What are the basics of buying a commercial property investment? As property accountants serving thousands of UK landlords that purchase buy to let properties, we know that risk reduction and profit maximisation are of prime concern. Many of our UK landlords and property investor clients are looking for ways to spread any potential risk. Diversifying a property investment portfolio can be a good way to do this, with a mix of residential and commercial properties. According to industry sources, commercial property accounts for 13% of the value of all UK buildings and is worth over £900 billion. The commercial property sector contains various property types, including office space and retail units. Commercial property investment includes high street shops to large out-of-town shopping areas. It also includes factories, industrial units, warehouses, restaurants, pubs, hotels, gyms and even car parks. Commercial property investment can be direct or indirect. Direct investment involves the purchase of buildings the ‘and bricks and mortar, while indirect investment can include investment in stocks, bonds and shares of companies that specialise in property investing. For our clients who are familiar with buy-to-let property investment, the idea is straightforward. Residential property is purchased and then let out in return for a rental income to the property landlord. With commercial property investment, the rental income might be generated each month, quarter, or on any basis agreed between the landlord and tenant. Most commercial property lease agreements are bespoke, rather than the Assured Shorthold Tenancy (AST) agreements used with residential property investments. Commercial property leases are usually agreed over much longer terms than UK residential buy to let, with lease lengths for commercial properties in the UK, usually signed for between three and 20 years. Commercial property investment has been seen as stable in the UK for some time. Although it involves a large and costly commitment, it is possible to invest through funds such as unit trusts and investment trusts. These trusts may own shares in property companies or own commercial properties directly. Commercial property investment can be funded using a commercial mortgage. These are the commercial equivalent of a buy to let loan. A commercial property investment mortgage will have some key differences to bear in mind. Mortgages for commercial property investors tend to be offered at higher interest rates, particularly for first-time commercial property owners. The load to values is also lower, with 65% being common. Finally, commercial mortgage lenders in the UK can often expect borrowing to be taken on a capital repayment basis. Some lenders accept interest only, but it’s not standard across the country. Is commercial property a good investment? Commercial property offers a good investment opportunity in the UK to earn a regular income, as they deliver higher rental rates than residential properties. There are two main ways to earn money from commercial property investment. Income from renting to a tenant and capital growth from an increase in the property’s value. The commercial property investment market in the UK benefits from a longer lease structure than in Europe and the US. The average lease length in a London office is between 10-15 years, with the average lease length across the UK being approximately eight years. This is much longer than a residential property, which typically sees a tenant lease of six months to a year. Commercial property investment offers more security relative to the returns offered by shares, as income is guaranteed for a commercial property investor at a set level over an extended period. As commercial property leases are much longer, these properties usually have an investment value higher than their bricks and mortar valuations. This means a commercial property investor can acquire a vacant property, and if let on a strong lease to a good tenant, an instant increase in value will be seen. Most commercial property leases are also fully repaired and insured. This means that the tenant is fully liable for repairs and insurance of the commercial property. These leases remove much of the maintenance costs associated with the properties. Assured Tenancy Shorthold agreements for residential buy to let property investments usually require repairs, maintenance and buildings insurance to be included at the landlords’ expense. Industry commentators have seen many commercial property investors diversifying their portfolios as a result of the Covid-19 pandemic. Many have shifted from traditional city-centre office blocks to smaller, premium office spaces. Other types of commercial property have become more popular during 2020, such as student accommodation, pop-up commercial units and specific areas such as logistics and healthcare. Do commercial properties increase in value? The value of a commercial property can be increased by simply increasing the rent. It is worth reviewing the tenant agreements to see if they are paying market rent or if their current rent can be increased. Commercial property types will become a more popular investment choice, as Covid-19 restrictions ease across the UK and consumer confidence returns. What is a good return when buying a commercial property? Yields for commercial property investors are typically much higher than for residential properties. Commercial property investments can yield up to 10%. Residential property usually delivers 1-3%. The reason for this difference in yield returns can often be attributed to the different lease agreements. Commercial properties that are capable of delivering the highest return are those with the highest number of tenants. These properties include apartment complexes, office buildings, student housing and storage facilities. Which is a better investment, commercial or residential property? Residential properties can be purchased for far less money, with commercial properties requiring much more money upfront and with stricter lending requirements to obtain financing. Buy to let investment has become less attractive in the UK in recent years. Property prices have increased, while the average UK rental yield is now just 3.53%. Tax rules have also become less favourable for residential property investors who own the property in their own name rather than through a limited company. The 3% stamp duty surcharge introduced in 2016 has further squeezed potential buy-to-let returns. Commercial property investment may have higher initial costs, such as building purchase price and refurbishment costs, but the overall returns will be much higher than a residential buy-to-let property. Commercial property investors usually deal with companies rather than individual tenants, which means that many common issues associated with renting out residential properties do not apply. Commercial leases are contractual, giving them more protection under the law than residential tenancy agreements. In most cases, the stamp duty is higher on residential and commercial properties. A buy-to-let landlord will also pay an additional 3% levy on top of the normal charge. Commercial