UK landlords weigh shift into commercial property for higher yields

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UK landlords shift to commercial property

Highlights

UK landlords are increasingly considering commercial property, attracted by higher yields such as 6.6 percent on a £1.1 million Sunderland site leased to Booker.
Yields for commercial properties sold at auction average 8.9 percent versus 7.2 percent for residential buy-to-let in early 2024, though commercial yields exclude extra costs.
Risks for commercial investors include protracted vacancies, higher finance costs, and price discovery challenges due to just 9,080 non-residential deals compared to 96,250 residential transactions in August.

Commercial property draws interest as residential returns tighten

As reported by Financial Times, investors with buy-to-let backgrounds are increasingly examining commercial assets as an alternative to residential property, attracted by stronger income potential and different tax treatment.

London-based investor Samir Mahdi recently studied a 40,000 sq ft industrial site in Sunderland let to Tesco-owned wholesaler Booker, with eight years remaining on the lease and annual rent of £78,000, producing a 6.6 per cent yield after stamp duty and other purchase costs on a £1.1 million price. Unlike a typical residential purchase, however, the deal required deeper analysis of the tenant, local demand and the building's long-term usability.

Mahdi says commercial investing is more strategic because investors must assess factors such as building condition, lease structures and the local economy. In his case, that included checking for signs of tenant demand, speaking to local agents, assessing prevailing lease lengths and modelling what happens if the tenant leaves when the lease expires.

That work can extend to estimating business rates liabilities on vacant space, the cost of redeveloping an ageing building and the likelihood of securing a change of use from local planners. Even where local supply appears limited, investors still have to consider the risk that new competing space could come to market nearby.

Market participants say mixed-use properties, such as a flat above a shop, are often the first step for landlords moving over from residential. Louis Theed of Propp says these assets can offer lower borrowing costs than fully commercial property while diversifying rental income, and they also benefit from lower non-residential stamp duty rates and no 5 per cent second-home surcharge.

Commercial borrowing still tends to cost more than buy-to-let finance, but brokers say the pricing gap has narrowed since interest rates began rising in the latest cycle. Theed says the best semi-commercial deals are now about one percentage point more expensive than the best buy-to-let loans, compared with a spread of roughly two percentage points in 2021.

Higher income potential comes with vacancy and execution risks

Yields remain a major attraction. Average gross buy-to-let yields in the first three months of the year stand at 7.2 per cent, according to UK Finance, while commercial properties sold at auction average 8.9 per cent, according to Acuitus, although that measure excludes purchase and other costs.

Investors and advisers caution that headline yields can quickly unravel if a tenant leaves. David Little, a chartered financial planner at Evelyn Partners, says a 7 or 8 per cent yield can look compelling until income stops and the landlord is still paying rates, insurance and maintenance during a potentially long vacancy period.

That risk is especially important for smaller office investors, who may be concentrated in one building, one location and one occupier. Little says covenant strength and building quality therefore become central to due diligence, particularly in a market where finding replacement tenants for shops, offices or warehouses can take far longer than in residential lettings.

Price discovery is another challenge because the commercial market is far less liquid. HMRC recorded 96,250 residential transactions in August versus 9,080 non-residential deals, leaving fewer comparable transactions for investors trying to assess fair value, according to chartered surveyor Josh Garside.

Advisers say local knowledge and relationships are often decisive, particularly in auctions and off-market deals. Chris Kempton, who runs a commercial property portfolio worth more than £10 million from Kent for his family, says information gathered from local surveyors and agents can provide an advantage in a relationship-driven market, even though deep-pocketed buyers can still push prices beyond expectations.

Bridging finance can add another layer of risk when banks are reluctant to lend on vacant assets. Mortgage broker Paul Butlin cites a former client who bought former Royal Bank of Scotland premises with flats above in Stafford using a bridging loan costing 1 per cent a month; while the flats generate £65,000 a year, a delayed planning decision on a new tenant for the commercial space continues to raise costs. Even so, investors willing to reposition untenanted properties may still find scope to unlock value.

In our earlier article, we covered how Equites Property Fund increased its interim distribution after accelerating its exit from the UK and selling the £200.5 million Aviva logistics portfolio. We noted that the disposal reduced leverage and freed up liquidity, with the group redirecting capital into South African logistics assets where fundamentals such as lower vacancies and rental growth are more supportive.

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