There are 4 main routes to commercial property ownership and usage:
- Renting, leasing or letting
- Leasehold
- Freehold
- Licence to Occupy
Renting or letting is shorter-term whereas leasehold is longer term, but still involves a contractual tenancy agreement between the freeholder and the leaseholder. Renting also involves a tenancy agreement, but renting is short-term, usually involving month-to-month payments, whereas leasehold is a longer-term relationship.
Freehold is different to both renting and leasehold. Freehold grants outright ownership of the property. Once you register a property’s absolute title at the Land Registry then this ensures “guarantees the land” to the freeholder.
Some confusion arises between these terms, particularly between renting, leasing and letting. In law, these terms do not have officially segregated definitions and are often used interchangeably.
In residential property, we generally consider a rental agreement to run from month to month, but rent may be paid in quarterly periods for commercial property. It’s a short-term, flexible type of agreement that either party can agree to terminate for various reasons. Each party has some rights over the property, but the freeholder retains most rights to the property with a rental agreement.
A leasehold agreement places more exclusive rights in the hands of the tenants, or lessors.
Here, we’re going to look at the pros and cons of renting a commercial building.
Leasehold Vs Renting
Leasehold agreements are longer-term rental agreements, usually lasting for more than 5 years or so. These longer-term tenancy agreements provide stability to the tenant – the lease can only be terminated prior to it expiring under specific circumstances agreed on the contract.
This is important for commercial tenants – month-to-month rental agreements don’t provide enough stability to ‘set up shop’ for a longer-term period. Additionally, leasehold agreements provide more rights to the tenant, including the rights to change and modify the property. The rights of leaseholders differ with commercial and residential tenants, as residential leaseholders are entitled to extend their lease when it expires, or enfranchise the property, forcing the freeholder to sell.
The rights of commercial leaseholders are more restricted than for residential leaseholders, but the leaseholder will still be typically able to make repairs and renovations freely, allow whoever they wish to enter the building, and can even sub-let or transfer the lease. The right to lease extensions will depend on whether or not the lease is contracted out of the Landlord & Tenant Act 1954.
Contrastingly, rental agreements are shorter-term. They obligate the freeholder to make repairs and maintenance, offering a more flexible hands-off approach to commercial building use and ownership. The freeholder retains most rights over the property and the tenants may be restricted with what they can/can’t do with the building. Whilst rental payments are usually made quarterly in advance for commercial property, the agreement itself can be fixed for longer stints to protect the tenants. It really depends on what is stipulated and agreed in the contract.
Let’s also touch on a Licence to Occupy, which is a short-term, relatively informal agreement that doesn’t adhere to the same statutory rights as a lease.
If you want to learn more about the difference between freehold and leasehold go here.
We’ve looked at the pros and cons of buying or leasing commercial property here, but what are the pros and cons of renting commercial property?
The Benefits of Commercial Renting
The benefits of renting a commercial property revolve primarily around the flexibility granted by shorter-term rental agreements. However, what a business might gain in shorter-term flexibility, they might lose in longer-term stability.
1: Renting is Flexible
Flexibility is the big one here. Leasehold is a more permanent route to commercial property ownership and it suits established businesses, but start-ups, SMBs and SMEs may gain more from a flexible arrangement.
Take offices as an example. Offices have faced changing market and social forces in recent years. The coronavirus pandemic placed great emphasis on two things; working from home and flexible working. Co-working spaces have been rising in prominence lately too as the self-employed look to collaborate in office spaces. Data from Statista shows the remarkable rise in co-working spaces, and London faces the highest demand.
These types of flexible relationships are best managed via a shorter-term agreement. The freeholder of the office space may offer a managed, flexible solution. Small teams rent out the office space – there may be room for several start-ups with co-working spaces, etc. Leasehold isn’t necessary for this situation, nor is freehold (at least from an ownership perspective). It’s an advantage for businesses to enter a managed space, use it ‘until the job is done’ and then move.
We believe that offices that facilitate collaboration, creativity and community will be in highest demand from employees, Pearl Gillum, Research Analyst, Commercial Research
From a commercial property investment perspective, acquiring offices and fitting them out for flexible coworking looks a promising strategy over the coming years. Businesses benefit from this – they can simply rent the space until they no longer need it.
2: Renting Commercial Property is Cheaper In The Short Term
Renting is cheaper for short-term usage. You’d have to occupy a building for a considerable period of time for freehold or leasehold to look better value. Of course, there are downsides in that you won’t own the property – we’ll discuss that shortly.
Renting is cheaper in terms of the start-up capital required. All you’ll need to do is provide a deposit and make regular rental payments. Freehold requires a mortgage (unless you’re a cash buyer) and there are numerous taxes and other costs involved.
Contrastingly, a short rental agreement of a year or so might cost just 2% to 3% of what it could cost to buy the building outright. Sure, you can sell the building when you no longer require it if you freehold, but what if you make a loss? You don’t need to worry about that if you rent, nor do you need to worry about the maintenance and management of the building (depending on your contract).
