As part of the annual review we conducted three Q&As with leading industry experts about the commercial property market.
This is what they had to say…
The Accountant's View
“It makes sense from a tax perspective for buyers to investigate the commercial market more than they perhaps have done in the past.”
What are the main ways of holding commercial property?
The four main ways are to own it individually; via a limited company; through a limited liability partnership (LLP); or through a self-invested personal pension (SIPP). People tend not to hold property personally as they prefer the limited liability.
There are advantages to holding commercial property personally though, as it is very straight-forward for tax purposes. The income goes onto your tax return, and you pay capital gains tax when you sell the property. Your net rent after expenses is taxed at a marginal income tax rate, which is up to 45%. You pay a maximum 28% on any gains you get from the sale of the property.
What are the advantages of owning a commercial property through a company?
Corporate ownership works for people who are looking for a long-term structure – those looking at long-term ownership, family ownership, and the ability to buy new properties. It doesn’t work as well for those who just want to have a single property to hold then sell.
At first glance paying 20% corporation tax on the gain and the profit looks better than 45% on the income and 28% on the gain. However there is additional tax incurred taking the money out of the company structure.
Dividend tax rates are set around at a maximum of 37.5%. Broadly speaking you end up with an effective tax rate on income, as if you owned the property personally. The big disadvantage comes from the tax on the gain. If you paid corporation tax on the property sale through the company, and you pay tax on the dividend as well, you would pay a higher effective tax rate on the gain than had you owned the property personally.
So for many people an LLP structure may be best?
LLP rates reflect personal rates, so they are transparent for tax purposes. As well as the obvious advantages of limited liability, LLPs make it easier to manage joint relationships as an investor – people can come in and out of the LLP structure easily. If you own it personally anybody who comes into the ownership structure has to be entered on the land structure registry.
There are also no restrictions on distributions. You are taxed on the year of profit, but after that anyone can take it presuming the money is available. If you have 10 partners with 10% each and the asset is sold, your share of the gain is liable at the 28% rate – 28% of that 10%.
Given the strong performance of commercial property over the long term, what are the considerations about holding commercial property via a SIPP?
The pension side is interesting given the government’s changes to stamp duty and how that affects people relying on residential property for their pensions. That raises the opportunity for people to do this.
There are two restricting factors on pensions: annual restrictions and the lifetime allowance. Annually, you can only put in up to £40,000 a year gross. This is reduced to a maximum of £10,000 a year for those earning over £150,000 annually, a very small amount for those hoping to build up a pension pot and often not enough in its own right to buy a property.
However, you can borrow up to 50% of the value in your SIPP, but it is difficult to build up enough with the annual allowance of potentially only £10,000 to eventually buy a commercial property.
The second restriction is the lifetime allowance , which sets a total limit of how much you can put in your pension, which is going down to £1 million from April 2016. To take the example of buying a £700,000 property, if its value went up to £1.4 million you would be given an excess surcharge of 55% on the amount in excess of the £1 million allowance when you came to take pension benefits out of the fund. Therefore commercial SIPPs are useful for commercial properties within the individual’s lifetime allowances.
Some people have lifetime balances over £1 million as prior to 2012 it was possible to fix your allowance at a much larger figure, but all those possibilities are now gone. You are able to fit it at £1.25m prior to April 2016, and the maximum is £1 million thereafter. It’s still a lot of money, but it is easy to breach that limit and pay the excess charge if you are investing £500,000 in commercial property over 15 or 20 years.
SIPPs can also be efficient inheritance tax planning vehicles
When you’re buying commercial property through auction, what taxes do you pay?
Stamp duty is paid on all commercial properties, but at marginal rates; if the property is worth less than £150k, there’s no stamp duty at all. The maximum is 4% for commercial properties worth more than £500k. Compare with the 15% top rate on residential from April 2016 and there is a huge saving in equally priced commercial property versus residential.
Are there any other considerations via auction?
A lot of people buy at auction then think about structuring later. But the key thing is that you need to turn up to auction knowing which entity you’re buying it in – whether it is as an individual, a company, an LLP or a SIPP.
It is much harder to sort out these things afterwards. If you purchase property in your name, transferring it to a different vehicle creates tax costs. If you want to avoid those costs, turn up prepared.
In what situations will purchases be subject to VAT and how can you manage this?
The basic position is that the freehold sale or letting of commercial property is exempt from VAT. There are, however, a number of exceptions to this rule. For example, the freehold sale of a new (less than 3 years old) commercial property is subject to 20% standard rate VAT. There are also situations where a vendor can ‘opt to tax’ commercial property, so that a transaction that would have been VAT exempt becomes subject to 20% standard rate VAT.
The VAT rules for real estate transactions are highly complex, so considering the VAT position well in advance of any transaction is essential. There are often steps which can be taken to reduce or eliminate any VAT costs. However, it is not usually possible to revisit the VAT treatment of a transaction after the event, so getting it right first time is important.
