Commercial property: an investment guide
Considering investing in commercial property? Or maybe you have already made the leap? If so there is a lot you need to consider.
There are two important strands to investment value, the first being the building itself, the second being the value of any leases you will agree.
Bricks and mortar
The bricks and mortar element will be very much the domain of your surveyor. They will advise on the property’s state of repair and whether additional expenditure is required to comply with fire safety, asbestos and disability discrimination legislation. All these issues will impact upon value although, as I will detail later, compliance with these types of statutory obligations should be the responsibility of the tenants (provided the leases have been properly drafted).
One point which is unlikely to be covered by existing occupational leases, will be who should take responsibility for works required to a building where the level of energy efficiency falls below band E.
Minimum energy efficiency standards require a landlord to ensure that commercial properties meet the said minimum level (band E), failing which a landlord may not grant a new tenancy, extend or renew an existing tenancy, nor (on or after 1st April 2023) continue to let the property.
If a property is in breach of these standards, the validity or enforceability of the lease itself is not affected. However the landlord will be in breach of regulations and thus liable to enforcement action if certain exemptions are not available. In short, prior to purchasing an investment property, you need to be clear as to the likely cost of improvements to satisfy energy efficiency standards.
Occupational lease terms fundamental to value
The next area to consider involves who your tenants are and the terms under which they occupy the premises.
It is firstly important to understand the financial strength of your tenants. This allows you to consider the risk of them defaulting, leaving you potentially with rent arrears, a dilapidated property and no income stream to service your mortgage requirements.
Once this has been established you can turn your attention to the principal lease terms.
Despite suggestions to the contrary and threats of government intervention, I am still yet to see any evidence of upwards and downwards rent reviews entering the market. As such, your occupational leases should always provide scope for upwards only rent reviews.
Rent review provisions should provide a true market rent calculation. Any leases that include artificial assumptions (so as to provide rental uplift on review) can sometimes work against a landlord. If this is the case then the tenant could argue for a discount on review based on the lease terms being unreasonable.
Subletting and assignment
The ability to assign or sublet the property is valuable for the tenant as it provides flexibility should they no longer want the property. Landlords however will not want to lose good tenants. Properly drafted leases will ensure any subletting is subject to the landlord’s prior consent (although it cannot be unreasonably withheld), allowing you to check the proposed assignee or subtenant is of sufficient financial standing to comply with the lease terms and rent.
Notwithstanding the above, there is no need for provisions to be overly restrictive. Onerous provisions imposing unusual restrictions can have a downward effect on rent review.
A landlord will always want an absolute obligation on the outgoing tenant to enter into an authorised guarantee agreement. This means the outgoing tenant stands as guarantor to its immediate assignee. You will also want all subleases to be contracted outside of the Landlord and Tenant Act 1954, so that you do not find yourself having to grant leases on renewal to a subtenant you may not otherwise wish to have.
Length of lease, break clauses and renewals
The tenant will want the length of lease to be appropriate for its business needs. As such, many leases will contain tenant’s break rights that allow the tenant to reconsider the lease at a time that suits. This however, will not be attractive to landlords. When purchasing investment property you need to always factor in the risk of tenants exercising break clauses leaving you with empty premises.
Tenants will want leases to be protected by the Landlord and Tenant Act 1954, providing a statutory right to renew at the end of the term. If the lease is contracted outside of the 1954 Act, the landlord can refuse to grant a new lease and insist on the tenant vacating. This may not necessarily be what the landlord wants but can give rise to more favourable renewal negotiations. That said, a protected lease is more valuable for a tenant, enabling a landlord to potentially demand a higher rent. A lot will depend on whether a landlord has designs on future redevelopment, making the ability to obtain vacant possession crucial.
Landlords will want tenants to be under a full repairing obligation, ensuring the tenant is required to keep the property in good repair. This includes an implied obligation to also put the property into good repair. Tenants will usually want such repairing obligations to be qualified by a photographic schedule of condition so they are only required to keep the property in ‘no worse condition’ than when the lease was entered into.
Alterations and change of use
Changes of use and the carrying out of alterations should always require the landlord’s consent. This consent should not be unreasonably withheld if the alterations are non-structural or do not affect the value of the premises. Again, overly restrictive provisions could hurt a landlord on rent review. However, on the flipside, you do need to maintain reasonable control on alterations and use to protect your investment and retain the attractiveness of the building for other occupiers.
In most cases the landlord will insure the property with the tenant reimbursing the landlord for insurance premiums. As owner of the property, you will want responsibility for maintaining the insurance and dealing with any repairs arising from insured damage. Problems arise however, where damage is caused by an uninsured risk as leases do not always satisfactorily cover such eventuality. Ideally landlords will want to pass on the unlikely risk of uninsured damage to tenants, but tenants will argue it should not be their responsibility when the landlord owns the capital interest in the property. The fairest approach is usually to allow either party to determine the lease in the event of uninsured damage, unless one or the other wishes to carry out the repairs at its own cost.
Where you have multi-let buildings, the likelihood is the tenant will be responsible for the maintenance of the interior, with the landlord maintaining the structure and exterior. The cost of providing such services will then be recovered through the service charge.
It is important to ensure there are no service charge qualifications or unreasonable caps which could lead to a shortfall in the event of significant outlay. The ability to build up a reserve fund is attractive to landlords when planning for long-term maintenance issues, such as roof repairs.
As mentioned previously, most leases require tenants to comply with all relevant legislation and statutory obligations relating to the property and its occupation. Landlords will want the occupier of the premises to be responsible for issues such as disability discrimination, fire safety, asbestos management, environmental protection and planning issues.
This article demonstrates the number of factors any potential landlord needs to consider when looking to maximise any investment in commercial property.
If you are considering purchasing a commercial property for investment, ensure you gain professional legal advice at the outset. Contact me directly via david.stone@GAsolicitors.com or call 01752 203500.
David Stone, partner