value ratio — the PWLB allows borrowing at 100% LTV, a facility Spelthorne is making use of, saying on its website that as of the end of 2018 it had debt of £1B.

“The Council has this amount of debt because it has purchased assets of equivalent value,” it said. “We will be steadily paying off that debt over the loan periods.”

It is inherently hard to predict over the length of a long-term loan whether there will always be sufficient income to pay down debt each year, and what the value of the assets will be at the end of the life of the loans. But the council thinks it is secure.

"If the values of the properties decrease then the Council will still have a number of tenants in situ who will be paying rent (for example BP paying rent until 2036)," it said.

It said it aims to have tenants with around 10-year leases, which is intended to stablise assets through multiple economic cycles.