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Is it time to consider commercial property investment?

For many first-time investors in property, the preferred path to making that first investment has probably been influenced by what they feel comfortable with. They have therefore, looked at residential property. This is of course understandable, most people who are considering property as an investment will have probably purchased their own home and they will be familiar with the process of purchasing a residential property.

The introduction of the Assured Shorthold form of tenancy made residential investment a much more palatable method of achieving a return and the relative lack of legislation and regulation has meant that it was fairly easy to let a property and deal with the tenants. This coupled with attractive long term capital growth, has made the residential buy to let market a very nice place to be.

However, with increasing legislation and regulation, changing tax rules, tougher mortgage criteria and slower rental and capital growth, it is beginning to look as if some of the shine has come off the buy to let boom. So, is it time to look at commercial property as an alternative?

There are some fundamental differences that need to be considered.

Repairs

Most residential tenancies require the landlord to be responsible for the repair and maintenance of their properties. They have to ensure that the gas system is properly certified, are advised to ensure that the electrical system is safe, and are responsible for any breakdowns, repairs and maintenance that may be needed. Commercial properties’ however, are generally let on a Full Repairing and Insuring lease, which means that the tenant is responsible for putting and keeping the property in repair. This can be taken to the extreme by landlords,  where if the tenant takes the property in a poor state of repair, they can be expected to hand it back in repair at the end of the lease, good for the landlord, but maybe not the tenant.

Rent Arrears

Collecting rent arrears from a residential tenants and getting possession from an awkward tenant can be a tortuous route, which requires lengthy court proceedings and can result in a significant loss of rent to the landlord whilst he waits for a court order and for the bailiff to take possession. It is also likely that the tenant will not be able to repay the arrears. With commercial property, there are several remedies that are open to the landlord.

If a tenant owes rent and the lease allows, the landlord can instruct a bailiff to take possession of the unit and change the locks. He needs no court order and can do this under common law. The tenant does have a right to recover their possessions from the unit, but if they don’t do this, the landlord can be left with a large bill to get the unit cleared out. The tenant may also be able to apply to the court to get relief from forfeiture and they have a right to do this for up to 6 months after the date of possession.

A landlord can also instruct a bailiff to distrain against the tenant’s goods to the value of debt. The rules have changed in recent years and the landlord’s right to do this have been watered down, but it remains a powerful tool in the landlord’s arsenal.

Business Rates

Landlords of commercial property are liable to pay empty business rates at the full amount after 6 months for industrial property, or three months for retail and office properties.

Valuation

Most commercial properties will be valued by capitalising the rental income that is produced. The yield adopted reflects the amount of return the investor requires, to reflect the risk on his capital. Therefore, an office producing a rent of £50,000 per annum could be subject to various interpretations of value depending on the investor’s perception of risk. The quality of the tenant can have a very real effect on this, as a very simple example shows;

Office let to HM Government (Low Risk) Yield Required 6%

Rental Value 50,000

Years Purchase @ 6% 16.66

Value £833,333

Same Office Let to Local small company (Higher Risk) Yield Required 8%

Rental Value 50,000

Years Purchase @ 8% 12.5

Value £625,000

This is a very simple example of a complex problem, but it demonstrates the difference the perceived risk can make on a commercial property transaction. Contrast this with a residential transaction where an investor may look at yield, but the bottom line is that they are able to get possession and sell it as a house, therefore base value is potentially more secure.

Rent Reviews & Renewals

Residential properties can be reviewed upon renewal of the assured shorthold tenancy, or by service of a notice if the tenancy is periodic. The tenant does have a right of recourse if they don’t agree, but in most cases, they will move to a cheaper property if the rent becomes too expensive.

In commercial property, most tenants will be protected under the Landlord and Tenant Act 1954, which gives them the right to have a lease of similar terms at a market rent. If a market rent can’t be agreed on renewal of the lease, the matter can be referred to the court, who will set the new terms of the tenancy. If there is a midterm rent review then the landlord or tenant can refer the matter to a third-party arbitrator or independent expert, depending on the wording of the lease.

Whilst commercial property might not enjoy the spectacular capital growth that residential property has shown over the last few years, it does provide an investment media that will produce a regular return, with lower costs than might be found with residential property. If residential growth does start to slow and the tax burden of owning a buy to let portfolio becomes too great, it might be time to diversify your portfolio with some commercial property.

As always professional advice from a local agent who know their market place is essential.

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