There are probably only three reasons for investing in commercial property, of which one does not apply to most landlords. The exception is a non-arm’s length transaction, where the tenant is connected to the landlord; for example, a group company subsidiary leases premises from the parent company, or the landlord’s business occupies the premises and rent is for tax accounting. Otherwise, the other two reasons are for income and/or capital growth. In the next article, I’ll write about investing for capital growth, but here I focus on income.
With commercial property (shops, offices, industrial, leisure, anything involving a business tenancy), income comes from two sources. Primary income is rent. Secondary income from opportunities that might arise during the management of the tenancy.
Primary income, or rent, comprises the rent for the premises and any additional items that are defined as rent in the lease, such as the building insurance premium, and the service charge.
With additional items, generally, the scope for making a profit out of the difference between the insurance premium payable by the tenant and the premium payable by the landlord to the insurer comes from block policy discounts, insurance policy commission, and blatant fiddles such as overcharging the tenant on proportionate share. With a service charge, profit possibility stems from being able to charge a percentage for managing the property, and carrying out any work that the charge covers without needing to use third-party contractors.
Secondary income can arise during the management of the tenancy. Depending upon the wording in the lease, and whether the tenant requests something of the landlord (for example, change of use, assignment, underletting, alterations, use of elevations for advertising hoardings, roofs for satellite dishes and such like, variation to the lease), it may be possible for the landlord to charge for consent, either for the consent itself and/or for administering consent. Even when the lease or overriding legislation states the landlord’s consent cannot be unreasonably withheld, that does not rule out the possibility of being able to charge costs for that consent. The ‘extras’ can mount up.
The (main) rent for the premises starts as a matter of agreement between the parties on grant of a new lease. Thereafter, unless the renewal of the tenancy is outside LTA54, on grant is the only time rent is solely a matter a matter of agreement (take-it-or-leave-it), otherwise it might be ascertained by an impartial third party in a dispute. Only when the tenancy is outside LTA54 would the new lease again be a matter of agreement, take-it-or-leave-it.
Depending upon the duration of the tenancy and/or what was agreed by the parties, the rent may be subject to rent review. Whether the rent increases at each review depends upon the type of review clause. In most leases, rent reviews are to market rent, subject to a cushion (known as an ‘upward-only’ review) whereby the rent payable after the review is agreed or ascertained would not be less than the rent previously payable. Other types of rent review include preset increases, index-linked, turnover reviews, etc.
On expiry of a tenancy that is inside LTA54, the renewal rent is the market rent, as defined by s34 and s35 LTA54. The impact of the difference between an upward-only review clause in the expired lease and s34-s35 is that the market rent could be less than the rent previously payable, which means the rent payable at the term commencement of the renewal lease would go down. The interim rent, per s24A, (the rent between the end of the tenant per notice and the renewal commencement, if different) is nowadays usually the same as the market rent, unless a substantial difference could be proven in which case that different rent would apply. The way to avoid the cost and complications of LTA54 procedure is to negotiate and document a further extension of the term a year or so before the statutory procedure could start. A reversionary lease, or surrender/simultaneous re-grant preserves rental income and should be less expensive to agree and document.
Therefore, the level of control that a landlord has during the term is curbed by the strictures of the rent review and overriding legislation. Presupposing a review to market rent, the landlord’s expectations for the increase take second place to the requirements of the lease.
Generally, shorter leases expose rental income to more risks. A short lease is often symptomatic of a tenant with no confidence in its business model, or indicative of an impending desire to relocate. A short lease enables the tenant to vacate the premises at the end of the contractual term, or with a break clause on notice beforehand. [Wanting a break clause is not only symptomatic of need for flexibility: it is also a negotiating ploy.] Whether the premises would relet at the same or higher rent would depend upon the state of the market at the time. Where a tenant wants to renew but not at the rent required by the landlord, the landlord would have to weigh up the difference between what rent could be agreed, the cost of any dispute procedure, and the cost of the risk of a void period, of which liability for empty property rates, deemed energy supplies, and risk of vandalism and structural deterioration figure highly
Longer leases provide more certainty of rental income, as well as more scope for secondary income. However, depending upon the location, type of property and form of review clause, longer leases also expose the landlord to the risk of overpaying for the investment to begin with, as well as nil increase at rent review. Since commercial property is a depreciating asset whose rate of depreciation has to be more than offset by rental and/or capital growth to enable the investor to profit in real terms, buying a commercial property for investment on the assumption that rent reviews necessarily imply increases at regular intervals is one reason inexperienced buyers come unstuck.
