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Acuitus Auctions on Transitioning from Residential to Commercial Property (Part 1)

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In a “post-Section 24” operational environment, the changing face of residential buy-to-let has spurred investors to explore alternative strategies as means of not only overcoming the impending punitive tax burden but also diversify into other asset classes. For capitalised buyers, the case for commercial property as a potential direction of travel is a compelling one: finance costs that are fully tax-deductible, lower stamp duty at purchase, Full Repairing and Insuring (FRI) leases and simplified enforcement of contractual breaches are just some of the commonly-cited advantages. However, evidence does suggest that the risks may be greater as investors can end up more susceptible to market swings, legislation and sector-specific behavioural shifts.  From the outset therefore, successfully investing in commercial property ultimately requires meticulous due diligence alongside an inherent ability to forecast changing trends well into the future.

We were very grateful to have a conversation on this subject with Richard Auterac, chairman and auctioneer at Acuitus.  Since first taking the rostrum Richard has overseen the sale of more than £5 billion worth of assets and advised financial institutions, major property companies, public authorities and private investors.  For the last 22 years he has also been chairman of the Real Estate Auction Group at the Royal Institute of Chartered Surveyors (RICS) and, prior to his time at Acuitus, spent over 30 years as a director and auctioneer at Jones Lang LaSalle.  In the first part of this interview, we ask Richard about some of the key differences between residential and commercial investing, how leases can be drafted equitably, the rent review process and undertaking due diligence (please continue reading part 2 here).

PIB: Ruban Selvanayagam from the Property Investor´s Blog

RA: Richard Auterac from Acuitus Commercial Property Auctions

PIB: Thanks for taking the time out to speak with us.  I was hoping to approach this conversation from the angle of a residential buy-to-let property investor who may be exploring a move into the commercial arena, particularly in light of the market changes such as the stamp duty surcharge and the tapered erosion of mortgage interest tax relief.

RA:  Absolutely. The commercial property market requires special understanding and it´s certainly important to make it more accessible to a wider pool of investors.  Acuitus has a large client base on the buy side and we have noted a greater appetite for acquiring commercial stock from residential specialists, despite sometimes the lack of access to suitable stock and knowledge.

PIB: Yes, with residential property, it is relatively easy to source impartial information on comparable sales, yields, demographics etc. There seems to be a wider array of specialist nuances and grey areas involved in commercial property.  Would you say, generally speaking, that the overall risk profile is greater?

RA: Risk is very important.  It is important to know what you’re doing – especially as the law, regulations and codes surrounding commercial property are more complex relative to residential.  For instance, a credit-referencing agency check for a buy-to-let would reveal any cause for concern straight away (missed payments, CCJs etc.), from which the landlord will be able to ascertain whether to take on the tenant (or not).  With commercial property you need to have a good understanding of the business operating in the building.  So in addition to individual credit searches, investors would need to undertake detailed analysis of the operational structure and trading accounts by means of examining assets and liabilities, borrowings, shareholdings and other relevant interests.  Conversely, commercial properties are generally less management-intensive as tenants tend to be more business-minded and you don’t have as many of the emotive issues that often come with residential.  This is providing that the leases are drafted in the right way as it´s not a simple case of producing a standard assured shorthold tenancy agreement and hope for the best.

PIB: Would you mind expanding on that?

RA: Every commercial tenancy is different and will vary according to the relationship between the landlord and tenant.  The respective obligations should be laid out clearly.  Take repairs – if the central heating of the property breaks down, can the tenant just patch the boiler up or does he/she have to put a brand-new boiler in? What does the lease say?  Another contentious issue is rent reviews and the underlying assumptions that surround this procedure.  In most cases the commercial landlord would want to maximise rental returns and the tenant the opposite.  Both the landlord and tenant will look through all the small print of the lease to exploit any potential loopholes at the point of review.

PIB: Are commercial rent rises usually Retail Price Index-linked?

