Something I get asked by quite a few investors is if commercial property is ‘similar’ to residential. There is a real eagerness to explore this next step in the property world but a fear of failing at it due to a lack of knowledge holding people back.

There are countless buy-to-let investors across the UK, many of which have built up large, valuable and impressive portfolios, yet the number of commercial landlords is significantly smaller even though returns here can be a lot higher and there is the security of much longer tenancies.

Whilst commercial property investment is more complex than residential in almost every respect, it shares a lot of similarities. If you have invested in houses and flats before then the concepts will ring familiar and you should find that you could regularly make more money with offices, factories and warehouses, though the risks are also greater.

To guide you along the right path, in this article, I will list some of the main considerations and differences to buy-to-let, with examples from deals we’ve been involved in and clients we’ve helped.

Contents

(Click to jump to each section)

 

Things to Consider Before Investing in Commercial Property

1. Income

Probably the biggest difference between residential and commercial property investment is how you make money from it.

Residential, for most investors, is mainly about capital appreciation (the overall value of the property rising over time), with any profit from rental income seen as a bonus. It’s the other way around with commercial. Many investors live good lives from the rent generated from just a few commercial units, though they won’t see them doubling in value over the next decade like residential properties have done in recent history.

Taking the South East of England as an example, according to Government data, the average rental value for new tenancies is currently around £995 per month, and Rightmove data tells us that average property prices in that region are £393,904. This means that if you were looking to purchase property to let out in the South East, the £11,940 annual rent equates to just 3% of the value. A buy-to-let property mortgage on one of these properties would eat up a significant amount of the rent, and then other costs would leave little leftover each month.

Rent from commercial properties is usually much higher, offering a much better yield. Take one of the office buildings we recently helped a client purchase in the same area. The cost of the building was £225,000, and the company that it was bought from paid £220,000 for it as a new building in 1989.

Compare that capital appreciation to the rise in value of your average house over those 28 years and the commercial unit looks like a truly awful investment. The difference is that the office building generates rent of nearly £2,400 a month.

This property has a yield of 12.8%, meaning it generates money four times as efficiently as the average South-East residence and, after the mortgage and other costs, there is £1,200 a month left over for the investor as profit.

 

2. Valuations and Borrowing

Understanding yield is key to knowing if you are getting a good deal when purchasing a property. Commercial property valuations are based more on the tenant than on the property itself. If you’ve previously invested in residential buy-to-let then you’ll have probably covered rental yields to a degree (usually when taking out a mortgage) but it’s much more in-depth with how the values of commercial are calculated.

There are three main considerations:

1. The amount of rent being paid.
2. When the rent will be paid.
3. The business that is paying the rent.

Similar to residential buy-to-let investment, the amount of rent being paid plays heavily into the value of the property. However, for commercial units, you also need to consider the length of the lease and the financial strength behind the tenant.

A “blue chip” tenant, such as a recognisable high-street brand with good financial standing, or a government department in a long-term lease, will give the property a high valuation. You may be looking at a 5-6% yield with the former, meaning if they pay £50K in rent, you’d have a valuation of around the £1m mark.

If the unit is empty, it might be up for sale for less than half of that amount because there isn’t any income, and with a lower quality tenant it’ll be somewhere in between as they offer less financial stability.

Not only does this affect the overall value of the property, but also the likelihood of getting finance, as well as how much a lender will offer you. The high-street brand tenant would make lenders comfortable and they may ask for less of a deposit than if you are purchasing a unit with an unknown tenant. They are calculating risk and the likelihood of you losing the tenant and then struggling to make mortgage payments.

Commercial lenders are far more comfortable knowing that a large and stable company like Sainsburys will be paying your rent than they are with an unknown start-up clothes shop. If the unit is empty, you may struggle to get a lender at all.

Lenders themselves range greatly. You can borrow this kind of money from the commercial divisions of high-street banks such as Barclays and HSBC, or from lesser-known more specialist lenders like Aldermore and Interbay, through to some of the newer peer-to-peer platforms.

Each will have their own appetite for risk and calculations on rental coverage, affordability, etc. At Pure, we placed deals with over 60 different lenders last year, so that should give you an idea of just how varied it can be!