For a cheap, easy way to start using a commercial building, renting shows some solid advantages. Renting frees up capital that can be directed elsewhere in the business.
3: It’s Less Hassle to Rent
Renting is easier – freeholding a property requires considerable experience and professional assistance. Property management is in-depth and requires the freeholder to uphold many responsibilities, particularly if they’re providing a managed service to rental clients. Of course, it depends on the size of the property and other factors, but on balance, renting provides a simple, hands-off approach to commercial property usage.
Furthermore, the time between striking an agreement and moving in is much quicker if you rent. The contracts are easier to negotiate and sign. You can move in and get cracking within just weeks, or days. You also won’t need to go through the process of negotiating mortgages and other finance. This also protects you against external economic forces, e.g. rising interest rates that increase your mortgage rate.
When it comes to moving out, you typically just need to pack up and go. This does depend on the contract and the level of wear and tear the building is subjected to. But still, you won’t need to think about selling the property or securing new tenants. Finally, if your business does fold or you experience financial difficulty, exiting a rental agreement is easier – just make your last payments and leave.
The Cons of Renting Commercial Property
There’s always a flip side to the coin, and for renting commercial property, the obvious downside is that renting isn’t a true form of property ownership. By renting, you’ll be a passenger in the commercial building, even if your business really grows into it. Of course, if you’re looking to flip or invest in commercial property then your only viable routes are freehold or leasehold.
1: Renting is a Not a Permanent Solution
For flexible businesses that are just getting from A to B at the start of their journey, a more permanent commercial premise is rarely at the top of their priorities. However, that can quickly change.
Take an SMB that runs an eCommerce operation. They’re renting the perfect commercial space – it has a small but expandable office and a decent warehouse for organising distribution and logistics. As they grow, they decide that a more permanent space would benefit. But then, the landlord decides to sell the building on, or has other plans for the future of the building and its tenants. The building may have rocketed in value – the SMB can’t afford the freehold now. At this business-critical moment, the tenants have to relocate!
Seems far fetched? The point is, you can’t really tell what will happen when you rent as you enjoy fewer rights than if you leasehold or freehold the property. Renting is flexible, but it’s flexible for the landlord too – that’s very important to bear in mind for rapidly expanding startups and SMBs.
2: You Won’t Benefit From the Proceeds of any Sale of the Commercial Property
Commercial buildings fluctuate in value and can increase dramatically if demand surges in a local area or industry. If the property’s value increases then the tenants receive zero benefit from this – it just means their rent will go up. When it comes to selling commercial property, freeholders take the profits.
Rental reviews can be conducted periodically as per the contract. Charges for maintenance and management costs can also rise over time, as can ground rent where applicable. Renting subjects tenants to a whole range of fluctuating expenses that can rack up over long rental periods, even if renting is cheaper in the short term.
This is a common dilemma – buy a commercial property and you may get your hands on a strongly appreciating asset that can help your business thrive. But, there are no guarantees of this – the same as any other investment. Either way, paying rent for a long period for a commercial property that could have been purchased outright is not ideal, assuming the business had the capital to buy it.
3: Renting Commercial Property Means an Overall Lack of Control
Renting withholds some rights over the tenants who will be subject to various restricted covenants stipulated in the contract. Renting does however grant exclusive possession of the defined premises, but not the right to modify or change the property at will, for example.
For businesses that just want to move in and use IT technology – computers and networking, for example – this will seldom be an issue. But what if a business requires greater control over the building; what if they need to make modifications to spaces, add new tech, etc? Under a rental agreement, this will be seldom allowed. Each commercial building will have its preset uses and the tenant will have to stick to these.
When freeholding, there is no issue of control over the building, providing building regs, planning for renovations and extensions, etc, and other legalities are upheld. Leasehold also grants a greater array of exclusive rights to the occupier.
Moreover, as mentioned, the freeholder retains the right to raise the rent throughout time.
If a business breaks the tenancy agreement then the implications can be severe also. Again, it’s a question of expansion – will it be economic to move out and find other premises when you could have purchased from the beginning?
A final consideration is that your rented commercial space might be shared with other businesses. This may pose no problem – but it’s tough to tell until you’ve moved in!
Summary: The Pros and Cons of Renting a Commercial Property
There’s a fair bit to consider here. Whilst renting inarguably offers shorter-term flexibility, it loses out in longer-term stability. Short-term benefits can quickly become long-term problems, especially if a business grows quickly. Whilst the capital for freeholding or even leasehold may not be present at the start, businesses should always assess the cost:benefit ratio of their commercial premises strategy.
Over time, the returns of renting unequivocally diminish – the benefits of long-term ownership increase. Always weigh up the pros and cons of renting a commercial property – for many businesses, it should be seen as a replaceable option when the right opportunity comes around.