Many residential investors have built sizable portfolios with only moderate debt and are now looking at the possibility of acquiring commercial property to spice up their returns.

Commercial property investment does indeed have several attractions; Gross yields are commonly 12%, and we have seen yields on purchase price of up to 25% per annum ! Lease agreements tend to be much longer than the 6 or 12 months commonly associated with residential property. And for the most part, you have much lower obligations to maintain the property than for your residential lets. Leases are often known as “FRI” ( Full Repairing and Insuring ) with the onus placed on the tenant for these obligations.

So why don’t more people invest in commercial property ? Well the general “mystery” and “aura” surrounding commercial property and business generally is the main deterrent for most. And certainly, you have to be careful. The dynamics around businesses are quite different to those around individuals.

Some key points to think about with commercial property are as follows:

• Transaction sizes. Generally they are much larger, so if anything goes wrong, the numbers are more scary. So try to start of with something of reasonable size – perhaps a shop or a small commercial unit for £100,000 or perhaps £200,000.

• Tenant reliance – you may well be reliant on just one tenant, or a few tenants. If you have voids, you have a much larger amount to cover on finance each month than on residential funding. So try to spread your tenant risk. For example, you might buy a shop with a flat above to get two rental streams, or you might buy a commercial unit that has been split into smaller units within it.

• Fluctuations in value. The commercial market has tended to be much more volatile than residential values. Recent reductions in values of as much as 50% have been seen compared to, say 15% in mainstream residential. (Some apartments, of course, have lost much more value ). It seems possible that in buying at the present time, you are purchasing at the bottom of the market. This is not guaranteed however ! Make sure you get opinions from local commercial valuers before buying. It can be useful to develop a relationship with one firm of valuers and if necessary pay them for their advice before proceeding.

• “Tenant Covenant” – It can be more difficult to assess the financial stability of your business tenants, and therefore their ability to pay their rents. However, with good advice, a reasonable assessment can still be made and appropriate decisions made. Look at how long the tenant has been trading – many years, or is the business start up ? Can they supply trading accounts which show a profit ? Have they been paying rent previously and for how much and how long ?

• Building type & location – is it a modern unit in a good location, with good access for delivery vehicles. Or is it an old unit in a dying part of town ?

• The economy. A further downturn may well impact more heavily on tenant demand and commercial property prices than residential values.

These points are a few of the things that you should look into. Consult your professional advisors – accountants and solicitors. Make sure your solicitor particularly regularly deals with commercial property !

As regards borrowing for commercial property – several lenders will provide commercial mortgages for you. For the most part, 70% funding is the upper limit, but additionally, the lenders will want to know that you have considered all the above points before proceeding. They will also want to know that if you have voids, you can continue to service the debt, so having some surplus income from other property, or a good spread of tenants within your purchase is important.

They also assume that interest rates are going to go up at some point. They therefore use a an interest rate of approximately 7% to “stress” the affordability of you loan funding, and typically want 140% interest cover from rents for your loan interest, using that 7% figure. Their actual rate charged will be much less than this – typically around 4% per annum.

Needless to say, most mainstream lenders won’t fund empty commercial property. If you are getting a good deal because a property is empty, you can probably fund 65% of the cost from a bridging company, who will charge you high rates. You can then move the lending to a mainstream lender when the property is tenanted. However, make very sure that you know what the state of the local rental market is like before committing !

So – there are lots of opportunities and benefits associated with commercial, and those in the know certainly seem to be taking advantage of the market at the moment. But there are risks as well. Our advice – buy some commercial, but start small with good advisors around you. Gradual diversification of your portfolio will eventually accelerate your yields and provide some excellent opportunities for future capital growth.