A guide to becoming a commercial landlord
Residential property has been popular with investors for the last 20 years, but landlords are now increasingly expanding into commercial property. Property expert Kate Faulkner explores the potential benefits and key things to know about this specialist market.
It's a common misconception that you need a lot of capital to invest in commercial premises and that it's only for large-scale and institutional investors. Of course, the bigger the building, the more it's going to cost, but there are plenty of smaller retail and office premises that can cost no more to acquire than residential property.
The commercial market experiences ups and downs, just as every market does, but with the potential to negotiate a lease of ten years or more, once you've got the right tenant and right management team in place it can be a relatively straightforward and long-term, mutually beneficial relationship.
- What are the key benefits of becoming a commercial landlord?
- What are the downsides of letting commercial property?
- Commercial tenancy agreement
- What is a landlord responsible for in a commercial lease?
- What is a commercial tenant responsible for?
- Commercial property Landlord and Tenant Act 1954 (LTA)
- What rights does a commercial tenant have?
- How to evict a commercial tenant
- Specialist insurance
- How to let commercial premises: checklist
As with investing in residential buy to let, the 'right' location depends on the type of tenant you want to attract. Remember that what you buy and where you buy it can make or break the success of the investment, so make sure you carry out lots of research before moving ahead with a purchase.
Traditionally, most commercial landlords choose premises in locations where there's high footfall and if you want tenants that operate shops, cafes, bars, etc. then a city centre or busy high street are obviously ideal.
However, bear in mind that there are lots of commercial tenants these days whose businesses are largely conducted online and they often prefer to be outside cities and even in rural locations. That's because they tend to get more space for their money, which is particularly useful if their business requires storage, e.g. events companies.
A specialist market
Commercial investment has a different legal and financial framework to residential property, so it's important to take advice from professional mortgage lenders, solicitors and agents that specialise in this market. You'll also need specialist insurance to make sure you and your building are properly covered for the cost of damage and protected against liability claims.
What are the key benefits of becoming a commercial landlord?
Commercial property is an attractive option for anyone looking for a long-term investment and is particularly popular with those who already have an investment portfolio and want to spread their risk. If all your money is in one place and that market experiences a downturn, you could quickly find yourself in financial difficulty. But if you invest in a diverse range of assets - e.g. commercial premises, shares, annuities and residential property - it can put you in a much more secure overall position.
- It can deliver steady, long-term income
- Returns can be higher than for many other investments
- It's relatively low risk
This is probably the main reason people choose commercial property. For most landlords, the ideal tenant is one who looks after a property well and stays there as long as possible, paying a good market rent. However, as a residential landlord letting property on an Assured Shorthold Tenancy agreement (AST), the tenant only has to commit to a minimum of 6 months. While most do stay for longer than that - with an average residential tenancy length in England, according to the 2017-2018 English Housing Survey, of around 4 years - commercial leases are generally for at least 3 years and commonly 10 or 15.
And, given that termination of the lease is more-or-less up to the tenant after the fixed term expires, as long as the tenant is happy with the premises, a commercial investment could deliver a steady stream of income for decades.
The yield on commercial rentals tends to be higher than for residential tenancies and has been relatively stable since 2015, at around 5%. And, compared to other assets classes, overall returns are high. Between 2000 and 2018, commercial property returned 308%, compared to 209% for the FTSE 100, according to research from the CEBR.
Also, unlike residential tenancies, commercial leases usually specify that rent can only be adjusted upwards. That means even if market prices are falling, you don't need to reduce the amount of rent you charge.
Probably the biggest risk to residential landlords is having void periods, where a property stands empty with no rental income. With an average commercial lease length of around seven years, void periods are not something to worry about day-to-day. If it's possible to let a building to two or more tenants, that reduces the risk further, as you're far less likely to have a completely vacant building at any point.
Returns are also more secure than with shares, for example, as rental income is guaranteed at a set level for an extended period of time. And the risk of the tenant defaulting is much lower than with residential properties.
What are the downsides of letting commercial property?
In terms of downsides, there are the same ones that apply to all property investment:
- You need to be prepared to hold for the long term in order to see capital growth
- You're tying up your money - i.e. you can't necessarily get capital out of the property if you suddenly want or need to
- There may be a market crash or sudden oversupply of that type of premises, resulting in a drop in value and/or long void periods
- It will require ongoing capital input for maintenance and repairs
- Unless you are a property professional yourself, you will almost certainly have the ongoing cost of paying for property management
But most of these are things you can overcome by taking expert advice and planning, buying and managing the let in the right way.
One big thing to bear in mind is that, once you've agreed a tenancy and signed a lease, you cannot evict the tenant and end the tenancy without a very good reason. (See What rights does a commercial tenant have? and How to evict a commercial tenant.) So you need to be very certain that you are happy with the incoming tenant before you make a legal commitment.
Commercial tenancy agreement
When you let a commercial property, you have certain obligations and responsibilities with respect to both the property and your tenant. Some are statutory (set in law), while others will be stipulated in the lease. As with all tenancy agreements, amendments or additional clauses inserted by either party cannot breach any rights or responsibilities stated in law. So, before you sign a commercial lease or tenancy agreement, you should consult a specialist legal representative to make sure the terms are (a) reasonable and (b) legally valid.
