Property has long proven to be one of the best investments in the UK.
But while residential properties have been popular with investors for generations, recent changes including the reduction of tax relief, fluctuating residential property market and the current political uncertainty surrounding Brexit have led many investors to turn to commercial properties for a greater yield and more stability as part of a portfolio diversification strategy.
UK mortgage brokers and lenders also suggest investors are increasingly interested in commercial buy-to-let as an alternative to traditional residential lets.
This is because rents on office space and other commercial lets tend to be higher, providing a better yield for landlords when pressure mounts on their costs as it has for buy-to-let residential landlords.
If done right, renting out commercial properties can reliably bring in higher annual returns than residential property investments.
There are different risks associated with running a property portfolio with commercial tenants. Assessing if a commercial property is a smart investment requires proper research, homework and undertaking thorough due diligence.
This article will look at the factors to consider when investing in commercial property, as well as the pros, cons and challenges associated with commercial real estate investment as opposed to residential.
Overview of Property Investment – Fundamentals & Differences Between Residential and Commercial Properties
Traditionally, buy-to-let property investment refers to property let by private landlords to residential tenants, meaning the property is a rented accommodation specifically aimed at people who need somewhere to live.
From a funding point of view, the mortgage lender will assess the value of the property and the associated rental income in relation to mortgage payments, agreed loan, interest rates and terms.
Buy-to-let can also include multiple units, blocks of flats rented out to different families or even HMOs (houses in multiple occupation) which typically house students or professionals in separate lockable rooms with shared common rooms (usually kitchen and living/dining room) within a common dwelling.
These particular types of investments require more complex financing and are often investments done through a limited company.
The next natural step in property investment is to invest in a semi-commercial or “mixed-use” property and usually refers to a building with a shop or an office (or any other business) in one part of the building (generally on the ground floor) and a residential flat (or multiple flats) in any other part of the property (usually above the commercial premise).
These types of commercial properties are typically let by private landlords (or private funds) to businesses as tenants conducting enterprise on the premises.
Commercial funding and mortgages are assessed on the value of the property, the rental income produced, but also and more crucially, the business that currently sits in the property (the quality of the tenant) and the strength of the lease (length, clauses, terms, etc).
All these factors will affect how likely a landlord is to secure funding for this type of investment.
Pros of Commercial Real Estate Investment
According to the Q3 2017 RICS (Royal Institution of Chartered Surveyors) UK Commercial Property Market Survey, investment demand for commercial property continued to pick up, and proved the strongest in the industrial sector, with 55% of respondents seeing an increase in enquiries (up from 40% in Q2), while 41% of respondents saw a rise in investment demand for offices and 9% saw a rise in enquiries to invest in retail space.
This surge in interest and demand for commercial property investment is not only coming from seasoned commercial property investors, private funds, investment trusts and corporations, but also from more traditional buy-to-let residential landlords and investors looking for alternative investments to create diverse portfolios.
Semi-commercial properties in particular, are growing in popularity because they typically produce higher yields than vanilla buy-to-let properties and are not subject to the stamp duty surcharge or the tougher affordability calculations on personal buy-to-let borrowing.
A recent research conducted by Mortgages for Business showed that semi-commercial properties produced an average annual gross yield of 7.6 per cent compared to 6 per cent for vanilla buy-to-let over the past 6 years.
Here are some of the reasons commercial real estate is attracting an increasing number of property investors:
- Higher income potential
Commercial real estate generally offers higher returns than residential property.
The yield produced on commercial real estate is usually higher than that on residential properties, both on a per square foot and an initial investment basis.
This is especially true if you decide to lease or rent a multi-unit commercial property, as the more tenants you have, the more income you can generate.
- Cash flow stability and predictability
Predicting cash flow year-on-year is easier with commercial property as commercial real estates leases are usually longer (3, 5 years or up to 15 years usually) than residential leases (12 months to 2 years).
- Professional relationships with business tenants
The commercial property landlord-tenant relationship is between two businesses rather than two individuals, meaning interactions are usually more professional.
As a result, commercial tenants and property owner interests are aligned, which helps the owner maintain and improve the quality of the property, and ultimately, the value of their investment.
Furthermore, business owners and tenants generally take pride in their businesses and have a vested interested in maintaining their store and storefront; the same does not necessarily apply when dealing with residential tenants.
