Mighty businesses expand from humble beginnings, whether it’s the small garage Steve Jobs and Steve Wozniak used to build Apple computers or James Dyson’s shed where he built prototypes of his now world-famous vacuum cleaners, every enterprise has to start somewhere.
At some point, though, many businesses expand to the point they need their own dedicated premises and then two choices arise; leasehold or freehold?
Property is not only a own stable asset for businesses and investors alike, but it also adds value to a company by providing a base of operations.
Commercial property, like residential property, can be owned in two ways, either as freehold or leasehold. When it comes to commercial property, the stakes are often high meaning large financial risks and harder decision making processes, ascertaining whether it’s advantageous for you to buy or lease will be a key choice in your business’s progression or investment strategy.
Commercial Property – The Must-Know
According to the PIA Property Data Report 2017, commercial property now accounts for greater than 13% of the value of all buildings in the UK which is pretty phenomenal when you consider that people do not live in these properties on a permanent basis.
Commercial property varies from smaller office spaces to massive warehouses and high-tech office blocks suitable for top-flight FTSE 100 businesses. There’s tons of choice and it’s usually possible you to quickly get involved in buying or leasing a commercial property with relative ease.
Generally speaking, commercial property types can be split into the four following categories:
- Office spaces – Buildings that are suited for office use with large open spaces and multiple well-lit and comfortable rooms.
- Retail – Shops, shopping complexes or centres, retail warehouses and supermarket floors.
- Leisure – Pubs and restaurants, gyms, sports centres, hotels and cinemas.
- Industrial – Warehouses, manufacturing plants and factories.
The significance of these varying property types is not just arbitrary, it also has legal ramifications. Under the Town and Country Planning (Uses Classes) Order 1987, commercial buildings are divided into different use classes which decides whether they’re suitable for a business’ operations.
You cannot go about setting up commercial retail operations in a hotel, for example. These classes are legally binding, your business must operate in-line with a building’s planned purposes. It is possible to convert buildings and redevelop them to change their planning use but this would require a lengthy planning application and ongoing discussions with councils. It’s best to look for buildings that suit your planned use.
Regardless of whether you’re buying or leasing a property for investment or for business use, location is absolutely pivotal in every respect. A great location provides you with access to a good workforce and low business operational running costs.
Key considerations for a good location:
- Transport links, (office spaces require effective public transport).
- Warehouses demand easy access by road.
- Is the location in a current state of decline or growth?
- Is the location undergoing redevelopment?
- What is the local price of commercial real estate? Is it cheap or expensive?
Investors will have to consider these questions in great detail to maximise yield, those who intend to use the building for an active business purpose should concentrate on whether they can extract maximum practical use out of a building. There’s not much good in owning a building which is increasing in value when your business has failed in part due to poor positioning.
Another technical location consideration is whether the building falls in a regional initiative or development scheme. A commercial building might fall in a Business Improvement District (BID), an area where businesses have voted to pay an additional tax to fund specific types of business-benefitting developments and services which provide long-term value.
Freehold is a comprehensive form of ownership which is permanent until the property is sold by the owner. Freehold property can also be leased out to provide a steady return on initial investments.
Free-holding means you own the property and the land it is built on, you are unrestricted in terms of what you can do with it and can, therefore, modify or redevelop so long as you obtain planning permission. When you own a freehold commercial building then just like for residential freehold, you will be entered into the Land Registry as holding the “title absolute”.
Free-holding is by far the most complete route to commercial property ownership, it ensures your building is protected in the long term, you do not need to move out until you want to sell and can, therefore, build a long-term base of operations for your business. With no restrictions, you’re also free to use the building how you like within law and planning permission which is excellent if you’d be otherwise limited by a lease that restricts access, noise or similar.
The Costs of Freehold Commercial Property
The costs of free-holding commercial property can be pretty prohibitive, the initial cost for commercial buildings is large and forking out for comprehensive surveys and other legal fees is pretty much a given – this is the main reason why many businesses choose to lease commercial property instead. Factored into that, because valuation in commercial property is difficult to forecast due to the speciality of commercial buildings and changing national or local demand, free-holding commercial property as an investment does tend to be high risk compared to free-holding residential property and mortgage lenders also take this into account with higher interest rates.
However in contrast, the rewards can be great, investing in just 1 or 2 large commercial buildings could be the equivalent to an entire portfolio of houses.
- Advice and Services – Commercial property purchases usually involve commercial estate agents, surveyors, lenders and solicitors. Commercial buildings require comprehensive and detailed surveys.
- Stamp Duty Land Tax – Commercial properties value over £150,000 incur SDLT. This is 2% up to £250,000 and 5% for anything above.
- Mortgage fees and VAT Where Applicable – VAT in commercial property is one of the trickiest areas of taxation in the UK. A vendor or landowner may charge VAT at 20% for a property if they have chosen to ‘opt for tax’ – a mechanism which can provide tax benefits to the seller.
- Preparing the Building – The main ‘extra’ cost on top of the original building purchase is often the cost of refurbishing or otherwise converting the building to your needs. Freeholds may come with everything you need if your business is an exact fit, e.g. you just need a generic office space but even then, you will find points of differentiation between you and the previous freeholder’s needs which means you generally have to spend some money on preparing the building.
- Insurance, Local Charges, Management and Security – Commercial buildings need to be insured and managed and you need adequate security to prevent break-in and trespass. Local councils may also charge for various waste disposal services.
Advantages of Buying Commercial Property as Freehold
- Free-holding your commercial property entitles you to your own unrestricted commercial space. You’ll be able to make modifications freely and develop when you need to, so long as you obtain planning permission.
