Differences in commercial vs. residential property investment
Discover the key disparities between commercial and residential property investment
Commercial property, or a non-domestic property, is a property which is not primarily a residence, though many mixed use (commercial and residential) buildings do exist:
Shops, offices, workshops, warehouses, factories, leisure centres and hotels are all examples of commercial property that could be considered to have investment potential.
Interestingly, licensed houses in multiple occupation (HMOs) are considered commercial property investments for financing purposes.
Both residential or domestic property and commercial rentals have their own legal regimes, though there are some broad similarities.
Governed by a whole raft of landlord and tenant rules and regulations, anyone contemplating becoming a self-managing residential or commercial landlord should be prepared to familiarise themselves with their legal responsibilities for each branch of the law.
Residential
Commercial
Generally easier to acquire as interest only buy-to-let mortgages are available at reasonable interest rates, and residential units tend to involve less money. You will also usually be asked for a smaller deposit.
Commercial mortgages are higher interest and lenders like to see evidence of a successful investment track record, so it can be a “chicken and egg” scenario to get started. Units tend to be more expensive, though small shops are often a viable option to start off.
Investment returns. Generally, a lower rental yield of 3 to 7% but higher capital growth, so coupled with more changes and more work, in the short-term, not as good. Tax changes over recent years have reduced profitability, especially for high-rate taxpayers, unless let through a limited company.
Generally, rental yields are higher, up to 20% in rare cases, but capital growth is less. Coupled with hands off clear unencumbered returns and long tenancies, good covenant tenants give almost a guaranteed high regular income. Watch out for properties opted into VAT and consider using a limited company.
Legal – letting agreements are straightforward and standard – up-to-date off-the-shelf ones are usually adequate. There are many regulations to comply with, including serving important pre-tenancy notices – do your own research.
Unless the letting is simple and short, leases are drawn up specifically for the individual letting, so it’s important to use an experienced property solicitor. If contracting out of the LTA 1954 there is an important procedure to follow – seek expert advice.
Less risk. Lettings can be easier and quicker, especially in a climate of rental shortages. As with all property investments, the right type of property in the right location is key to guaranteeing good tenant demand.
Higher risk as voids can be long-term tenant finds, while landlords become liable to pay business rates, insurance and utilities. Risk can be mitigated with multi-business and/or mixed residential use, such as flats above shops.
More work involved. Tend to let quicker but tenant changes are more frequent, so this adds to the amount of work involved and the expense of reletting each time. Landlords are responsible for insurance, all repairs and general maintenance.
Often more difficult to find the right tenant but once let, tenancies can last many years. Lease lengths vary but 3, 5, 10 15 and even 25 or more year leases are common. Generally, with a full repairing and insuring lease (FRI) the tenant is responsible for everything.
It is crucial to do thorough research to establish your target tenant type and the demand in a particular location.
This is particularly important for commercial as many high streets have been decimated with home shopping, and office demand has been reduced through working from home.
There is potential for converting offices and shops into residential through the relaxation of permitted development rights, and there are some tax concessions for this.
You should use a risk reduction strategy.
This might involve finding run-down properties that can be bought below market value and transformed through refurbishment and splitting into multiple units, or made into mixed-use such as flats above shops – there are the special permitted development rights planning rules in some situations.
You need to decide whether you would be better off developing properties – as a property developer - or if you simply want to be a landlord owning and renting them out long-term. There are different tax implications for both – seek professional advice.
Commercial properties have a particular tax benefit in that they can be owned in a pension, a SIPP or a SASS. These trusts give you freedom to invest your own pension money however you want, including buying commercial property, and they have major inheritance tax (IHT) benefits.
Get professional advice before you invest, form a limited company or pension vehicle.
Selecting tenants is a very important part of being a successful landlord and successful business tenants are the most important aspect of letting commercial properties.
A “blue chip” business tenant, known as covenant strength, on a long lease gives you a secure long-term income – a guaranteed income-return for the x number of years on the lease.
Not every tenant is a blue chip, especially if you are letting small units, and you are at the mercy of the market if demand is low.
But remember, as a landlord you are better off with a vacant unit than one with a bad tenant in place.
Always do thorough background checks. This is important with businesses as many are limited companies with limited trading records.
Take director guarantors having done background checks on them.
Have generally shortened in the modern era. In years gone by nothing much changed in the business environment and companies would take on very long leases.
This has become much less common in an era when things can change rapidly. Therefore, even the biggest blue chips are looking for shorter leases, down from 15 or 20 years to perhaps three, five, 10 or 15 years if you are lucky.
Unlike residential, which has its highest sale value when vacant, commercial property has its value multiplied when occupied by a strong covenant business tenant.
So, a successful conversion / refurbishment and a good letting adds tremendous value to your investment, especially if you wish to sell and move on.
Office space
Retail space
Industrial space
Mixed-use space
Other
