Investing in commercial property – The pros and cons compared to buy-to-let.
Some investors will have been looking at commercial property, either for the first time or with a new eye as a result of the recent tax and Stamp Duty Land Tax changes. The tax relief on mortgage interest has been restricted and is being withdrawn and the 3% SDLT surcharge for second homes or where a company purchases a residential property, is having the effect of discouraging buy-to-let as an investment.
So what are the advantages of commercial property over residential buy-to-let?
Stamp Duty Land Tax
Quite simply, the rates are lower and there is no 3% surcharge. Also, non-residential rates apply to mixed use property so investors can still acquire a building which has flats within it but where there is say a retail unit on the ground floor and the stamp duty will be charged on the lower non-residential rates. The difference can be significant. For example, purchasing a building for £975,000 would incur the following SDLT, assuming that the 3% surcharge applies:
Residential: SDLT would be £70,500
Non-residential/mixed use: SDLT would be £38,250
Rental Income Stream
A buy-to-let investor will often acquire a residential property with vacant possession and then may have to spend significant sums refurbishing it before finding a tenant. Whereas, it is often the case that commercial property is purchased with the occupational tenant and lease already in place and so there is no delay before receiving income.
Further, there can be a cash flow advantage with a commercial lease because rent is usually paid 3 months in advance whereas with buy-to-let under a normal assured short hold tenancy (AST), the rent is only payable monthly in advance.
Even though the length of commercial leases have reduced in more recent times, commercial lease terms still tend to be longer than assured short hold tenancies, often 2, 3, 5, 7 or 10 year terms, whereas ASTs are commonly 12 months. The longer term gives greater certainty for the landlord as regards income stream and enhances the value of the investment. Both of these things help when it comes to arranging finance.
A commercial lease with a term of more than 5 years will usually have a rent review clause providing for periodic rent review to open market value or in line with the RPI and again, this can enhance value and assist with financing.
Tenants and security
Whilst references are taken up on residential tenant applicants, the due diligence process on a commercial tenant is usually much more thorough. Tenant covenant strength is highly regarded and so tenant trading history and credit worthiness is usually looked at in some detail. Furthermore, other security is often taken such as rent deposits or personal guarantees. Good tenant covenant strength (for example, a well-known high street branded retail chain) can add significantly to the value of a building.
ASTs are usually non-assignable so when a tenant leaves, the landlord has to find a new tenant and may face a rental void period. On the other hand, a commercial lease is usually assignable with the landlord’s consent and a landlord will be entitled to look in detail at the incoming tenant’s financial strength. The outgoing tenant will invariably have to sign up to an authorised guarantee agreement which guarantees the incoming tenant’s obligation to pay the rent and observe the lease terms and this enhances the landlord’s security.
Landlord’s Repairing Obligations
The cost of maintaining and repairing a residential building let under an AST falls on a landlord whereas many commercial properties are let on a fully repairing and insuring lease. This means that the tenant pays for all of the repairs, either by having direct responsibility to actually do the work or pays via a service charge. And, of course, the commercial tenant has to reimburse the landlord the cost of the insurance premium. A commercial landlord usually seeks a ‘clear lease’ where the landlord simply collects the rent and all other expenses are down to the tenant.
And the Cons of Commercial Property?
When commercial properties do become vacant it will often take longer to find and install a new commercial tenant than it does for a residential property.
Also, if a commercial tenant goes bust or disappears, it is often more costly to remove the tenant and forfeit the lease and the rental arrears may be greater.
The documentation for a commercial lease is more complex and so usually takes longer to negotiate than an AST. This can delay the point at which the tenant will go into occupation and therefore the point at which the landlord will start to receive income. Further, commercial tenants usually seek to negotiate a rent free period at the outset, causing further delay to the start of the landlord’s income stream. Overall, the landlord is likely to incur significantly more legal costs in ensuring that the commercial lease documentation is in order than would be the case with a straightforward AST.
As commercial property lawyers, we think commercial property is great!