Picture this: You find a brilliant residential property… but it’s got a commercial unit in it. So then you worry, how do you analyse the commercial element?
Is this you? You’ve been out looking for the right residential investment that stacks… but the only property that you can find has a commercial element in it (which makes it a mixed-use property) and you have no idea how to analyse it, after all commercial property is dying, right? And why would you take on that risk?
Don’t worry, this article has you covered.
Commercial property, for the most part, is analysed very differently to residential. Mainly because commercial units are valued by capitalising the rental income. By capitalising, I mean using an appropriate yield and multiplying this by the anticipated annual rent, to get the value of the commercial unit.
Sounds complicated, but it doesn’t have to be, I’ll break it down here.
Firstly, commercial units within a building are defined predominantly as property that cannot be lived in. I’m talking about retail, office, restaurant or takeaways, industrial (storage and warehousing) those kinds of properties. Usually, when it's mixed in with residential, you would be looking at office or retail property.
There are pros and cons to incorporating a commercial unit. The pros are that it diversifies your investment. Commercial tenants are more likely to take longer term leases, pay rent quarterly plus service charges, to help maintain the building as well as a share of the insurance. Commercial tenants are also more likely to have higher deposits in place, which means if they default on their rent or other outgoings, you have a back stop available.
The cons of commercial units are that they typically take longer to let than a residential unit and void periods can be costly, as you, as the landlord could be responsible for paying business rates and service charges until a new tenant is found.
The other consideration with a mixed-use property is tenant mix. While landlords usually opt to get the easiest possible tenant into a commercial space, they forget to think about the management headache this may cause. For example, tenants such as takeaways, may cause nuisance with late night deliveries or food smells coming from the unit, which residential tenants could complain about. If residential tenants could complain, then this will also hinder the availability of mortgage products… lenders feel that if it’s a problem for residents who live there, then the residential units may have a lower value.
Therefore, you want to look for properties where the commercial tenants are beneficial to the residential tenants. Think coffee shops, convenience stores, launderettes, gyms, nurseries, etc. Or if the unit is vacant, contact local businesses who may want to take this space, the benefit to that business is that there would already be potential customers in the building. Having a ‘useful’ commercial tenant would be a major bonus to residential tenants, who are often looking for good amenities within a building.
Start by considering location and accessibility. While residential property has a wider range of areas it will be suitable in, commercial property needs to be in the right place. The location should be accessible to the people who would work at the property, as well as their customers. Accessible could mean either by walking, by car or public transport links. Next up, do a quick market analysis. What is the local demographic of the area and what services would be well placed here? I know it's rather morbid, but there is a reason you find multiple funeral directors in certain locations. Whenever you’re looking at a mixed-use property to buy, think about the potential tenants that would fit in the space. Look for similar type units in other locations and see what tenants are in that space, use this as an idea for what your space could offer.
A myth I want to bust, is that you can’t have multiples of the same types of tenants in an area. For example, you may baulk if you see two coffee shops side by side. However, in practice this can be a great thing, customers like options. Not too many options; a row of five coffee shops may be overkill and all five businesses will suffer. But say you have a Starbucks next to a local independent, you’re giving customers choice; Starbucks offers familiarity, whereas the local independent offers the customer a chance to discover local, more specialised coffees and treats to go with it. Using your previous assessment of what type of tenant would suit the space, see if there is any local competition, if there is only one other offering of that type of tenant and that offering is doing well, a second offering may enhance the area.
At this point you should have decided whether a commercial tenant would actually want the property. Now it’s time to do a financial assessment and see if the property price stacks.
As a surveyor, I would be going into the unit and measuring up, then finding comparable transactions and doing a rental analysis. Next, I’d look at sales comparables, to see what yields similar commercial properties are transacting at and finally, I would speak to local agents, to find out how long units are taking to let.
If you are thinking, “Natasha, I haven’t got time for all of this research,” I’ll make it a little bit simpler.
Get the area (size) of the commercial unit from the property details. Or failing that, go on the government’s Valuation Office Agency (VOA) website and use their floor areas (please note, the VOA is notorious for under or over measuring, so don’t rely too heavily on this).
Then check Rightmove commercial to see what properties are listed for rent nearby. Pick the closest property to let. Phone the agent marketing that property, explaining that you are looking to buy a property of a certain size nearby. Ask them roughly how long it would take to let the property and what rent you would expect to achieve per annum, in a worst-case scenario.
Now, you need to find the appropriate yield for this transaction, so that you can come up with an approximate value of the property.
The easiest way of doing this, is to use an online database such as Edozo or EIG Property Auctions, look for recently sold commercial property in the local area and what yield they sold at (this will require the building to have been tenanted, for the yield to appear next to the sales comparable). If you haven’t got access to these databases, phone a local commercial agent and ask what yields commercial properties are transacting for in the local area. If you are not in a prime location, like central London or Edinburgh and the tenant is a big covenant, like Tesco, I would expect the yield to be somewhere between 7–12%.
Using this information, you can calculate a loose value for the commercial.
Find your yield multiplier. Using the comparable yield, add 0.5% to it for risk, i.e., if your comparable yield is 8%, I would add 0.5% to this to get to 8.5%, which is the yield you will use to value the property.
Next, calculate the multiplier by dividing 100 by the higher yield. In my example, this would be 100 divided by 8.5, which equals 11.76 – meaning 11.76 would be the multiplier.
Now multiply your estimated annual rent by the multiplier, to calculate a corresponding value. If my estimated annual rent was £20,000, my calculation would be £20,000 times 11.76, which equals £235,200. This would be the approximate value of the commercial element.
If the commercial element was vacant, I would then want to deduct the cost of a void period from this amount. This would include letting and legal fees (which is about 15% of the first years’ rent. In my example, this would be £3,000) and the rent for the time it would take to let the property. If the agent had said it could take six months to let the property and my annual rent was £20,000, this would be a £10,000 deduction. Therefore, the value of the commercial element, if it was vacant, would be somewhere closer to £220,000.
If you need to renovate the commercial element or do any upgrade works, you would also discount this from the purchase price.
And of course, without teaching you ‘how to suck eggs’, you would offer to buy at a price lower than the estimated value.
Now, you have all the information you need to understand whether the commercial element of the property is a good deal. You’ll know whether the commercial property would let and to which tenant demographic, as well as the value of the property.
The final decision that you have to make is, does this property fit in with your investment goals? That final question is something only you can answer.
If this article has got you interested in taking your commercial property journey further, you can access my step-by-step Commercial Property Investment strategy, for free, by scanning this QR code or visiting, https://ncrealestate.co.uk/commercial-strategy-flowchart
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