Written Evidence submitted on behalf of Cheetham & Mortimer (Chartered Surveyors)
Cheetham & Mortimer (C&M) is a firm of Chartered Surveyors that specialises in the retail and leisure sector. It was established in 1978 and operates throughout the North of England. The firm provides letting, development, investment and valuation advice.
We have experience within each of these fields where we have observed an apparent willingness by some Local Authorities to expose themselves to what we perceive as unnecessary and excessive risk in pursuit of commercial property investment and regeneration. We have concerns that in some instances this will result in future legacies that have potential to undermine long term financial stability.
We appreciate that it is important to distinguish between those investments that are intended to serve as a catalyst for regeneration and those that are simply designed to generate income by exploiting an arbitrage in the yield on cost and return. The former might generate a social return that cannot be costed in financial terms. Nevertheless, the resulting ownership carries risk through the mechanisms that are deployed to achieve the investment.
We would also stress that our observations are wholly confined to the retail and leisure sector. This is a sector that is undergoing immense structural change and presents its own set of unique challenges but in many ways, this merely serves to amplify the risk factor.
We have chosen an example from each of the above skill sets listed above to demonstrate the risk;
2.0 Letting Risk.
Winsford Cross Shopping Centre, Winsford, Cheshire.
C&M were the incumbent letting agent on this shopping centre when the investment was acquired by Cheshire West & Chester Council (CWAC) for a figure rumoured to be in the region of £19.75m. The scheme is typical of such shopping provision within secondary towns. It is suffering a contraction in demand from comparison retailers with an oversupply of redundant and obsolete accommodation. A simple change in ownership does not change this dynamic. Such schemes need to be re-purposed. At no point during the period between agreeing to buy the scheme and legally completing did the council approach C&M to obtain an understanding of the ongoing occupational issues such as which tenants were likely to vacate and what constituted a stable and sustainable rental level.
After the purchase was completed, C&M were invited to attend a meeting with a council officer who had been appointed internally to manage the asset. It quickly became apparent that the council had not formulated an asset plan either before or after the purchase had completed. Whilst the Council had been represented by a highly regarded international firm of property consultants, they did not provide any advice as to the asset management opportunities and the like, which the scheme presented. The Councils purpose for ownership and their intended objectives were clearly undetermined. Furthermore, the designated officer had no experience of managing an asset of this nature.
We were alarmed that an investment of this magnitude could be made without a prior understanding of the risks associated with ownership, the trajectory and stability of future rental income and the skill set to formulate and implement a relevant asset management plan.
CWAC are not alone in this approach. Trafford Borough Council acquired the Grafton Shopping Centre in Altrincham in 2017 for a figure in the region of £9m. At the time, the purchase was justified as a regeneration initiative but with a large portion of the building already leased and occupied by Travelodge until 2037, this argument seemed somewhat flawed. The council then decided to invite developers and investors to come up with ideas for the property. We have attached a link to an article published by Place Northwest.
To the best of our knowledge, this did not result in the selection of a Joint Venture partner and the council now hold an asset that was acquired with no visibility on the risks of ownership or the cost and viability of any perceived development potential.
3.0 Development Risk.
Riverside Shopping Centre, Rochdale, Lancashire.
This is a new shopping centre that was scheduled to open at Easter. C&M are appointed as letting agent to the developers – Gener8 and Kajima. Many of the UK’s leading Financial Institutions have developed a product known as a “strip lease”. The name is slightly misleading as it is more akin to a long term mortgage but it is promoted as a method by which Local Authorities can leverage against the strength of their own financial covenant to boost the viability of development projects that would otherwise be unviable. They typically involve the local authority committing to a long lease (between 25 and 35 years) over the entire development in return for a capital sum. At the end of the lease, the local authority often have the ability to buy the freehold for a nominal sum – say £1. This is promoted as an added advantage although in reality the building is possibly approaching the end of its economic life. This is the mechanism that Rochdale MBC adopted to deliver the above scheme. In essence, it enabled the council to raise twice the capital sum that might have otherwise been the case had the funding been achieved against the income of the occupational tenants (M&S, Next, H&M etc).
The annual rental payments made by the local authority are initially geared to a percentage of the occupational income – say 80% of the projected rent. However, they are typically index linked with annual increases. Hence, in the absence of organic market rental growth, it is quite conceivable that after a period of years, the rental payments made by the local authority exceed the total received from the occupational tenants. This could be further compounded by the fact that rent review cycles in most occupational leases are every 5 years during which period, the income received by the authority is static and where competition is actually putting rental values under downward pressure. Hence, the gap between the income received and paid by the local authority is diverging.
