Commercial property investment: how it differs from residential
Commercial property is a different asset class with a different risk profile. The yield is higher because the risks are larger.
Commercial property — shops, offices, industrial units, warehouses — typically yields more than residential, and the reason is not that it is overlooked. It is that the risks are higher and the asset is harder to sell, and the yield is the market's price for accepting both.
The differences that matter most are the lease, the tenant, and what happens when the tenant leaves.
The lease, and why it is the asset
In commercial property, the lease is a substantial part of the value. A long lease to a strong tenant with upward-only rent reviews is worth considerably more than a short lease to a tenant of uncertain covenant, even on identical buildings.
- Lease length: a short unexpired term is a risk, and a lease with under five years is difficult to finance
- Tenant covenant: the financial strength of the tenant, and whether there is a guarantor
- Rent review structure: upward-only, open market, or index-linked, and the frequency
- Repairing obligations: a full repairing and insuring lease puts the building's condition on the tenant, which is valuable to the landlord
- Break clauses, and who can exercise them and when
- Assignment and subletting rights
Voids and rates
Commercial voids are longer and more expensive than residential ones. A tenant who leaves an industrial unit may be difficult to replace, and the landlord remains liable for business rates on an empty commercial property after an initial relief period, which can be a substantial ongoing cost.
Business rates are the cost that most surprises residential investors. On an empty commercial property, rates relief is time-limited and the liability then falls on the owner, and the amount can be large relative to the rent. A void on a commercial property can be loss-making rather than merely unprofitable.
Financing and exit
Commercial mortgages are priced higher than residential, typically require a larger deposit, and are assessed on the property and the tenant as much as on the borrower. Lenders are wary of short leases, unusual buildings and tenants of weak covenant.
The exit is narrower. A commercial property appeals to a small pool of investors and owner-occupiers, and a property with a short lease or a vacant unit may be very difficult to sell at any sensible price. That illiquidity is the main reason to demand a higher yield, and it should be assessed before the income.
Common questions
- Are commercial property yields higher than residential?
- Yes, typically. Commercial property commonly yields 6% to 10%, against 3% to 6% for residential. The difference compensates for longer voids, business rates liability on empty property, a narrower buyer pool, and higher financing costs. A higher yield is not a free lunch; it is the price of those risks.
- Do I pay business rates on an empty commercial property?
- Yes, after an initial relief period. Empty property relief is time-limited and varies by property type, and once it expires the owner is liable for the full rates. On a property with a high rateable value this can be a substantial ongoing cost during a void, which is why business rates belong in the appraisal.