property tenants are responsible for property maintenance and repair, saving time and money for commercial property investors. This makes commercial property investment a good option to deliver a stable investment with minimal input. How much do I need to know before buying commercial property? Before buying commercial property, it is worth considering the following key factors: – Decide why you want to invest in commercial property – Establish financing options early on – Talk through the process and get professional advice – Research location and review the UK hot spots – Do relevant industry analysis – Book in time to speak to a property tax expert How is commercial property taxed? Profit on commercial property is taxed at the same rate as income tax or corporation tax. This is dependent on how you structure your property investments. Some commercial property landlords invest in their own name and will be taxed at 0%, 20% (basic taxpayers), 40% (high-rate taxpayers) and 45% (additional-rate taxpayers), depending on their income levels. If a commercial property investor holds a property inside a limited company, the corporation tax is currently 17%. The impact of Stamp Duty Land Tax (SDLT) needs to be factored in when considering the taxation of profits made from commercial property investment. There are legitimate ways to avoid Capital Gains Tax on UK property but speak to a property tax expert. The HMRC has laid out clear guidelines on different stamp duty rates in place for non-residential and mixed-use. There are also some deductions and relief available from the HMRC for commercial property investors. Is now a good time to buy commercial property? Many retail businesses were forced to close during the first Covid-19 lockdown in the UK. This likely led to a fall in rental income for many commercial property investors. At the same time, essential retailers such as convenience stores saw sharp increases in sales. This made them a popular choice for commercial property investors in the UK, as they were seen as ‘pandemic proof’. Industry sources have estimated that retail pop-up now represents a £1 billion industry in the UK, while there has been a rise in demand during 2020 for logistics and warehousing commercial units nationwide. The boom in demand for warehousing space from E-commerce has led to estimates of demand increasing to 92 million square feet of commercial warehousing space required by 2024. Some high street retailers such as John Lewis have responded resiliently to Covid-19 and the negative impact on footfall in UK shopping centres. They are currently looking to turn surplus stores into affordable housing and rent unused storage facilities into gyms and housing projects. This mixed-use change bodes well for commercial property. Industrial properties are experiencing higher demand. Properties that had before Covid-19 been mainly for industrial use with low rents have become important in the development of the online retail sector since 2020. They offer well-located warehouse space to store, arrange and dispatch products across the country. Commercial property investment remains a good opportunity, and now is a good time depending on the type of commercial property being invested in. Retail units are slowing down, good quality warehousing is hugely popular, and offices will require prudent selection during 2021 to ensure a reasonable return for UK commercial property investors. Hidden Value Added Tax (VAT) charge when buying a commercial building One area that you need to be careful of is the potential VAT on buying a building. If you were not careful and purchased a building for £400,000, then you could face a nasty surprise of a VAT charge of £80,000. This would easily wipe out the tax savings achieved from the above. As we can see from the other article that the VAT charge when buying a commercial building may be removed if you are converting it into a residential one. The form that needs to be completed by the seller is called a 1614D. This form disapplies the VAT charge and saves you the £80,000 VAT bill. There are conditions to be met before the 1614D form may be applied. Ensure you take professional advice on this point. How is commercial property taxed? Profit on either residential or commercial property is taxed at the same rate as income tax or corporation tax. This is dependent on how you choose to structure your property investments. Some people may invest in property in their own name and will be taxed at 0%, 20% (basic rate taxpayers), 40% (high rate taxpayers) or 45% (additional rate taxpayers) depending on their income levels, as shown by HMRC’s website. At the time of writing, income tax is charged as follows: – 0% for income up to £12,500 – 20% for income from £12,500 to £50,000 – 40% for income from £50,000 to £150,000 – 45% for income over £150,000 If you hold a property inside a limited company the corporation tax rate is currently 19%. We know from HMRC’s website that the corporation tax rates will drop to 17% from April 2020. We are ignoring the fact that people may have mortgages on their residential property investments. As shown in our article, the Section 24 mortgage interest relief cap will damage residential property investors’ tax status. Capital allowances on commercial buildings help reduce tax It is also likely that commercial property investments will benefit more from Capital Allowances. These tax benefit costs are for the plant & machinery and Fixtures & fittings within a property. These items will typically be valued by surveying companies such as Six Forward. The value of items found will be used to generate a capital allowances claim. Depending on how you purchased the property, these items will reduce your income or corporation tax. It is possible to claim the full cost of plant & machinery and Fixtures & fittings within a property within the year of acquisition. This is because HMRC provides investors with an Annual Investment Allowance (AIA). You can offset the lower of the plant & machinery and Fixtures & fittings and the annual investment allowance as shown below. You cannot claim capital allowances on (as shown on HMRC’s website): – things you lease – you must have a purchase lease agreement and not an operating lease – buildings, including doors, gates, shutters, mains water and gas systems – land and structures (bridges, roads, docks) – items used for business entertainment What specific items are allowed to be used as capital allowances within commercial properties? Integral features are: – lifts, escalators and moving walkways – space and water heating systems – air-conditioning and air-cooling systems – hot and cold water systems (but not toilet and kitchen facilities) – electrical systems, including lighting systems – external solar shading Fixtures – fitted kitchens – bathroom suites – fire alarm and CCTV systems At the time of writing, you could get a £1m tax benefit from the Annual Investment Allowance. More details about making a capital allowance claims to save property tax may be found on our website. In addition to the potential capital allowances claims it is also possible to make an enhanced claim on the structures and buildings allowance.