Read more: 2017 in Review: A Great Year for Pure Commercial Finance

When borrowing money, you’ll need to contribute a much higher percentage as the deposit. Buy-to-let lenders often go to 85% and in the past were doing 90% loan-to-value (LTV) deals, whereas most commercial mortgages are between 60% and 70% LTV as standard, with the exception of higher debt exposure to sector specific or tenant quality.

 

3. Leases

Leases tend to be long-term, much longer than you will have experienced with any apartments or houses that you let. Unlike those 6-12 month Assured Shorthold Tenancies, commercial leases last years and can even stretch into decades.

Businesses spend a lot of money getting premises up to the spec they need so don’t tend to move unless they have outgrown their space or are downsizing. When businesses rely on footfall, they want the long-term stability of knowing they are building a local reputation that they will benefit from for years to come.

You will often see in a commercial lease something called a “break clause”. At certain pre-defined stages, the lease can be called off by either party. These exist because the needs of any business can change over time and things don’t always go to plan, so the tenant may want to move before the 10 years is up, or the landlord may want to rent the unit out to someone else or even change the use of the building.

The general rule is the longer the lease, the greater the value and the more you’ll pay for that building. It’s also worth bearing in mind that the longer the lease, the more you’ll sell it for if and when you look to exit.

On that note, many of our clients do incredibly well by buying up vacant commercial units, sometimes refurbishing them, finding good tenants with strong financial standing and putting them in place on long leases.

In the industry this is called a ‘value add’ model where the asset is taken at risk to purely create value and asset stability. This can be a very lucrative and cost-effective strategy for a developer.

We see a lot of our clients adopt the strategy not to retain them, but to take advantage of the capital growth created. Whereas, most clients acquiring tenanted assets naturally tend to retain, rather than sell, as they want the residual income. Each to their own, and either is a plausible business model.

 

4. Running costs

One of the most regular complaints I hear from buy-to-let landlords is how much time and effort is spent on property upkeep and dealing with issues, from faulty washing machines to broken windows. Commercial landlords don’t have these same issues because their properties are all under what’s known as “Fully repairing and insuring” leases and, unlike with residential property, as a commercial landlord you often aren’t responsible for the upkeep of the building.

It is standard in the commercial property industry for the landlord to hold responsibility over insuring the building itself (which is usually a condition of the mortgage), but the tenant is responsible for also insuring it, as well as things like contents cover and repairs.

When the tenant leaves, they have to put everything back exactly as they found it, or they have to pay the landlord the costs of rectifying any changes and putting right any damage. This is known as “dilapidations” and is a part of most commercial leases and is something you should definitely include in yours, as fixing commercial units can be very expensive.

A huge cost that many investors aren’t aware of before stepping into commercial is that of business rates. Possibly the largest downside to commercial property investment is when you have a void period and have to cover this cost yourself.

With a residential investment property, you may go a few weeks without a tenant and you have to cover any mortgage payments, but council rates do not apply. With commercial, void periods can and usually do last months, if not years, and the huge downside is you are liable for council rates during that time.

Rates are based on a percentage of the rentable value and after a 6 to 12-week grace period (this varies council by council) you have to pay them.

One of our clients who won an empty office building at auction last year had to start covering the rates after 2 months, which cost him around £1,000 per week.

If you have commercial properties and you find them empty in the future, then they can soon go from an asset generating thousands of pounds of profit to one costing thousands of pounds a month! This is something you need to put some serious consideration to before diversifying into commercial property, so that you are confident that you will be able to find future tenants, or have a slush fund to cover this cost.

 

5. How to Find Commercial Property

Many estate agents have a couple of commercial properties on their books, but few specialise in this area. I recommend seeking out the agents who do concentrate on commercial, who tend to go by the title of “surveyors” or “property agents”. These professionals exist to help commercial property owners sell and let their units, as well as help investors and businesses find commercial property to rent and buy.

It is well worth spending some time to meet up with them and let them know that you are in the market for purchasing commercial property and will also then need help finding tenants. They can advise you on the areas where units are hard to tenant, as those are the ones to shun and therefore limit void periods.

If you can form good relationships with some of these agents then you may well find you get offered off-market opportunities in advance of others. Many of our clients believe that when a property hits Rightmove, it’s too late, as all of the better deals are done before it gets to this point.

