Commercial property offers a distinct investment avenue, characterised by its potential for stable income generation, long-term capital appreciation, and portfolio diversification. Unlike residential property, commercial assets are typically leased to businesses, providing a steady rental income stream often linked to inflation indices for protection against rising costs.
Types of Commercial Property
The commercial property market is diverse, encompassing various property types, each with its own investment characteristics:
- Office Buildings: These properties house businesses and corporations. Prime locations in thriving business districts tend to be highly sought after.
- Retail Spaces: Encompassing shopping centres, high street shops, and retail parks, this sector relies on consumer spending and foot traffic.
- Industrial Units: Warehouses, distribution centres, and manufacturing facilities cater to the production and logistics sectors.
- Commercial Land: This can be developed into various property types, offering significant potential for capital growth.
The Appeal of Commercial Property
Investors are drawn to commercial property for several reasons:
- Income Generation: Commercial leases often have longer terms, providing a reliable income stream.
- Capital Appreciation: Property values can increase over time, especially in prime locations with growing demand.
- Diversification: Commercial property can balance a portfolio by providing returns that may not correlate with other asset classes.
- Tax Benefits: Depending on the jurisdiction, commercial property ownership can offer tax advantages.
- Challenges and Considerations
While commercial property offers significant opportunities, it also comes with challenges:
- Market Cycles: Commercial property values can fluctuate with economic conditions.
- Tenant Risk: Vacancies and tenant defaults can impact rental income.
- Property Management: Commercial properties require professional management to maximise returns.
- Higher Entry Costs: Commercial properties typically involve larger investments compared to residential properties.
Expert Guidance is Key
Navigating the commercial property market requires specialised knowledge and experience. Working with a seasoned professional can help you make informed decisions, identify promising opportunities, and mitigate risks.
UK commercial investment boom as interest rates fall
UK commercial investment volumes and values will start to improve shortly, says Savills, after the Bank of England base rate cut this month.
Savills reports that cross-border investment into UK commercial property reached US$14 billion in the first six months of 2024, with the country attracting more capital than the USA or any of its European peers. While an element of caution will remain among the most circumspect investors until after the new government’s first budget in October, Savills says that an initial interest rate cut and rising confidence about the economic fundamentals have led to an inflection point for most buyers now being reached and more capital will be deployed in Q4.
The average UK prime commercial property yield stayed stable at 6.07% in July, says Savills, but it expects yield hardening from Q4 2024 after a predicted further 25 basis point interest rate cut in November and in anticipation of further cuts coming in 2025.
James Gulliford, joint head of UK commercial investment at the agency says "we are seeing rising confidence in the UK’s economic fundamentals which should drive tenant demand and feed through into yield hardening from the end of the year. For the first time since 2017 all of the main MSCI average rental growth indices are showing positive year-on-year growth, with the biggest swing in recent months being in retail rental value. As the typical retail rental cycle is still underway, with rents now rebuilding after previously falling when they reached affordability peaks, retail rents now join prime industrial and offices in seeing consistent rental growth.”
Mat Oakley, head of UK and European commercial research at Savills, adds “the UK’s return to a focus on creating an environment to support economic growth is a solid strategy, although reversing the macro trend of the last eight years or so will be slow and there are risks that could threaten this growth. However, the UK potentially looks more politically stable now than it has for a long time, and in a European context its real estate now looks cheap, so a recovery in international real estate investor’s perceptions of comparative risk and return is easier, especially if we shortly do return to low inflation, stronger economic growth environment.”
Tips for landlords on letting commercial premises
As a landlord, or a potential landlord, you will want to maximise the return on your commercial property investment. The landlords who get this right follow a few key rules.
Finding a tenant
The easiest and often safest way to do this is to put the property into the hands of an experienced commercial property letting agent. The agent will have their finger on the pulse of the local market and know how much rent can be charged.
It is important to select your tenant carefully. Make sure you take up references. The minimum should be a bank reference, accountant’s reference, a trade reference, a personal reference and, if the tenant is currently occupying rented accommodation, a landlord’s reference. Again the agent should actively help you with this.
Contract – Terms of Lease
You should negotiate the terms of the contract carefully. You need to consider the length of the lease, any fitting-out period required by the tenant, the rent reviews, any break dates, schedule of condition and security of tenure. And of course, the amount of rent.
The length of the lease is negotiable and will depend on the tenant’s business. Some tenants will be looking for shorter flexible terms, others for longer terms. This will be impacted by how long the business has been operating and whether it is still growing.
Typically rent reviews should be contracted for at least every five years. Break clauses can be tenant only, landlord only or mutual. The terms may vary but the break clause should stipulate the length of notice required to be given and any other terms to be adhered to.
The 1954 Landlord & Tenant Act grants business tenants’ security of tenure. Broadly this means that at the end of the term of an existing lease the tenant can apply to the landlord to renew the lease on similar terms to the expiring lease. This gives the tenant security of tenure and enables them to carry on their business from those premises. A lease may be “contracted out” of the 1954 LTA by agreement. This gives the landlord flexibility regarding the premises. For example, if the landlord is looking to sell the premises 5 years’ time, with vacant possession, but wishes to profit from the premises in the meantime, they may go down the route of “contracting out” of the 1954 LTA.
Alterations and Dilapidation
It is common for a commercial tenant to want to make alterations to the premises. These alterations may be to “fit-out” the premises before they can move in and start trading. As landlord you will need to grant a Licence for Alterations to the tenant at the same time as the lease is granted. The licence will set out the permitted works and contain a schedule of works and materials to be used. The tenant will not be permitted to deviate from the prescribed works.
Many tenants will ask for a rent-free period to allow them time to carry out this “fit-out”. Of course, you will need this to be as short as possible. It’s therefore important to negotiate and limit the term allowed for this.
One of the issues that can cause expensive legal issues, when the tenancy ends, is the condition of the premises. The Schedule of Condition should include photographic evidence of the condition at the date the lease was taken. The lease should stipulate that the premises do not have to be returned to the landlord in any better state and condition than in which they were taken. This detailed record of the condition of the premises, seen and agreed by both parties, will normally avoid any lengthy and expensive dilapidations claims.
Safe guarding the payment of rent
You will want to ensure that the rent is paid. You should consider:
Rent Deposit. This is an efficient way of securing any unpaid rent. A sum of money is lodged by the tenant with the landlord and held by the landlord in a separate account. The amount remains the tenant’s and must be returned to the tenant on the expiration of the lease, along with interest earned on it, but can be used by the landlord to off-set any arrears of rent during the term of the lease. A three or six month rent deposit is the norm.
Personal Guarantees. If the tenant is a company without a “track record” the landlord should consider taking a personal guarantee from the tenant’s directors. This will mean that if the company fails to pay the rent the directors of the company will become personally liable to pay it. A personal guarantee can also be taken where the tenant is an individual and the landlord considers that the tenant does not have a good “track record”. A second individual, perhaps a member of the tenant’s family who is more creditworthy, can be asked to be a guarantor for the landlord. Then the tenant has the possibility of recovering the rent from two individuals.
Final top tip. Before you do anything please speak to your solicitor who will be able to explain your rights and responsibilities in more depth.