Commercial property has always been an important asset class in the UK and worldwide.
The Property Industry Alliance found that commercial property accounted for 13% of the value of all property in 2018, totalling some £883 billion, which is 10% of the UK’s net wealth.
Commercial property ranges from mixed use retail units to offices, warehouses, leisure centres, schools and airports. The huge diversity in what’s on offer is attractive for investors – commercial property is more dynamic than a residential property and has a more volatile, low-liquidity market.
This investment landscape is riskier than residential property, but also more historically lucrative in the long term.
So where do you start if you want to get involved in commercial property investment?
Fundamentally, there are two ways to earn money from a commercial property:
- Income from renting the commercial building to a tenant or tenants
- Capital growth from an increase in the property’s value
There are 3 main ways to invest in commercial property. Investors do not have to purchase commercial property themselves, they can invest in commercial property funds with diversified, managed portfolios of property.
Direct investment is of course possible and has the highest maximum yield potential, but is also much more hands-on and will require more active investment involvement.
Indirect commercial property investment or managed direct property funds are suitable for investors seeking long-term growth. This is partly why commercial property is often targeted by pension funds.
Direct investment involves buying a commercial property or a share in a commercial property. This acts as any typical property investment, though the process is more complex. The buyer can either buy-to-let, or buy the building to redevelop it and sell it, or flip it in some other way.
There are numerous profit making angles for direct commercial property investors, but some experience, creative and astute grasp of the market is essential.
Investors can also look to commercial property funds in the form of a unit trust, OEIC or investment trust. These are also called brick-and-mortar funds, as the investment company owns the buildings – you invest in the buildings directly via the company. This allows very high-value commercial buildings to be divided out to smaller investors.
One such example would be investing via a SIPP pension into a commercial property fund. It would also be possible to club together with other SIPP owners to purchase shares in commercial property directly via the pension provider. In the case of property funds, the property types in the funds will likely be highly diversified to protect against short-term risk
These are indirect collective investment schemes that instead invest in the shares of property companies listed on the stockmarket. These include Real Estate Investment Trusts (REITs).
Indirect forms of investing in commercial real estate are much more flexible. Less start-up capital is required than for direct property investment, and it’s also easier to diversify portfolios to protect from market volatility.
Of course, any prospective commercial real estate investor will have to weigh the revenue potential of commercial property against other asset classes available on the market.
If we were to make a quick comparison between commercial and residential property rental yields, then the average UK rental yield is around 3.53%, according to SevenCapital.
If we look at the Statista graph below, then we can see how the vast majority of UK commercial property yields outperform this average figure. Some, like shopping centres, are more than double the average UK rental yield.
In terms of the profitability of indirect real estate stocks and shares investment, commercial property funds have registered 3% average growth each year since 2000, according to Realla.
Successful funds have reached much higher growth rates; the AXA UK Long Lease Fund registered 6.6% 5-year growth and the Standard Life Investments Long Lease Property Fund registered 7% 5-year growth, according to data listed in Aref.
Regardless of whether you’re considering direct or indirect commercial property investment, commercial real estate is clearly profitable, but it is a constantly shifting picture.
There are many trends to take into account, particularly the reduction in office space use following COVID19 and the rise of work-from-home business setups. However, when one door closes, another one opens, and the decline in office demand has led to an uptick in office conversions into flats and houses.
This is one of the unique caveats of commercial property – there is great scope for renovation and redevelopment, largely because of progressively relaxed planning laws and Permitted Development Rights.
For example, one Use Class change currently permitted under PDRS with Prior Approval is B1(a) (business – offices) or A1 to A5 (shops) to C3 (dwelling houses), and the government is now further encouraging investors and developers to convert empty offices and shops into residential property.
Direct property investment involves directly purchasing a property or a share in a property.
There are 3 main ways to earn money on a direct commercial property investment:
- Method 1: Buy-to-let; buy the property and lease it to tenants
- Method 2: Change the property in some way and then lease it or sell it on
- Method 3: Flip it in the short term without making any changes
Method 1, buy-to-let, is by far the most conventional approach. This allows the investor to act purpose-designed buy-to-let financing that creates a smooth deal, though interest rates will be higher than average and you’ll need a much higher deposit, probably somewhere between 20% and 40% of the property’s value.
Method 2 will probably require the investor to pay in cash, or to provide a very large quantity of the cash up-front. This is because there will be no tenants during the redevelopment period, so the investor will have to cover the mortgage from other cash flows. Bridging finance is an option, and there are certain specialist mortgages made for this type of investment. This method is akin to fix-and-flip investments in residential property. Upgrades can greatly enhance the profitability of the building and enable the investor to locate higher-value tenants.
Method 3 is more conventional in residential property where seasoned flippers can locate new buyers for a house before they’ve even completed the transaction. This allows them to complete the transaction and then sell the property immediately, netting a quick profit. An example would be locating a specialist building that is obviously underpriced, finding a buyer that has been in the market for this type of building for a while, purchasing the property and then selling it on to the new buyer at a profit. Of course, margins have to be big enough to pay for Stamp Duty and fees. This method would also need to be compared against the profitability of leasing the property instead.
Buy-to-let is by far the most common direct commercial property investment strategy. Like with residential property, the idea is simple; you buy the property and then let it out to tenants who pay a rental income.
Commercial lease agreements are usually longer than residential shorthold tenancies or ASTs (Assured Shorthold Tenancy). They also often place repair and maintenance responsibility on the leaseholder, though this can vary. The risk is that tenants default on their rent, hence why mortgage interest rates are higher, though this will depend on other financial factors.
Lenders will typically accept rental income of some 125%, so 25% in excess of your monthly mortgage repayments. It’s vital to factor vacancy rates into your net operating income calculations to adjust for periods where you have no tenants. You can read more about this in our article on net operating income here.
It’s possible to invest in commercial property both directly and indirectly.
Direct investment involves purchasing the commercial property either individually or with others. It’s also possible to invest in direct property investment funds that offer diversified portfolios of commercial properties up to many investors.
The former is suitable for those that want direct influence over the building and their strategy. The latter is a more hands-free approach that still involves ‘bricks and mortar investment.
The third way is via indirect commercial property funds. These allow investors to purchase stocks and shares in real estate companies or invest in REITs.
For more practical advice on buying commercial property, read our guide on 8 tips for buying your first commercial property and our article on flipping commercial property for investment ideas and angles.
Prime yields for commercial properties exceed that of residential properties, sometimes by a considerable margin. There is potential for massive capital gain, but the low-liquidity, volatile commercial real estate market poses some risks. As an investment class, commercial real estate is up there with the best and this is set to continue.
It has become trickier to define what a good yield in commercial property is, but as a rule of thumb, a yield of 5% is well above the current 2021/2022 property average. Some classes of commercial buildings enjoy rent yields north of 7%. Yields above 8% would be classed as exceptional.
Not especially, but the risks are higher and the process is more complex than residential property investment. There is a good deal of crossover between the two, so an experienced individual in the former should be well-equipped to understand the latter. Any commercial real estate investor should work with experienced professionals including commercial property solicitors and Chartered Surveyors.