Probably half of the properties we fund are done privately, via introduction from an agent, and they are almost always the ones where the investor is getting a great deal.

You should also look at the property auctions. If you are outside of London then some of the commercial units in your area will likely come up in local monthly or quarterly property auctions, as well as the bigger auctions in London. Register on their websites for catalogues, so they send you the stock beforehand and you can see if any appeal to you and you are usually allowed to have a viewing beforehand.

Some auction deals can be very lucrative. One of our clients recently bought a large office building at a Cardiff auction. The previous owners had gone bust and the bank put the building up with a tenant already in place on one floor. The other floor was empty, which is a situation that puts lots of investors off due to the lower yield and the rates payable, as only half of the building was generating income and the other half was liable for rates payments.

This investor already had a business lined up to take on the empty floor so it suited him perfectly. The previous owner paid around £1.3m for it in 2007 and thanks to the quirky situation, our client won it for under £500K. Rent across the two floors is over £70K per year, whereas the monthly repayment mortgage is less than £2,000 a month. When I said earlier that you can make a good living off just a few commercial units, this really proves my point.

However you go about finding your commercial units, make offers. Very little sells for the exact price that is being asked and you can often offer more if it’s initially too low. As one of our clients always says, “when it comes to commercial property, you make your money when you buy, not when you sell”.

 

6. Taxes and Fees

You will find fees here a fair bit higher than you are used to. The charges from lenders, conveyancing fees from solicitors and surveyor’s costs can all be a lot more than with buy-to-let investments. You will also probably have to pay solicitors to draw up new lease agreements every time you want to let a unit and there is often some back-and-forth between each party, which increases the costs.

You may also have to consider VAT. At Pure Commercial Finance, we are not accountants, so cannot offer any advice in this area other than to say that about half of the units we’ve help fund have been VAT applicable, meaning the client had to find the money to cover an additional 20% on top of the asking price.

Even though in most instances this was claimed back soon afterwards, it’s still a big amount to have out and not something that many lenders will consider funding.

Commercial property is one of the few asset classes that can be used for your pension. You’ll need to have a SIPP (Self Invested Personal Pension) in place and that can be used to buy and retain commercial units. This means that any income generated adds to your pension pot which enjoys all of the tax advantages that come with that. Perfect if your plan is long-term, but not applicable if you are looking to generate immediate income.

A SIPP can raise 50% of its value towards the purchase so, say you have a pension worth £200K, the SIPP will allow you to purchase a £300K property.

 

A Few Business Models to Consider

If you like the sound of commercial but feel that it may be too big a leap forward from buy-to-let then you may want to consider semi-commercial properties. Along most of the high-streets and villages of the UK are shops, cafes and offices with accommodation above; With these you would get the benefits of having residential tenants as well as commercial, so it could even out costs a bit.

If you fancy some property development work as well, then the commercial side of the market can be a great way to add value to a property. A good number of our clients make their money by finding old, unloved commercial units and giving them a completely new lease of life.

This can be as small as refurbishing them and making any communal areas more attractive, so that they command a higher rent. It can also be as big a job as changing their use and redeveloping them as mixed-use schemes that then contain many commercial and residential units.

Either way, this works well as most councils are behind on the number of houses being built in their area, so planning permission is often accepted at a much higher rate than when houses are built up from the ground.

Those clients often then sell the residential units to pay for the entire project and give a healthy profit whilst retaining the commercial element, so they also get future regular income. This is not for the fainthearted, but can bring huge rewards.

 

To Summarise

If you are a casual investor and residential property is working for you, then the added costs, complications and risk of commercial property investment may well be prohibitive.

However, if you are looking to generate more income, are confident that you can negotiate well and buy smart, believe you can find good tenants and add value to units, then the gains to be made here will mean you probably soon turn your back on buy-to-let property and stick to commercial-only investments going forward. This has been the case for many of our clients and they don’t look back.
 

If you would like to talk about commercial property investment more, and the funding available to you, then the team at Pure are ready to help. Fill in one of our enquiry forms or call us now on 02920 766565.

Read more:

Everything You Need-to-Know About Buy-to-Let Mortgages
How to Fund Additional Investment Properties
6 Months, 3 Properties, 3 Funders, 1 Client: A Case Study