Furthermore, in addition to a disparity in the level of income, we are concerned that the model fails to adequately match the long term lease liabilities facing the local authority. This is particularly pronounced in respect of the retail sector where many occupiers are unwilling to commit to lease lengths in excess of 10 years (and it seems likely that post the current crisis lease terms will be even more tenant “friendly” with shorter, flexible lease lengths, rolling breaks, turnover only rents, etc being the norm). It is conceivable that the local authority could face a catastrophic shortfall in income during the life of their leasehold liability if occupational tenants fail to renew their leases after expiry and long void periods prevail.
4.0 Investment Risk.
C&M were instructed by Salford Council to advise on a possible purchase of a secondary shopping centre within their Borough. The Council had already entered into a dialogue with the owner who was keen to sell the investment. The owner is a Building Society and the property has been in receivership for approximately 10 years. In our opinion, the Market Value was significantly less than that suggested by the owner. A sale at such a level would have crystallised a huge loss on their original loan. The parties were unable to reach agreement on price and the negotiations were terminated. However, throughout the ongoing discussions with the owner, there was an expectation that the council had some sort of moral obligation to take ownership to enact some form of regeneration. As such, they were considered to be a “Special Purchaser” and that this should justify a premium price.
In reality, and having regard to prevailing market conditions for secondary shopping centres, it is often the case that a local council might be the “Only Purchaser” for such a scheme. Under such circumstances, they would be deserving of a discount in the Market Value. As previously stated, a change of ownership does not necessarily cause a change in the market dynamics. For example, it is reported that Shropshire Council acquired two shopping centres in Shrewsbury (The Pride Hill and Darwin Shopping Centres) for a combined figure of over £60m from a Joint Venture structure held between Standard Life and Shearer Property Group. What could the council hope to achieve that was beyond the capabilities of these two professional organisations?
In our experience, councils are at risk of being coerced into buying declining assets out of some form of moral duty or civic pride. In the absence of specialist pre-acquisition advice, it is conceivable that acquisitions might be made at inflated prices. Unfortunately, the officers charged with managing the process might have insufficient experience or knowledge to ask the appropriate questions and obtain the required information to make informed decisions.
A further dilemma might relate to fee agreements. It is common practice for investment transactions to have a fee structure that is performance related. Qualification is based on the outcome. If the transaction does not happen, then a fee is not payable. Clearly, this has the potential to create a conflict of interest for some acquiring agents, especially as the sums involved can be considerable. This can nurture a temptation to provide incomplete or non-existent advice.
5.0 Valuation Risk.
Based on discussions with a Partner from a national firm of Auditors, who are prolific service providers to the public sector, we understand that it is often standard practice to value assets on a rolling basis over a four year period. Hence, only 25% of the portfolio gets valued in any 12 month period. Therefore, an asset acquired in 2018, might not get valued again until 2022. This might be appropriate for special purpose assets but not for multi let income producing investments such as shopping centres and retail warehouse parks.
This sharply contrasts with the procedures adopted by many Financial Institutions who often value all their assets on a quarterly basis throughout the year. In a market that is evolving, dynamic and volatile, the need for regular valuation updates is critical to assess risk. This is particularly relevant to the retail sector. For example, according to research published by Savills, prime rental values within the retail warehouse sector declined by 17.8% from an average rate of £28 to £23 per sqft between the period 2016 to the end of 2019. During this period, prime yields rose from 4.75 to 6.0%. The combined impact results in a 41.7% reduction in value over the period. Clearly, without regular appraisals, it is not possible to implement strategies that might arrest an ongoing decline in value.
At the very least, when acquiring investment property, local authorities should be encouraged to undertake regular and periodic valuations by a suitably qualified valuer who is fully interfaced with both the occupational and investment markets. This does create an ongoing cost.
Local Authorities have the statutory powers to affect change. Going forward, and having regard to the rapid decline in the retail function of many town centres, Local Authorities are likely to become key players in any transition. However, their involvement does not necessarily require ownership. There are alternative Joint Venture models that offer a lower risk profile but can provide for some form of return – either financial or social.
Where Local Authorities do become involved in the ownership of investment property, they need to ensure that they deploy the appropriate level of resource prior to purchase to properly identify and assess the risk associated with ownership and to formulate a clear plan that will deliver any strategic objectives post purchase. They must also ensure that they have the skills and resource to manage the objectives. If such resource is not available internally, then they must be prepared to commission the knowledge and skills externally. This has an ongoing cost implication that should be factored into the initial decision making process.
In many instances, the larger Metropolitan Authorities have the luxury of this internal resource. In our opinion, there is a risk that smaller Authorities will make poor investment decisions in pursuit of fiscal prudence. This could result in reduced returns, a loss in value and a drain on anticipated income.