- Free-holding is a stable and hands-off approach to investment if you’re simply holding a building unoccupied. If you plan on leasing or renting then bear in mind that commercial leases are generally shorter than residential leases which can give you greater flexibility over what sort of leases you offer. Free-holding allows you to rent or lease the building if your business moves or you can even sublet areas or rooms to others. You also benefit maximally from any appreciation in the building’s market value which can be dramatic if you’ve chosen it wisely.
- Ongoing costs are reduced as you won’t need to pay ground rent or other service charges.
Disadvantages of Buying Commercial Property as Freehold
- Initial costs are high but so are some ongoing costs if your building is tough to maintain. Services that would have been provided to you if you’d have leased are now your sole responsibility.
- If your business changes, fails or moves then selling freehold commercial property can be long-winded and finding buyers can be tough.
- The expensive nature of commercial property and their niche uses means they are generally considered a high-risk strategy for property investment.
Leasehold is a far more common route to commercial property use, it allows for businesses to scale flexibly from a fixed base without opting into long-term freehold ownership. By leasing, you’re usually paying an investor who decided to freehold a commercial building as we described in the last section. Leasing a commercial building means that you’ll occupy it on a temporary basis in accordance with terms negotiated and agreed between the landowner and leaseholder.
Leasing, in essence, means you never own unrestricted rights to a building and you’ll have to comply with rules and regulations stipulated in your lease agreement. When it comes to commercial leases, long-term leases are much less common what you find in residential property with most landowners preferring to lease commercial buildings on an auto-renewing short-term basis. This means they can conduct rent reviews regularly which may increase the cost of rent which, for commercial leases, is usually paid quarterly.
The landowner may stipulate that they only accept one type of lease term or otherwise, it might be down to you to negotiate a term which works for you.
Auto-renewal/Periodic Lease: Auto-renewing releases means you and landowner agree on a short-term period for which the lease automatically renews until either one of you gives notice to terminate the lease and leave the property. This is often only suitable for small, agile businesses who don’t need the use of a much longer-term guaranteed lease.
Fixed-lease: This is similar to residential property leasehold in that you’ll hold a longer lease fixed-term lease. This is suited to longer-term business applications and commitments where stability is needed. In a fixed lease, the landowner may not be able to increase rent or other charges unless this concession is made in the lease and agreed to by both parties.
Additional Costs of Leasehold
Security Deposits: The leaseholder will have to pay a security deposit to the landowner which can be held for the duration of a lease. Like deposits for residential properties, fair “wear and tear” is acceptable but damages beyond this can be taken out of the deposit.
Ground Rent: As still indicated in the rather old Law of Property Act 1925, ground rent is paid for the ground a building stands on, i.e. the land. It is usually a fairly small fee but it can increase over time so it’s something to watch out for when you negotiate your lease.
Service Charges: Service charges may include waste disposal and cleaning fees, energy usage, though this may be accounted for separately, internal repairs, air conditioning and security. In the case of reception or entrance staff, service charges can also be charged for staffing a commercial building unless you can provide your own staff.
The Advantages of Leasehold
- Lease-holding a commercial building provides a flexible means to ownership. Since you can negotiate your lease, you can usually find one which fits your exact requirements in terms of length and level of commitment. Shorter-term leases are less secure but they suit businesses that can easily change from one premise to another.
- Leasehold means reduced upfront costs which are obviously incomparable to making a full commercial purchase. This allows businesses to scale up with their growth and greater control over regular monthly outgoings.
- The landowner is usually responsible for the ‘fabric of the building’ which includes external walls and the roof. This protects leasehold buildings from particularly expensive structural maintenance costs.
- Added value from services can enrich businesses that do not have the capacity to staff security and cleaners, etc.
Disadvantages of Leasehold
- Leasehold comes with restricted covenants which disallow the leaseholder from conducting certain activities in the property.
- Depending on the lease, costs can rise steadily over time. Leasing may become expensive in the long run, deposits and other fees can strain businesses in the early stages of their lease.
- Leasehold means you’ll never own the property unless you can negotiate a sales price. If the property rockets in value, it’s only the landowner who benefits.
Leasehold and freehold are the two main routes to commercial property use and ownership. Commercial buildings vary from tiny office spaces to massive warehouses and thus, the law is complex and diverse – it’s imperative to take legalities seriously and scrutinise your decision-making process, you’ll also need to contact specialist solicitors and surveyors.
Surveys are very important if you’re planning to purchase any commercial building, commercial buildings require detailed commercial valuation surveys, which include a review on all of the internal and external components, to provide you with a clear picture of the current state and potential future repairs.
Your choice, as always, depends on your needs, small businesses often benefit from short-term leases whereas more long-term stable businesses can benefit from making a commercial purchase rather than taking out a long-term lease.
Is it better to invest in residential or commercial property?
This depends largely on your budget and investment intentions. Commercial property may be very expensive but this isn’t always the case and there’s often a healthy amount of older commercial buildings available for redevelopment and refurbishment. This is high risk but it can yield massive profits even over short periods of time. Residential property investment is more stable and allows investors to disperse their investments over a greater quantity of properties for risk management.
Why would a company lease instead of buy?
Leasing operates on a temporary flexible basis which suits many agile startups and small businesses. Also, since leased buildings are partially managed and maintained by the landowner, the leaseholder generally has fewer ongoing responsibilities.
Can I live in a commercial property if I own it?
You cannot live in a commercial property unless you convert it into a residential space. You will need to obtain planning permission for this.
Can you get a mortgage on commercial property?
Commercial mortgages generally last for over 15 years and the property is at risk if you cannot make repayments. Commercial mortgages are widely available at around 70% – 75%, your business and personal financial credentials and credit ratings will be overviewed.
- There aren’t often fixed rates for commercial mortgages
- Due to higher risks, interest rates are also usually higher but often lower than business loans as the property acts as collateral.