RA: No. Historically rents have been reviewed to open market value. RPI-linked reviews are relatively new and usually apply to new convenience store lettings. The rental rises are based on incremental rises of the RPI as this tends to keep things simple and avoids unnecessary arguments or complex negotiations.  RPI-based rental increases also put less strain on the landlord and tenant relationship!

PIB: Avoiding potential acrimonious disputes and ensuring rent reviews are aligned with the market will also help with forecasting and is more likely to mean that the business will remain in the building for longer.

RA: Yes – on that point, landlords should ensure reviews are upwards only as you don’t want your rent to fall midway through a lease.

PIB: What about at the point when the lease is due for termination or renewal?

RA: There are certain provisions for renewing the lease by law under the 1954 Landlord and Tenant Act. Commercial landlords have to comply with those timescales and notices. It is important to get the right kind of legal advice to make sure you are getting the timing right and that tenant notices are being responded to correctly. Working with an experienced commercial property lawyer to ensure lease agreements are watertight has become imperative these days.

PIB: Moving on to the question of the level of research that a buyer needs to carry out, in similar vein to drafting lease agreements, I would imagine that there are a number of extra considerations compared to residential property?

RA: Absolutely.  There’s a lot more comparable evidence for residential than there is for commercial and rents are generally easier to assess than the former.  For instance, certain types of retail stock dropped by over 50% after the credit crunch as many were over-rented.  However, prices have stabilised over the last 2-3 years meaning it is slightly easier to gauge the necessary trends.

PIB: Another factor is that the face of the high street is changing – there are some making the argument that retail floor space will be in less demand as online shopping increases for example.

RA:  Yes.  This indeed highlights the importance of picking the right kind of stock to buy – checking whether it is in a primary or secondary position on the high street whilst understanding the overall business picture and the relevant trends is fundamental.  Broadly speaking, there are a number of extra variables to consider when analysing commercial property – including the possibility that market rent could actually fall when the lease is due for renewal or the property becomes vacant.

PIB:  Weighing up all these all the factors should therefore influence the price an investor is willing to pay in the first place.

RA: Yes, to use a crude example: if you see people spending lots of money in fashionable boutiques then you could conclude that capital values and rents will remain more buoyant in the future (taking into account some potential volatility).  Ultimately, what you’re looking for is a long lease (of 10 years plus) to a good tenant (i.e. a solid business) with strong financial covenants in place and upwards-only rental agreements.  For this kind of property in London, investors are currently looking at yields at 4% plus – but if you are prepared to explore outside the Capital, then good investments can still be obtained for 6.5% or maybe 7% without too much risk.

In terms of lease lengths, there are some segments of the occupier market where you can have longer leases in place as they are desired by the operators.  For example, restaurant and pub owners usually like to build up a clientele and long-term reputation – so leases of 15 to 20 years are not uncommon. However, the popularity of pubs in particular has oscillated quite considerably in recent years in line with changing consumer behaviour.

PIB: In addition to looking buildings that are let to blue-chip tenants, another strategy I hear of is to look for buildings where the tenants can operate sustainably, irrespective of the economic circumstances.  Pharmacies and hairdressers would perhaps be good examples.

RA: Pharmacies are very popular and their associated licenses are incredibly valuable.  Buildings that are let to mainstream outlets such as Tesco or Sainsbury´s Local are also good, as is anything related to the motor trade.  Generally speaking, these sorts of businesses tend to take on longer leases.

PIB: On the downside, I would imagine that the competition for these kinds of buildings would be high?

RA: Yes, towards the end of last year we auctioned a property in Kentish Town (North West London), with a starting guide price at £1.2 million which we moved up as demand was so high.  The seller ended up achieving £1.75 million.  We had a similar situation in February of this year.  We´re noticing that there are simply not enough good quality investment products on the market.

See part 2 of this extended interview by clicking here.

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