For anyone coming or escaping from the residential buy-to-let market, the thought of investing in commercial property with full repairing and insuring leases, long-term leases, and upward-only rent review, must surely seem like a godsend.
On the plus side is the likelihood of less hassle, more secure income often from corporate tenants, longer leases, and status. On the overt downside there is the risk of overpaying, and/or the tenant could go bust: whatever, such risks can be reasoned away, by reading about how past performance of capital appreciation and rental growth has made up for buyer mistakes, and with wise-buys another tenant will be along in a minute.
But for all the obvious advantages and apparent disadvantages that on balance can be weighed up to sound favourable, it is not until one exchanges contracts and completes the purchase that the covert downside of commercial property investment emerges in the form of extra costs, whether recoverable or not, that can and do eat into returns. Ignoring the difference between costs, charges, fees, duty, and tax, the whole lot lumped together can reduce what looks good on paper into becoming worse off. And if you go two steps further and adjust the equity for inflation and deduct capital gains tax, a comparison between the illusionary methodology and the reality can be depressing.
Amongst the attractions of commercial property is what is known as the ‘clean lease’. The principle of the clean lease is that the tenant should be responsible for everything and for any exceptions the cost to the landlord in complying with an obligation would be recoverable from the tenant. For example, when repair and maintenance of common structure is the landlord’s responsibility, the cost would be recoverable in a contribution payable by the tenant via a service charge to include a management fee. Similarly, the tenant would be responsible for the cost to the landlord of obtaining a valuation for the building insurance.
During the management of a tenancy, what costs are recoverable from the tenant would be stated in the lease, but whether and when recoverable depending upon the tenant’s honourability. Sometimes the money must be laid out in advance before becoming recoverable, other times the tenant would pay up-front. With mixed-user buildings, for example shop and separate residential upper part where the upper part occupancy is under the direct control of the landlord, it is common for more crafty landlords not only to try to impose a disproportionate amount of the building insurance premium onto the shop tenant but also get away with doing so.
Even with clean leases, it is rare to avoid any disputes over seemingly routine tenancy management issues. Apart from slow or non-payment of rent, probably the most thorny issues involve services charge and building insurance premium. How long a matter drags on can depend upon whether the landlord or tenant or both is advised and by whom. With insurance, proving the premium paid, the policy renewed, is easy: contention is the level of cover and amount of premium. Tenants claim they could get a lower premium, forgetting that another insurer will often charge less to attract new customers and/or the tenant has no idea how to calculate the level of cover. With service charges, whether the amount demanded is correct depends upon what the payment is for and whether recoverable under the lease. The landlord carrying out works might not think any difference between an improvement and a repair, but the tenant would. But compared to ‘routine’ management issues, the costs incurred can pale into insignificance compared with what happens at rent review and lease expiry/renewal.
It is interesting that despite an abundance of information on-line and elsewhere, investors new to the commercial property market somehow think that their perception of their choice of the investment’s rental potential should override how rent review is done. There is no right or wrong way to do a rent review, but there is a right way to approach the review at the onset; and if selling the investment were contemplated then whether better to agree the review or leave it outstanding to trap a buyer into thinking there is something to go for. The right way is to remember that no tenant is likely to willingly agree to an increase unless doing so would be of benefit to the tenant. When an investment is bought with a rent review outstanding or imminent, the new landlord shouldn’t assume, as so many newbies are prone to doing, that the previous landlord didn’t do anything about the review before selling. On the contrary, the previous landlord is likely to have thought things through, that at the time the proposition is offered the price likely obtainable would be higher by leaving the review outstanding.
At rent review, landlords can aim to save money by doing it themselves – how hard can it be? a question that inexperienced landlords is soon answered by tenant silence/tenant-surveyor resistance, coupled by a Calderbank offer at nil increase and triggering the dispute resolution procedure. Even when successful landlords instruct experienced surveyors to deal with a review, non-recoverable costs can mount up, particularly if referral goes all the way: whether the mounting up is substantial is relative to the investor’s resources: generally, the more experienced the landlord, the less likely the penny-pinching.
Ahead of lease expiry, the prospect of the tenant not renewing, presupposing the landlord would like the tenant to continue, can be worrying: the thought of empty property rates, of hefty insurance premium, dilapidation claims, the cost of reletting. On renewal itself, of concern is the tenant’s rental offer being less than the rent currently being paid, also the tenanting wanting a shorter term lease or a break clause: such factors can affect the capital value of the investment, and create problems for mortgage loan-to-value covenants between the landlord and the lender.
With growth hard to come by for anyone paying top prices for an investment, it makes one wonder what they are seeing that the more experienced do not.
The Rent Review Specialist