If you're looking at commercial property as an investment, buying something with a tenant already in place can be attractive.
You've potentially got rental income coming in from day one.
But one thing I'd say straight away is:
Don't buy a commercial property just because the yield looks good.
When we're looking at an investment for a client, we're really looking at four things:
The tenant.
The lease.
The rent.
The property.
The yield helps bring those things together, but it doesn't tell you the whole story.
You're Buying an Income Stream
If you buy a vacant commercial property, you're buying the bricks and mortar and taking on the job of finding a tenant.
Buy one with a sitting tenant and you're also buying an existing income stream.
That can make the property attractive to an investor, but you need to understand how secure that income actually is.
Take two shops both producing £30,000 a year.
One might be occupied by a large national company with ten years left on its lease.
The other might be occupied by a small independent business with two years remaining and a break option approaching.
Same rent.
Potentially very different investment.
Start With the Tenant
One of the first things I'd want to know is:
Who's actually paying the rent?
You'll often hear people in commercial property talk about a blue-chip covenant.
Generally, they're talking about a large, established organisation with strong financial standing.
But there are plenty of other perfectly good tenants.
You could have an established national operator, a strong regional company or a successful local Edinburgh business.
Equally, you might have a relatively new company without much trading history.
The important thing is to look behind the name.
How long have they been trading?
What's their financial position?
What's their payment history?
Which company is actually named on the lease?
Is there a guarantor?
Is there a rent deposit?
Ultimately you're trying to understand the strength of the tenant covenant and how confident you are in the rental income.
Then Look at the Lease
A strong tenant doesn't automatically mean a strong investment.
You need to understand the lease as well.
If somebody tells me there's a national tenant paying £30,000 a year, one of my next questions will be:
How long is left on the lease?
Ten years remaining with no immediate break is very different from ten years on paper with the tenant able to leave next year.
I'd want to understand:
Lease expiry
How much of the lease is actually left?
Break options
Can the tenant bring the lease to an end early?
Rent reviews
When is the next review and what does the lease say?
Passing rent
Is the current rent around market level, below it or above it?
Repairing obligations
Who's responsible for maintaining and repairing the property?
Guarantees and rent deposits
Is there any additional security behind the tenant's obligations?
These details can have a significant effect on how an investor views the property.
Understanding Yield
Yield is a useful starting point when you're comparing commercial investments.
At its simplest:
Annual Rent ÷ Purchase Price × 100 = Gross Yield
For example:
Annual rent: £20,000
Purchase price: £250,000
£20,000 ÷ £250,000 × 100 = 8% gross yield
Nice and straightforward.
But don't stop there.
Is a 10% Yield Better Than a 6% Yield?
Not necessarily.
This is probably one of the most important things to understand when you start looking at commercial investment property.
Imagine these two investments.
Property A
Purchase price: £500,000
Annual rent: £30,000
Gross yield: 6%
Large established national tenant.
10 years remaining on the lease.
No immediate break.
Property B
Purchase price: £300,000
Annual rent: £30,000
Gross yield: 10%
Smaller independent tenant.
2 years remaining on the lease.
Break option approaching.
Both properties produce exactly the same £30,000 annual rent.
One gives you a headline yield of 6%.
The other gives you 10%.
It would be very easy to look at that and say:
I'll take the 10%.
But why is somebody apparently offering you a higher return?
There may be more risk attached to that income.
That's the bit you need to understand.
Higher Yield Can Mean Higher Risk
It can seem backwards at first.
Why would an investor accept 5% or 6% when another property is showing 9% or 10%?
Because investors aren't simply buying rent.
They're pricing risk.
If you've got a good property in a strong location, let for a long period to a financially strong tenant, investors may be prepared to pay more for that income.
The higher purchase price means the yield comes down.
If the tenant is considered higher risk, the lease is getting short or there's an approaching break, an investor may only be interested at a lower purchase price.
That pushes the yield up.
So sometimes that attractive-looking higher yield is the market telling you:
There's more risk here.
That doesn't necessarily make it a bad investment.
You just need to understand what you're being paid to take on.
Don't Forget the Property
This is something I think investors sometimes overlook when they concentrate too much on the tenant.
You're still buying the building.
Ask yourself:
Would I still want to own this property if the current tenant left?
That's a really useful question.
I've lived in Edinburgh all my life and I've dealt with commercial property here for many years. Locations change, businesses change and tenants come and go.
So look at the underlying property.
Is it in a good location?
Is there demand for this type of space?
What's its condition?
Is the layout flexible?
Does it have parking, servicing or good access where that's important?
Could another type of business occupy it?
If the tenant left tomorrow, how easy would it be to find another one?
A strong covenant can make the income attractive today.
The underlying property helps protect you tomorrow.
Look at the Rent Too
The fact that a tenant is paying £30,000 doesn't necessarily mean the property is worth £30,000 a year on the open market.
The passing rent might be below market value.
It might be about right.
Or it could be above what you'd realistically achieve if the property became vacant.
That's important.
If you're buying an investment based on £30,000 of annual income and the property might only achieve £22,000 if it had to be re-let, you need to understand that before deciding what you're prepared to pay.
The opposite can also happen.
A tenant could be paying below the current market rent.
Again, that's something to investigate rather than simply looking at the headline yield.
Gross Yield Isn't the Same as Money in Your Pocket
An advertised gross yield is useful for comparing properties.
But it isn't necessarily your actual return.
Depending on the property and the deal, you've potentially got:
Purchase costs.
Legal and professional fees.
Management costs.
Repairs and capital expenditure.
Insurance costs that aren't recoverable.
Finance costs if you're borrowing.
Future letting fees.
Rent-free periods.
Periods where the property could be empty.
And tax.
So if somebody tells you a property is yielding 8%, understand exactly what that percentage represents.
What I'd Want to Know Before Buying
If somebody sent me an Edinburgh commercial investment tomorrow, I'd want answers to these questions:
Who is the tenant?
How strong is the covenant?
What's the annual rent?
What's the asking price?
How long is left on the lease?
Are there any break options?
When is the next rent review?
Is the passing rent in line with the market?
What are the repairing obligations?
What's the condition of the property?
What would it realistically rent for if it became vacant?
How easy would it be to find another tenant?
And then I'd come back to that question:
Would I still want to own the property without the current tenant?
The Yield Is Only Part of the Story
Buying a commercial property with a sitting tenant can provide an attractive income-producing investment.
But don't buy the percentage on the sales particulars.
Look at what's behind it.
The tenant.
The lease.
The rent.
The property.
A 10% yield isn't automatically better than 6%.
And a 6% yield isn't automatically safer just because the number is lower.
You need to understand why the market is pricing the investment at that level.
IME has been dealing with commercial property in Edinburgh since 1994.
If you're considering buying a commercial investment in Edinburgh, speak to us.
We'll help you look beyond the headline yield and understand the property, the tenancy and the local market behind the numbers.
Thinking about buying a commercial investment in Edinburgh? Speak to the IME team.
The examples above are illustrative only. Every commercial property investment is different. Appropriate professional, legal, financial and tax advice should be obtained before making an investment decision.
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