Like other major cities, London scores highly across a range of economic metrics. But while London’s continued capacity for renewal and attracting investment is undeniably impressive, it is often in stark contrast to other UK cities. Chris Urwin, Luke Layfield and Stanley Kwong explain what can be done to make those cities more attractive, and the respective roles investors and the public sector should play in that process.
6 minute read
First, some context. London experienced 49 per cent jobs growth between 1996 and 2018 compared to 25 per cent for the UK, according to the Office for National Statistics.
The UK’s dependency on its capital exceeds that of many other nations. In Germany, for example, economic activity tends to be more evenly distributed. Berlin may have developed into a tech hub, but Frankfurt’s focus on financial services and Munich’s manufacturing strength allows each to thrive.
The gulf between London and the rest of the UK is widening at the expense of some smaller towns and cities, most visibly in their centres. They are languishing from a lack of funding, online retail trends that decay town centres, and broad demographic shifts away from urban areas. Meanwhile, local authorities face increasing budget constraints and fewer options to meet residents’ needs, exacerbating the problem.
The gulf between London and the rest of the UK is widening at the expense of some smaller towns and cities
Regeneration is needed, but not in the traditional context of focusing on the physical environment in isolation. What has worked in previous years to encourage economic activity may not be suitable to promote knowledge-based growth, which is more dependent on factors such as innovation, skill development and connectivity. For this, policymakers are increasingly turning to the private sector to harness competitive advantages locally, while strengthening ties to major city hubs.
To establish more effective regeneration programmes, it is important to understand the local impact of broader economic trends. Although the UK’s economy may benefit from “a greater concentration on services sectors that tend to be less automatable on average than industrial sectors,” some regions are expected to suffer more than others, a recent PwC report concluded.1 By the 2030s, approximately 30 per cent of existing jobs in the UK are at high risk of automation. Jobs in manufacturing, which are often more concentrated in less economically developed regions, are at a higher risk than those in services.
Job creation is a complex exercise, particularly for regions lacking the talent, clusters and scale of major cities. To reinvigorate these areas, it is important to connect them to the ecosystems of larger city hubs. According to PwC, some local authority partnerships are better able to compete “on a global stage and unlock transformative growth for the region and the UK” by collaborating on shared economic development strategies.2
What constitutes an urban renewal project is being redefined, going beyond bricks and mortar to integrate aspects that are more difficult to measure such as skill development, well-being and the environment. Importantly, ESG elements are no longer optional in order to ensure long-term sustainability. In addition to the development of new skills, the success of regeneration projects often depends on less tangible building blocks for growth, such as health, social services and a sense of community. More emphasis on how developments may change the fabric of the community is needed to realise the long-term benefits.
Political trends present another set of challenges. In the private sphere, certain creditors will have a higher claim within the capital structure. While this is also true in city regeneration projects, policymakers may still face a public backlash if they opt to pay the rent owed to investors before other expenditures such as social services, even if they are legally bound to do so. Assessing that risk not only requires a clear understanding of the council’s balance sheet, but also other factors such as how the council manages the underlying asset, the related governance structures and the level of public support for the project.
Take St. George’s Shopping Centre in Gravesend, which we are funding. The scheme is part of a regional plan linking Gravesham Borough Council to businesses, national government agencies and other local authorities throughout the region. With multiple parties with potentially different goals, governance structures may be more complex. While a top-down perspective is warranted, the role of governance in urban regeneration also requires cooperation at various levels across jurisdictions. Otherwise, policymakers may end up simply moving problems from one area to another.
Long overlooked, investors and broader stakeholders are starting to consider the longer-term impact of their actions on health and the environment far more carefully
Long overlooked, investors and broader stakeholders are starting to consider the longer-term impact of their actions on health and the environment far more carefully. While many UK cities have generally committed to decarbonising, the threat to the environment tends to increase with economic growth through higher demand for services such as transport, energy and waste management.
For regeneration developments, with their longer time horizon and increased public scrutiny, the stakes are even higher to mitigate any environmental impact. To help future proof assets, energy sustainability and pollution control strategies may help, as does reducing the construction impact to the area.
Plugging the funding gap: The role of institutional capital
While regeneration schemes are becoming more complex, the financial barriers for local authorities are rising. Annual budgets for UK local authorities, on average, have fallen by 21 per cent in real terms between the 2009-2010 fiscal year and 2017-2018, see Figure 1. This gap is expected to widen, potentially creating opportunities for investors to step in.
Local authorities primarily depend on three major sources of funding – council tax, business rates and central government grants. All are under pressure and are unlikely to keep pace with the rising costs of public services, according to the Institute for Fiscal Studies.3 They state that the reduction “is without parallel in modern times,” and disproportionately impacts councils serving more deprived communities and which are highly dependent on national government funding.