The lease will lay out:
- The length of the lease term, including any break clause
- The landlord's rights and responsibilities towards the tenant
- Who is responsible for which aspects of maintenance and repair
- Whether the tenant can assign or sub-let the property
- Service charges
- Timescales for rent reviews
Fundamentally, the lease is there to protect both parties and should help in potential disputes by clarifying what was agreed at the outset.
What is a landlord responsible for in a commercial lease?
The exact responsibilities of each party are likely to vary from one lease to another, so it's vital you thoroughly check the terms and make sure you understand what you're committing to before signing.
As a general rule, the landlord is responsible for the external and common parts of the property, as defined in the lease, including any fixtures and fittings:
- General upkeep and maintenance
- Making repairs when necessary
- Gas safety - including ensuring there is an annual inspection, the Gas Safety Certificate is obtained and a copy given to the tenant
- Electrical safety - advice from the Electrical Safety Council is that a registered electrical safety engineer should inspect commercial properties every five years and the landlord should obtain an Electrical Condition Report (EICR)
- Fire safety - including installing, checking and maintaining equipment, such as the fire alarm system and extinguishers
- Other general health and safety requirements in the communal areas, including:
- Water supply - including making legionella checks
Commercial landlords must also take reasonable steps to make sure their tenant complies with their own health and safety responsibilities.
What is a commercial tenant responsible for?
In terms of health and safety, the tenant is generally responsible for the interior of the specific premises they are renting. Their specific responsibilities should be detailed in the lease.
Tenants must carry out a risk assessment and take any action required to remove hazards. In the workplace, they must also provide:
- A reasonable temperature
- Sufficient space
- Toilets and washing facilities
- Drinking water
- Safe equipment (including making required gas and electrical safety checks on their own equipment)
If the tenant fails to comply, they can be prosecuted under the Health and Safety at Work etc. Act 1974.
Commercial property Landlord and Tenant Act 1954 (LTA)
One of the main functions of the LTA is to protect commercial tenants and ensure that successful businesses can carry on trading from the premises with confidence, without the worry that they might be evicted. So it gives tenants significant rights to continue to occupy the premises and tightly regulates how a commercial lease can be terminated.
What rights does a commercial tenant have?
Under the LTA, tenants have two important rights:
- The landlord can't simply take possession once the lease has expired. Instead, assuming the tenant keeps paying rent, the lease automatically continues until the landlord terminates it under one of the specified methods required under the LTA. (See section below.)
- When the lease expires, the commercial tenant has the legal right to apply to the court for renewal - i.e. to begin a new lease term.
In short, once a lease has been granted, the tenant has the right to continue to occupy the premises unless they breach the terms, such as by defaulting on the rent, or the landlord has a valid legal reason to evict them.
How to evict a commercial tenant
If a landlord wants to terminate a commercial lease, essentially evicting the tenant, they must have very good reason.
- During the lease term: The landlord can only end a lease early if the tenant fails to pay rent or meet other lease obligations. If the lease includes a 'forfeiture clause' (giving the landlord the right to enter the property, change the locks and terminate the lease), that can be used in this situation, but be aware that the tenant could challenge this in court and may be allowed to stay in the property.
- At the end of the lease term: The landlord must serve a Section 25 Notice on the tenant
between 12 and 6 months before the termination date specified in the lease. The Notice must state the grounds on
which the landlord opposes the granting of a new tenancy - and these grounds are deliberately limited to make sure
landlords only evict tenants for a substantial reason, including:
- Tenant's failure to make repairs
- A persistent delay in paying rent
- Substantial breaches of other obligations
- Possession is required for disposal (sale) or letting
- Reconstruction or demolition of the property
- The landlord is providing alternative suitable accommodation
- The landlord intends to occupy the premises for their own commercial purposes
Letting commercial premises has specific risks, so it's important you take out an appropriate specialist insurance policy.
Direct Line's Commercial Landlord Insurance provides a range of options, so can be tailored to each landlord's requirements, including:
- Buildings insurance
- New-for-old contents cover
- Boiler repair or replacement following breakdown (excluding damage caused by wear and tear)
- Public liability cover
- Relocation of tenants following an insured event (e.g. fire or flood)
- Malicious damage by tenants
- Loss of rent
How to let commercial premises: checklist
- Engage a specialist letting and managing agent
- Use a specialist commercial property solicitor
- Ensure you have consent to let from your mortgage lender
- Carry out due diligence on the prospective tenant
- Carefully consider lease terms, including:
- How will the property be used - could there be any planning permission issues?
- Length of the lease term
- Do you or the tenant want to insert a break clause?
- Responsibility for maintenance and decoration
- Responsibility for insurance
- Is any work required before the tenant moves in? You may need to instruct a surveyor to check how the value or structural integrity of the building might be affected
- Rent reviews
- Will you allow the tenant to assign or sub-let?
- Who is paying surveyor and legal fees relating to the lease?
- Consider specialist commercial landlord insurance
- Make sure you have carried out a risk assessment and met your health and safety obligations
- Ensure you have a valid EPC and it's fixed to the building