By Paul Aylott, Partner and Head of the Valuation & Lease Advisory Division at Glenny LLP
The property investment landscape is changing. According to studies, the number of buy-to-let landlords turning towards commercial property investment has grown by 200% over the last three years, with investors moving away from residential property and looking to commercial and mixed-use investments as an alternative.
The residential buy-to-let investor has had to face a series of recent challenges, including a 3% Stamp Duty Land Tax (SDLT) increase on residential investments and a phased reduction in tax relief on mortgage interest repayments, which has encouraged many landlords to either move portfolios across to limited companies, or to transition into the commercial property market.
Changes to the way investors vet and verify tenants, which includes conducting residency checks and taking out Tenancy Deposit Protection (TDP) schemes, are also creating a barrier to investment. Other landlord obligations – fundamentally designed to protect the tenant population – include providing the tenant with an Energy Performance Certificate, a Gas Safety Certificate and a copy of the Government’s latest copy of the guide “How to Rent” when they move in.
The benefits of commercial investment
With obligations such as these, the initial benefits of making this move from residential to commercial investment seem obvious. Firstly, the Stamp Duty Land Tax liability is lower and the 3% increase does not apply to commercial properties, including mixed-use premises that offer retail on the ground floor and residential above. Over the last 12 months, we’ve seen an increased number of borrowers looking to profit from the mixed-use nature of such investments.
With a commercial lease normally lasting considerably longer than a 12-month Assured Shorthold Tenancy (AST), investors are notionally guaranteed income for a longer period, an attractive proposition for an investor looking to borrow against a secure income stream. In this asset class, often upward-only rent reviews are built in – something excluded from a residential AST – with the rent compared to the open market or inflation hedged against RPI increases.
Often, residential property is bought with vacant possession, and only after a period of refurbishment is it let. But commercial property is typically bought with a tenant and lease already in place. The benefit to the investor is the immediate flow of income without losses during void periods. Added security comes with more stringent commercial tenant credit checks, undertaken with a higher level of due diligence than those typically completed by a residential landlord prior to a lease agreement. And, in times of financial stress, a commercial tenant is able to assign their lease to another tenant. This same option is excluded from a residential AST, with the property and the landlord subjected to a void period should a tenant default on their payment.
A commercial landlord’s repairing obligations are significantly less than those of residential landlords; commercial leases often impose full repairing and insuring (FRI) obligations, making it the tenant’s responsibility to carry out repairs within their premises. The insurance is reimbursed by the tenant and the landlord seeks what is known as a ‘clear lease’, where the landlord collects rent and the remainder of the obligations of the property are the responsibility of the tenant.
Understanding the asset class
However, although there is a current trend towards commercial property investment, it’s worth taking note of some of the potential pitfalls. Commercial property is a very different asset class from residential property, and investors should ensure they fully understand both before considering a change in the direction of their investment.
The litigation process, for example, is a long and detailed one; the drafting of a commercial lease takes considerably more time and incurs a much higher legal cost.
These complexities particularly around commercial lease clauses often result in the need to employ professionals to act on behalf of investors to advise on issues such as rent reviews, assignments, sub lettings, alterations, dilapidations and dealing with lease renewals in accordance with the relevant legislation, including the Landlord and Tenant Act 1954. The volume of case law involving commercial leases is perhaps one of the reasons for it, until now, being constrained to the professional investor who has some understanding of the commercial property market and a network of professional advisors to rely on.
Furthermore, the holding costs of a commercial property, should it become vacant, are often significantly higher than an equivalent buy-to-let investment.
The residential buy-to-let market is arguably far simpler to understand and affected by fewer legal intricacies to that of commercial. The financial return from commercial and mixed-use investments can often be more attractive than buy-to-let but this needs to be balanced against an investors’ knowledge of the commercial investment market and access to professional advisors.
Where the best opportunities lie
It’s important for investors to know what their objectives are prior to deciding where and when to invest. There is a trade-off that needs to be taken into consideration A single let commercial investment, leased to a strong covenant, would offer a secure rental return but is likely to be relatively low yielding.
For example, we recently valued and subsequently sold a warehouse in Hertfordshire, that had been let to Amazon with an unexpired lease term of four years. The rental yield was 5.5% and the investment would require limited landlord input during the term of the lease. By way of comparison, a mixed-use retail and residential investment in Tottenham, North London, offering a large shop and nine flats above, sold earlier this year at a rental yield of 8%. The Tottenham mixed-use investment produced a higher yield, but carried with it a greater liability in the way of landlord management input, a less secure income stream and a higher risk of voids.
Capital asset appreciation in respect of both scenarios is dependent on rental growth and demand in the investment market. Compare this to the typical single let residential buy-to-let investment, where the market can sometimes include owner-occupiers as well as buy-to-let investors, which can drive capital growth.
Residential investment is by no means dead. There is still profit to be made from investing in this asset class, which is very different from its commercial counterpart. However, commercial investment is a growing trend, and provides an interesting investment opportunity as long as the risks, as well as the rewards, are fully considered, and the investor has the right professional team in place to make the most of the opportunities available.
Glenny LLP is a multi-disciplinary property consultancy. Its Valuation & Lease Advisory division works closely with financial professionals to offer a range of services relating to residential and commercial property.