Figure 1: Change in local government service spending, 2009-2010 to 2017-2018 fiscal years (per cent)
The UK government also plans to eliminate general-purpose grant funding next year and increase the proportion of business rates retained by councils. The latter should offset some of the losses from the former, but the shift puts more pressure on policymakers to expand their sources of funding. Regeneration can help unleash the potential of local assets, but it will require new sources of private funding to complement public capital, particularly since the government in October increased the interest rate it charges local authorities to borrow.
Many local authorities are reviving existing assets such as government buildings, empty offices or underused town centres
Many are reviving existing assets such as government buildings, empty offices or underused town centres to promote economic activities, ease budgetary constraints and improve the environment without having to hit taxpayers. The types of developments vary widely, ranging from a single-building conversion or land purchase to mixed-used multiplexes.
The flip side of the regeneration coin is how best to marry the projects that can help deliver such outcomes with investment capital looking for reliable income streams. Financing approaches are evolving, partly as a response to councils’ budgetary challenges but also because of the lower-for-longer interest rate environment, which is driving investors to seek long-term secure income from real assets, see Figure 2.
Figure 2: Growth of long income real estate vs. gilt yields
Long income real estate financing solutions generally fall into three categories: sale-and-leaseback arrangements, ground rents and amortising leases. Sale-and-leaseback and ground rent strategies have been employed by institutional investors for some time. The third – amortising leases – was less common but is increasingly seen as a preferred funding option for regeneration projects in the UK.
How amortising leases work
Effectively, these are income-strip transactions, allowing local authorities to retain control of the assets at the end of the term and investors to access a secure, long-term income stream.
For many local authorities the ability to retain long-term control of their town centres is particularly attractive
Typically, amortising leases include the option for the council to repurchase the asset for a nominal £1, assuming rent payments and other obligations in the terms of the contracts have been met. For many local authorities, the ability to retain long-term control of their town centres is particularly attractive, as indicated by the increasing prevalence of amortising leases. Between July 2014 and June 2019, the value of the income strip market increased threefold, as shown in Figure 3.
Figure 3: Capital value of the income strip market
Lease financing can also provide more flexibility compared to other forms of debt, such as government loans or bonds, potentially resulting in more efficient use of capital and more certainty on funding costs. Traditional borrowing generally requires the council to immediately draw down the entire funding amount, or otherwise take additional risks as to the cost of funds can vary if drawn over time. An amortising lease, however, can be structured to allow funds to be drawn down as and when work is completed. Interest rates on the rental payments are fixed from day one, giving both investor and borrower more certainty during the development period.
The predictable, inflation-linked and relatively low-risk income generated from amortising leases can help meet pension liabilities, making them an increasingly attractive option for investors with a long-term view. The cash flows are backed by high-quality tenants such as local authorities, other government entities, quasi-government organisations and investment-grade companies, so cashflow certainty is high given the strong tenant covenant strength.
Portfolio diversification adds another potential advantage, particularly versus equities. According to our analysis, the correlation between amortising leases and UK equities is -0.17 based on quarterly returns between September 2011 and 30 September 2019. (The correlation coefficient indicates a measure of the relationship between the two asset classes, with 1 indicating a perfect positive correlation and -1 a perfect negative correlation.)
Amortising leases can endure decades of negative performance before the project’s total income falls short of the rent payment
However, the complexities of amortising leases require a robust due-diligence process. Not every regeneration project will be successful. Risk scenario analysis, therefore, needs to prioritise the downside. Economic growth assumptions may change, for example due to Brexit uncertainties. Rent may be below expectation, impacting the cash flows generated for local authorities to pay investors. Core retail tenants could experience financial pressure from increased online competition and may not fulfil the terms of their lease contracts.
Structured prudently, however, amortising leases can endure decades of negative performance before the project’s total income falls short of the rent payments. Importantly, additional revenues from economic activities associated with the project can strengthen the council’s financial position. If there is a shortfall towards the end of the lease term when local authorities are closer to owning the assets, the incentives are even stronger for them to meet rental obligations, helping to reduce investment risk at a crucial time.
The divide between thriving cities and the regions left behind has often resulted in physical and often political scars. But success does not have to be so unevenly spread geographically, with larger cities gaining the competitive edge. To thrive in the knowledge-based era, local authorities will need to find new paths to generate growth, and they can’t do it alone.
It is important to scrutinise regeneration plans through a risk-return lens
Pension schemes and other institutional investors may feel a social responsibility to help communities evolve through regeneration. But these also need to align with the responsibilities they have to their own constituent members. Therefore, it is important to scrutinise regeneration plans through a risk-return lens, partnering with local authorities with a clear understanding of the ties between financial opportunities and ESG risks, and between local developments and major city hubs.
At a time when many pension schemes are de-risking but reluctant to add government bond exposures, the built-in cashflows from amortising leases could help schemes meet member benefits without taking on a lot of additional risk. More than that, they can help save the communities that those members depend upon for a better retirement.