Nil increase at rent review to market rent isn’t necessarily a reflection of market rent itself, it can also be a reflection of the tenant surveyor’s knowhow, including the ability to frighten the landlord into conceding. Generally, landlords that are prone to being frightened can be identified by a tendency to claim that a previous review has not been actioned for some reason that might be thought plausible, but does not fool an experienced surveyor.
New lease rack-rented (market rent) commercial property investment on long leases (10 years or more) are known as ‘dry’ investments. The next rent review is years off, and for the landlord nothing else to do but renew the building insurance policy collect the rent and hope that the market for the location and type of property will improve. Sale-and-leaseback is an example of a dry investment, so too are the numerous new lettings and lease renewals (where the seller reckons the investment is ex-growth and sells before it becomes apparent to buyers.)
Everything else is speculative. An outstanding rent review, an imminent review or expiry, potential for redevelopment, buyer expectations can run wild. It is as though buyers imagine that the seller is naive. In some instances, there is opportunity for profitable active management, but mostly the experience is one of disappointment.
It doesn’t really how much is paid when the investment objective is income, because the price should reflect the yield required. But, to keep pace with inflation, rental yield cannot remain static, which is why comparing yield on commercial property with returns available elsewhere is a mistake. Rental income yield reflects the commercial property market’s assessment of risk. In a property market whose prices are geared to low interest rates, the yield differential between an income investment and a growth investment can be overlooked.
Yield is normally expressed gross, before tax. Tax is subjective, it depends upon your tax minimising arrangements. Yield net of expenses (but before tax) is harder to estimate, because there is no way of knowing for certain whether all expenses would be recoverable. Whether the purchase price costs are added to the purchase price or treated separately depends; also, whether to adjust for loss of interest on the equity. In real terms, the way to calculate net yield (before tax) is to deduct the total management expenses from the total rent received during the year, then adjust for inflation.
For landlords owning property bought in a bygone era, there comes a point when the yield on original cost is so attractive that it would be impossible to replace. Whether the yield calculation should be based on cost or current market value is a subject for debate. An advantage in thinking current value is whether the yield is really that impressive, compared to what could be done with the money elsewhere. Whether it would be prudent to sell depends upon where to reinvest the proceeds, especially when it is considered that the vast majority of commercial property investments on the market including auction prices are overpriced. In my experience, the decision depends upon accessibility to market and whether propositions are continually proffered, or if the investor has to go looking for something suitable. Since property investment is costly, on current low yields the first year’s rent could be swallowed up in buying costs and SDLT, investors generally are more inclined to buy and hold and only sell when the property gets to the stage either when a likely replacement tenant would never be as good a covenant as the existing tenant, or marketing would produce an offer too good to refuse.
For many investors, rental income is akin to an annuity or bond. Whether it matters the property appreciates during the period of ownership is less important than concern about the ability of the tenant to pay the rent for the term and on non-renewal for the property to let at the same or higher rent or fetch the purchase price.
Investing in commercial property for income has attractions, provided you are not overpaying to begin with. Apart from loss of equity when an overpriced purchase is revalued, the downside is risk of benign thinking. Commercial property is a dynamic market. Locations change, tenant requirements change, rent levels fluctuate. Past performance is no guide to the future. Property has reputation as a long-term hedge against inflation, but it doesn’t follow that what you bought will perform without any effort on your part or that of your advisers. A passive approach to investing in commercial property is only likely to be successful when the choice of property is judicious to begin with.