Assessing the risks

Commercial Market & Repossessions.

The commercial property investment market remains buoyant and has been one of the best performing asset classes in recent years. However, increasingly evident are the pressures associated with rising interest rates, rent increases and landlords making inadequate preparations before investing.

Increasing diligence over the Landlords & Tenants Act 1954 should help ensure that the risks and responsibilities associated with becoming a commercial investment landlord are thoroughly researched before signing on the dotted line. Why then, are commercial repossessions on the rise?

Commercial investment

Commercial investment deals typically fall into either a semi-commercial – for example, a residential flat above a shop – or true commercial category – for example, a factory – but the principles behind assessing the viability of the deal are the same.

Investments in commercial property should be self-servicing, but part of the repossession issue lies in poor account being made of rental voids, short commercial leases, tenant quality, refurbishment scenarios and interest rate volatility. Additionally, getting the correct qualified legal advice and correctly interpreting valuers’ comments is key to a successful investment.

Taking a semi-commercial property, for example, it is likely that a flat above a shop would be let on an assured shorthold tenancy basis, typically six months to a year. In these situations it is usually easy to find substitute tenants meaning fewer and shorter rental voids.

The trend for leases on true commercial properties is to shorten them, and this brings inherent risk as well as a significant increase in the reliance on remote assets and other independent income to demonstrate fallback serviceability to a lender.

Many landlords and tenants have viewed the insistence by lenders on minimum commercial lease terms of, say, 10 years as perhaps unreasonable. However the benefits of longer leases for both parties are many. Continuity of income, clear definition of rent required and timing of rent review, greater ability to monitor and enforce the repairing and insuring obligations of the tenant are just a few.

Most commercial lenders will insist on a minimum lease outstanding of at least two years, and dependent on the quality of the lease document and tenant, look for rental income cover of between 100-150 per cent of the annual mortgage repayments. The lower the cover, the greater the risk to the landlord.

Some landlords really don’t realise that even after finding a suitable tenant, it can still take a few months to iron out contractual issues between the solicitors for the landlord and tenant.

Landlords often take inadequate steps to ensure the quality of their tenants, even though there is a plethora of business and credit-related searches available at minimal cost. In the event of non-payment, rights are still stacked in favour of the tenant and in addition to lost rent, the landlord is likely to bear the additional litigious costs of removal.

Making assumptions

Often assumptions are made that changing the property’s use will be automatically granted by local authorities, for example, office to shop or shop to cafe. Delays in getting new tenants can be caused by having to wait for permissions to be formalised, and situations do arise where tenants are forced to stop trading due to landlords not holding relevant insurance and planning certification. No trade means no rent, often with nil cost implication or liability on the tenant’s behalf.

Refurbishment and restoration are key areas where mistakes can be made. The advent of short leases, with watered down repairing and insuring obligations, puts more onus on the landlord to remedy situations. Structural repairs are more prevalent with industrial and manufacturing tenants, and disputes arise over schedules of conditions. So-called dilapidation and service charge issues often end up in the hands of solicitors, representing yet more unbudgeted costs and obvious delays for the landlord securing new tenants.

Properties are frequently purchased speculatively at auction by investors who are often unrealistic when considering the timescales for major refurbishment. Basic attention to building costs, fixed price contracts, appropriate detailed planning consents and the practicality of conversion are missed. Cost and construction overruns often feature, and if the investor does not have sufficient financial means, the venture fails before would-be tenants get anywhere near occupancy.

Impact of rates

Looking toward the impact of interest rates, the market has witnessed five Base Rate rises so far this year, with predictions of a further hike or two during the remainder of 2007.

Commercial lease documents tend to feature staged rent rises normally subject to fixed time periods, typically at renewal or every two, three or five years. With so many interest rate rises within the last six months, it is landlords bearing the full brunt as they are unable to pass on the increased debt servicing cost to the tenant. Each 0.25 per cent rise on an average £500,000 mortgage equates to an additional £1,250.00 required to cover the debt repayments.

Fixed rates are in vogue, but due to forecast volatility in the short to medium term, lenders are reluctant to offer a fixed option much beyond three and five years. Forward swap rates have yet to peak, and Bank Base Rate is likely to follow the upward trend.

Interest only commercial mortgages are being sought more often, but landlords wrongly assume that the mortgage coverage requirements will be relaxed and therefore the debt will be easier to service. Heavy reliance is placed on capital asset appreciation, as the eventual exit route from the mortgage, but the reality is that commercial investment property is prone to much slower increments in value than residential stock.

Ignorance no excuse

Ignorance is no excuse for getting it wrong. But inexperienced landlords often turn to local legal practices and conveyancers with insufficient experience of commercial conveyancing or commercial litigation. Reasons for this tend to centre on using small, local firms and perceived cost savings which in reality often backfire when services are further required. Small practices are not typically geared toward speedy resolution of non-paying tenants, issues with covenant or schedule enforcements and easements. This arbitrary process undertaken by some ill-equipped local practices protracts resolution of disputes, hanging the landlord out to dry and unable to collect rent in a timely and efficient manner.

Valuation reports

Perhaps another area to examine is the implications of valuation reports. Commercial and semi-commercial property appraisals are typically more involved and highly detailed when compared to a standard residential property survey. Reference is normally made to MV1/Retail Open Market Valuation, and MV2, value with key assumptions. Again, subject to location, there can be a huge variation between these figures, often ignored by the investor.

Where rent yield is perceived to be high, some investors are prepared to pay over the true market value when compared to the commercial valuation. What is often missed is the fact that the valuer usually quotes comparable properties to substantiate their findings. The lender will always advance monies based on the lower end of the market value or purchase price. Subject to substantiated independent findings, the surveyor is open to challenge, but they are rarely too far off beam with their ‘true’ values. However, some investors will still borrow additional monies from other sources and be willing to pay the premium or difference between true value and actual purchase price. In this situation, the investor must check that the rental income will be sufficient to service all debt.

A surveyor will make reference to any general areas of concern or that require further investigation specific to the structural integrity of the building. Obvious examples are damp and timber issues and cracks within the property. If causes are not thoroughly investigated at the outset, the lender security can be compromised and the landlord’s asset will depreciate quickly. Arguably the tenant may have grounds for non-payment of rent if stock is spoiled due to structural problems with the property.

Where an existing tenancy is in place, the valuer will normally require copies of the lease and make a number of observations as to the obligations of the landlord, including protected tenants’ rights, length of term remaining and, in some situations, the actual validity of the lease. Surveyors do also make specific comment on market rent, again often with comparables, and may give a detailed assessment of future rises. This information is vital in assessing the viability of the investment asset’s performance and the serviceability of the debt.

Interest rate rises, currency fluctuation, manufactured product or service produced market supply and demand also affect the commercial owner occupier and many of the points above can be applied equally to the commercial owner occupier sector.

In summary, there are many reasons why commercial property repossessions are increasing and proper assessment of the risks involved in commercial property investment should always be taken at the outset of the venture.