- Limited hours of operation
Most businesses usually operate during the day (during business hours), meaning as a landlord you can rest assured that you won’t get a call from your tenant late at night informing you of boiler breakdown or loss of keys.
- Diversification strategy
Owning a commercial property and leasing to multiple tenants lowers the chance that you will lose your rental income in any given month as the likelihood of all tenants vacating your commercial property at the same time is low.
In this case, you will still have tenants generating an income as opposed to a single-family residence where your investment income is dependent on the rent of a sole tenant.
Cons & Challenges of Commercial Real Estate Investment
While there are many positive reasons to invest in commercial real estate over residential, there are also many challenges to consider as well.
- Commercial property investment requires a bigger initial investment.
Acquiring a commercial property typically requires more capital up front than acquiring a residential rental in the same area (typically requiring 30% deposit).
And, although the buying process is very similar to residential investment, commercial property investment requires more thorough due diligence which makes the conveyancing more expensive and time consuming.
- Specialist lenders usually required at slightly higher rates
Getting commercial finance to fund the purchase of a mixed used or commercial property is different than for a residential property.
This can potentially be a challenge for some residential landlords as high street banks tend to offer the best rates but insist that the borrower has previous commercial experience.
Buy-to-let mortgages are not available on semi-commercial properties so investors have to go down the commercial finance route.
Finance for investors looking to cross over from residential to commercial is consequently available through specialist lenders – albeit at a slightly higher price.
Certain lenders will also prefer the business tenant to have a strong covenant (quality of tenant, e.g. Plc or large national retailer as opposed to local newsagent) and require the lease length to mirror the term of the mortgage (usually 5 to 15 years).
In addition, most commercial lenders will favour stable retail and business/trade operations as opposed to pubs or restaurant investments for example, where the quality of the operator and business failures rates are higher.
Investors have to be prepared for unexpected expenses, and these can be large with commercial properties.
Vacancies can take time to fill and void periods can be long between commercial tenants, triggering costly business rates for the landlord.
Repairs to commercial properties typically need to be done by professional workers and can be on a much larger scale than repairs to a house or an apartment unit.
Preparing for these expenses is a fundamental part of owning commercial property.
- Commercial property investment can be more risky.
Don’t assume that owning commercial property is guaranteed to bring you a consistent, higher return on your investment than residential.
Acquiring a commercial property is a much more complex process. Determining if a property is a smart purchase is a key part of due diligence, and particular consideration should be given to the type of business tenant and nature of business as part of the investment.
Income potential for commercial property is usually influenced by two main factors: market demand and property operations.
There are also some factors that influence the commercial real estate value:
- Demographics: changes in the composition of a population such as race, income and gender have a greater impact on the real estate value and its performance.
- Cyclicality of the economy can also have an adverse effect.
- Finally location, an important key in influencing the price values.
On the subject of location of a commercial property, particular attention should be given to particulars such as distance from clients, customers, end users and suppliers; transportation connectivity required for building use (roads, rail or water); and accessibility and ingress/egress.
Future developments in terms of infrastructure also have the ability to both positively and negatively impact a property’s value.
Income from commercial real estate is cyclical. When you rent your property to businesses, your income is directly linked to the prospects of the business that occupy your building.
When the economy is good, demand for commercial space is high and rents go up, but in an economic downturn, businesses pull back and close, reducing rental income and occupancy.
What are the vacancy rates with the current owners? How are current tenants doing financially? Are they planning to renew their leases? Are any residential properties being built close by? Are any major retailers moving into the area?
If so, that might be a sign there will be more demand for rental from businesses.
All these questions form part of a thorough due diligence process and are instrumental in determining if a particular investment will be a good and sound investment.
Failure to answer these could have dramatic consequences.
Commercial property investment is a much more complex process than residential property investment.
In today’s economic climate, gaining a robust understanding of the asset being purchased and the income it generates is more important than ever, with the due diligence process now a key part of any property transaction.
Undertaking a thorough due diligence is consequently paramount when considering buying a commercial property. The due diligence process can initially seem rather daunting as it requires extensive research, analysis and enquiries but it is an essential first step of any investment.
But we’ve simplified the process by creating a FREE due diligence guide and checklist that can walk you through the process step-by-step. Get your free copy by clicking here.
Find profitable commercial properties
Getting your due diligence right is the difference between a high-yield, profitable portfolio and disaster. Get your FREE copy of our ultimate due diligence guide and checklist and do yours right every time.