Following on from part 1 of our interview with Richard Auterac, chairman at commercial auction house Acuitus, we continued to explore the question of due diligence and how building relationships with commercial agents and attending auctions is fundamental to gain a greater understanding of the sector. No contemporary interview would be complete without asking about the EU referendum and Richard also gave us his thoughts on how business rate reforms may impact buying decisions in the coming years. Finally we approached the office building segment, the rapid growth of schemes with B1 to C3 Permitted Development Rights and gained some practical insights on buying commercial property at auction.
PIB: Do you have specific advice on how an investor can engage in more granular research?
RA: My view is that if you are a first-time commercial buyer, it would be best to stick to your local area to start – i.e. no more than 25 miles from where live as you will be able to gradually gain a detailed understanding of demand / supply patterns, local planning legislation and other influential factors. You will probably need to decide whether you´re going to buy an office, industrial / logistics unit or shop / leisure. Currently, 65% of our auction sales are for shops and this is generally the most common form of transaction, particularly for those new to buying commercial. When you have found a property that you are interested in, make sure you check the Title (downloadable from the Land Registry or via the auctioneer´s website with the legal pack) and ensure there are no restrictive covenants, issues with rights of way, boundaries, first and second charges or other pertinent issues. Also check through the existing lease with a fine tooth comb and ask as many questions as you have. I must reiterate the importance of using a good solicitor to run through the documentation with you – as they will usually be able to flag up specific concerns prior to progressing with the sale. Other questions worth asking include:
- Are the tenants occupying the building operating in line with the terms of the lease?
- Is the rental value aligned with the local market and genuinely affordable?
- For shops, what is the local footfall like?
- What is the overall local socio-demographic picture?
- Are there any infrastructure issues (such as poor transport links, heavy traffic, noise pollution)?
- What other commercial activity is occurring?
- Is the area lively and are there competitors operating within close proximity?
- Is there any planning potential (for example, change of use, surplus land or capacity to build into airspace) or have there been any previous planning applications? It may be worth communicating with a local planning consultant to explore potential angles.
PIB: I´m guessing building close relationships with local commercial agents would also be a good idea?
RA: Absolutely – this will be of huge benefit. In addition to informing you of new opportunities, they will be able to inform you of the most recent deals, current rental levels and other important trends. Also go along to the auctions, network and observe how other investors are bidding on properties in your area. The Essential Information Group database is invaluable for these purposes and you can also gauge what properties are letting for prior to going on to the market.
PIB: Looking at the market from a wider perspective, it would seem that last year´s referendum decision and the lack of clarity around the UK´s future relationship with the European Union has failed thus far to hinder market growth in both residential and commercial property sectors. Do you feel that we are experiencing some form of “calm before the storm” or are the fundamentals strong enough for the market to continue growing?
RA: No one likes uncertainty. Some are currently sitting back and seeing how the cycle plays out but the momentum in the market that has built up in the post-financial crisis climate has meant that demand has not dissipated. However, if the last 10 years have taught us anything, nothing is ever predictable. If it was a one-way ticket, everyone would be in the market. As mentioned, my general advice is to become an expert at what you do (know your market, understand the numbers, read the leases, documentation etc). Now I am obviously going to be slightly bias, but perhaps what makes commercial property so interesting is the relatively stable income return especially as equities markets tend to be more volatile over the short-medium term. With savings and government bonds still paying derisory returns, investing in a building with a blue chip tenant, 4.5% yield, strong covenants and a 10-15 year lease is still better than you would achieve from a building society (plus there´s the potential for capital appreciation prospects from property). Of course much will depend on your own appetite for risk but as long as you buy well and you are willing to take the time to engage in thorough due diligence, commercial property is generally able to withstand macroeconomic turmoil better than many other asset classes.
PIB: Another risk being pointed out is that of business rates which, particularly across Greater London and more affluent parts of the South East, are expected to double (although the increase will be capped at 42% in the first year). Is this just another just factor that investors will have to incorporate into their appraisal process?
RA: Yes, an occupier will look at his/her total cost of occupation and rent. Rates will have to be paid from profits. Over the last 10 years, business rates in Midlands and the North have been very high as they have been based on pre-crisis rental levels. Commercial values in many of those markets have still not recovered, contrary to what has occurred in London and the South East. Investors would therefore be wise to examine the net cost of occupation as it could be an issue for commercial tenants in the coming years that could quite possibly trigger defaults or reduced rents.
