Buying a commercial property can be an attractive way to generate income and build long-term wealth. However, commercial property investments are often more complex than they first appear. The headline purchase price, rental income and advertised yield only tell part of the story.
A property that appears to offer an attractive 8% yield may, after closer examination, carry significant risks relating to the tenant, lease, building condition, location, planning, future expenditure or rental income. Identifying those risks before committing to a purchase can make the difference between a successful investment and an expensive mistake.
For this reason, obtaining independent professional advice before buying a commercial property is one of the most important steps an investor can take.
The advertised yield is not the whole story
Commercial property is frequently marketed by reference to its rental income and initial yield. For example, a property producing £50,000 per annum and offered for £625,000 might appear to provide an attractive 8% return.
But an investor should ask why the yield is 8%. Is the rent below market level? Is the tenant financially secure? Is the lease nearing expiry? Is the property difficult to re-let? Are there significant repairs required? Is the location declining? Could the property become subject to an expensive rates liability if the tenant leaves?
A professional assessment can look beyond the headline figures and establish whether the return adequately compensates the investor for the risks involved.
Understanding the tenant
In many commercial investments, the tenant is one of the most important elements of the investment. A long lease does not necessarily mean that the income is secure. The financial strength of the tenant, the nature of its business and its ability to continue paying the rent should all be considered.
A professional adviser can examine matters such as:
- The tenant's financial strength and covenant
- The length of the remaining lease term
- Break clauses
- Rent review provisions
- Rent payment history
- The tenant's business and trading position
- Whether the current rent is sustainable
- The likelihood of the tenant renewing at lease expiry
An apparently secure 10-year lease can be a very different investment depending on whether the tenant is a strong national business or a financially weak company.
The lease needs careful examination
Commercial leases can contain significant financial and legal obligations that may not be obvious from the sales particulars. The lease should be reviewed alongside the investment appraisal to understand exactly what the investor is acquiring.
Particular attention should be given to rent reviews, break clauses, repairing obligations, service charges, insurance provisions, alienation rights and obligations at the end of the lease.
A Full Repairing and Insuring (FRI) lease can provide considerable protection for a landlord because many of the property's repair and insurance costs are recoverable from the tenant. However, the precise wording of the lease is critical. Investors should not assume that every commercial lease provides the same level of protection.
Building condition can have a major impact on returns
A commercial property may look satisfactory during a viewing while concealing significant future expenditure. Roof coverings, cladding, windows, mechanical and electrical installations, heating systems, drainage and external areas can all require substantial investment.
A building survey undertaken before exchange of contracts can identify defects and potential future expenditure. This is particularly important because a £50,000 repair bill can have a significant impact on the effective return from a £500,000 investment.
Professional advice can also help an investor distinguish between relatively minor defects and problems that could materially affect the property's value or lettability.
Location and future demand
Commercial property is highly dependent on location. A property may have a good tenant today, but the investor also needs to consider what happens when the property eventually becomes vacant.
Questions should include:
- Who would occupy the property if the existing tenant left?
- Is there demand from other occupiers?
- What alternative uses might be available?
- Is planning permission required for those uses?
- Are rents in the area increasing or falling?
- Is new competing accommodation being developed?
- Is the local commercial market expanding or contracting?
A professional adviser can provide an independent assessment of the property's underlying investment fundamentals rather than simply relying on the current tenant and rent.
Planning and alternative use
Planning can have a significant impact on the value of a commercial property. The existing use may be secure, but an investor should understand whether there are realistic opportunities for alternative uses if the current use becomes obsolete.
Conversely, assumptions about redevelopment or conversion can be dangerous if planning permission is unlikely to be obtained. A property may appear to have significant development potential, but that potential should not be included in the investment valuation unless there is reasonable evidence to support it.
Hidden costs can change the investment calculation
The purchase price is only one component of the overall investment. An investor should consider:
- Stamp Duty Land Tax
- Legal fees
- Valuation and survey costs
- Financing costs
- Asset management costs
- Insurance
- Service charge liabilities
- Repairs and maintenance
- Empty property costs
- Business rates exposure during void periods
- Future capital expenditure
- Leasing and marketing costs
Understanding these costs before purchase allows the investor to calculate the true net return, rather than relying on the advertised gross yield.
Independent advice can provide negotiating leverage
Professional advice is not only about identifying problems. It can also help an investor negotiate a better deal. If due diligence identifies a significant roof replacement, below-market rent, short lease term or potential vacancy risk, that information can be reflected in the price offered.
For example, if a property is advertised at £750,000 but professional assessment identifies £75,000 of likely expenditure, the investor may be able to negotiate the purchase price accordingly. The cost of professional advice can therefore potentially be recovered many times over through better negotiation.
Why independent advice matters
One of the most important considerations is independence. The selling agent is acting for the vendor. Their role is to market the property and achieve the best possible sale price for their client.
That does not mean the information provided by the agent is incorrect. However, the purchaser should have their own independent assessment of whether the property represents a good investment at the proposed purchase price. An independent commercial property adviser can act solely on behalf of the purchaser and provide an objective assessment of the risks, value and potential returns.
Professional advice should be obtained before committing to the purchase
Ideally, professional advice should be obtained before making an unconditional commitment to buy. Once contracts have been exchanged, the purchaser is generally committed to completing the transaction. Discovering a significant problem after exchange can therefore be extremely expensive.
Early due diligence allows the investor to:
- Understand the investment properly.
- Identify potential risks.
- Establish whether the asking price is justified.
- Negotiate where appropriate.
- Decide whether to proceed, renegotiate or walk away.
A relatively small cost can protect a substantial investment
Commercial property investments can involve hundreds of thousands or even millions of pounds. Against that background, spending a relatively small amount on professional advice before committing to the purchase is a sensible form of risk management.
The objective is not simply to find reasons not to buy a property. Good professional advice should establish both the opportunities and the risks, allowing the investor to make an informed decision.
Conclusion
Commercial property can provide attractive rental income, potential capital growth and opportunities to create additional value. But successful investment depends on understanding what is actually being purchased.
The headline yield is only the starting point. The tenant, lease, building, location, planning position, future demand, costs and potential liabilities all need to be considered before deciding whether the investment represents good value.
Independent professional advice gives investors the opportunity to identify risks before they become expensive problems and, importantly, to make investment decisions based on evidence rather than sales information.
For an investor committing £250,000, £500,000 or £1 million to a commercial property, professional due diligence is not an unnecessary expense. It is an essential part of protecting the investment.