PIB: So the motive behind the legislation in your view is to create more of a level playing field across the market?
RA: Yes – I would say about 85% of the commercial properties that I am auctioning are outside London – this is not because stock doesn’t sell in London but owners simply do not want to! So many landlords who have bought well outside the Capital may benefit from these changes. However, it is worth noting that we have noticed some inconsistencies in the way the new rates are being calculated in parts of the North and the Midlands – so the system is far from perfect.
PIB: It would be good to get your perspective on the office building segment. From what I have observed, it has perhaps been one of the most massively changing areas of the market particularly in terms of the rapid growth of Permitted Development Rights since 2013 which triggered a spate of residential development activity which now, it is being debated, has led to a scarcity of office space.
RA: Generally speaking, offices are more complex as they have a tendency to become physically obsolete within shorter periods of time – commercial landlords usually have to renew the boilers, lifts and carry the burden of other expenses. PDRs were introduced as a means of boosting the development sector in line with the massive demand for residential housing and by virtue of the fact that many of the buildings built in the 60s and 70s were redundant. Vendors have also been able to achieve excellent prices thanks to PDR.
PIB: Yes, this has become particularly apparent more recently as more developers have wanted to tap into this space and fast-track their way through the planning process.
RA: Yes, but as you mentioned, I think that this particular segment of the market has become much more competitive, increasingly complex and more for the experienced property companies.
PIB: It wouldn’t be a simple case of obtaining B1 to C3 prior approval (ensuring you overcome traffic & highways, contamination, flood risk noise issues etc.) and assume that you will be able to produce a successful outcome?
RA: Exactly – buying office buildings then converting them into residential is not as simple as people think. Developers still need to play close attention to the marketability of their units as buyers are increasingly demanding and living in a building that clearly looks like an office is unlikely to appeal. Indeed, there has been an emerging trend of bad schemes that don’t quite work. A better idea, albeit more cumbersome, is to buy the office building, secure the PDRs and develop a proper scheme that meets the needs of the council and local community. I feel that this would secure a more sustainable business plan for developers and the wider market.
PIB: Interestingly, it may actually making more sense now to keep buildings as commercial and perhaps think about redeveloping or retrofitting – particularly in line with the growth of flexible office space by the likes of fast growing companies like We Work and The Office Group?
RA: This is certainly a growing area and goes back to the point of understanding market trends. We’re pretty certain we know what the future of residential is: people will still want to live in houses or flats in 10 years’ time. However, over the same period, office tenants may start demanding more flexibility, shorter leases, frequent tenant-break clauses etc.. The removal of swathes of building from office use to residential may lead to a scarcity of office space, thereby pushing rents up!
PIB: Mixed-use buildings also seem to be as popular as ever.
RA: Absolutely – indeed if you are new to the commercial market, providing that the model is appropriate to the area, a building where you convert the upper parts into residential and keep ground-floor as income producing can work well.
PIB: So moving on to a couple of last practical questions. For those that are unaware, is the timeframe for exchange and completion at a commercial property auction the same as residential?
RA: Since the recession in 2008, Acuitus and other commercial property auction houses have recommended to sellers that they consider extending the exchange to completion timeframe from four to six weeks – given the extra complexity involved in such transactions and a perception that buyers were needing longer to raise the necessary funds.
PIB: Are most of your transactions made with cash with the idea of refinancing post-completion?
RA: Yes, in as far as purchases are made from own financial resources and then financing post-completion.
PIB: I guess the difficulty for many readers of this blog is to get the funds together, particularly in London and the South East where capital values are high.
RA: Having financial resources at your disposal gives investors a lot more flexibility. The problem is that very few banks can operate within the timescales necessary.
PIB: Is bridging finance commonly used in such circumstances?
RA: It can be – the cost of bridging is coming down as there is a lot more competition.
PIB: Finally, are there any other pointers you would like to highlight?
RA: Yes, a word of warning with regards to the special conditions of sale that are in the seller’s legal pack. It is fundamental the prospective buyers read through these terms prior to bidding. At Acuitus we strive for transparency for the benefit of buyers and it is within these documents that sellers can apply their special terms in the contract such as an extra 1% buyer´s premium which can potentially come as unwelcome surprise at the point of exchange.
PIB: Excellent insights Richard. Thank you for your time.