Are all commercial properties subject to VAT?
Not all commercial properties are subject to VAT. It usually depends on the age of the property and whether the vendor has made an option to tax. The VAT treatment will also depend on whether the property is acquired as part of the transfer of a business as a going concern (TOGC). If it is, then no VAT will apply, provided that certain conditions are satisfied. For example, TOGC treatment is very common when purchasing a commercial property with the benefit of existing tenants. Some of the TOGC conditions are time critical, so understanding the VAT treatment of the transaction in advance and being ready to comply with the VAT rules is essential. This can be a particular issue when purchasing commercial property at auction as, in some circumstances, it may be necessary to deal with certain VAT related matters on the day of the auction.
Can you opt in and out of VAT and what are the benefits and pitfalls?
It is usually possible to ‘opt to tax’ commercial property, so that any future sale or letting will be subject to 20% standard rate VAT, rather than VAT exempt. The benefit of opting to tax and charging VAT to future tenants/purchasers is the ability to register for VAT and reclaim VAT incurred on property related expenditure.
Whilst it is common for businesses to opt to tax their commercial property interests, this can be a disadvantage in some situations. For example, not all future tenants or purchasers will be entitled to reclaim the VAT that is charged, which may mean that the property is a less attractive proposition. This is particularly common with tenants/purchasers in the financial services, insurance and charity sectors, which very often have little or no entitlement to reclaim the VAT that they incur. As the option to tax cannot be revoked for at least 20 years, except in very limited circumstances, the consequences of opting to tax need to be considered carefully before proceeding.
The Lawyer's View
“New leases are being granted for slightly longer terms. This adds extra value and could provide a good opportunity for a seller to release value.”
What do you view as the main difference of buying and selling by auction?
Compared with private treaty, an auction creates a very short time limit to finalise a deal. For those who want a quick sale; who like the certainty of knowing the price is final; and who enjoy the transparent nature of the process, it’s clearly a good opportunity.
Of course, if you don’t do your homework as a buyer, you risk getting burned but this is the same as with any type of business transaction. The crucial thing is that as part of the auction process, all relevant papers have to be made available up front. Buyers can’t complain if there was a problem pre-advertised which they could have found with due diligence. If they find a problem after the property is knocked down to them, then the commercial question is what happens next.
What are some of the things you wouldn’t want to find?
Provisions within leases are some of the most common causes of difficulty, for example with a long leasehold property where the lease could be forfeited by the landlord if the tenant became insolvent.
While auctions are for cash, many people will chose to refinance, particularly to drive better cash-on-cash returns. Such a clause makes the whole lease unacceptable as a mortgageable asset, because banks normally take security over the property precisely to give protection if the borrower goes bust.
There’s another clause which is also sometimes found, that if the building burns down and cannot be rebuilt, the parties share out the insurance money but the lease ends. That is also unacceptable to most people because, in reality, buying a lease is about gaining ownership of the land for a set period. The insurance money is based only on the cost of rebuilding, not the value of the building and the land. So giving up your entitlement to the land under such circumstances would result in significant loss.
Office-to-residential conversions have been a major driver of transactions in many areas. Are there any additional considerations now the government has loosened this policy up to allow things to be knocked down?With erosion of pension sizes and contributions and continued low rates, there’s a compelling case for more people to invest in commercial property as part of their pension plans. What’s your view?
Clearly if you’re buying to hold for 10-15 years or more, then any upfront cost is minimal when spread over such a period.
It certainly beats the half a percent you get from your local high street bank. Obviously, in the long term buying a reasonable property is an excellent investment for people for their long-term savings and pensions. And sometimes you can pick up very good things at auctions. The balance you have to weigh up as a buyer is in spending money beforehand for structural or legal check-ups.
A lot of the statutory provisions allowing permitted development have conditions and processes attached to them, in which people do need to get professional advice. For example, one of our clients found councils making orders taking away permitted development rights for particular pubs or cafes that they were going to take over for use as estate agencies.
In some cases problems can arise by local people applying to designate such units as “assets of community value”. Councils can also call things in for prior consent if they are perceived to warrant extra scrutiny around highway or contamination issues – all of which are subjective.
How can you minimise costs during ownership?
The main thing to consider when buying a commercial investment is that you don’t want to be spending money on repairs and maintenance – which is one of the key differences between commercial and residential, where almost everything is the landlord’s responsibility. If it’s a full repairing lease – where the tenant covers all repairs – that’s what people want and it’s what people should be looking for.
Is it a good time to be selling now do you think?
With interest rates remaining low and the prospect of an increase delayed, at least in Britain, it looks as though property should generate a good return for a while provided the fundamentals are right.
We have seen a real surge in convenience retail especially now with big supermarkets also taking smaller units. Clearly it will depend on prosperity of the area, but we’ve seen a lot of this. We also have lots of clients retaining parades of shops while developing around and behind them.
One of the other prevailing trends is that new leases are being granted for slightly longer terms – between seven and 10 years. This adds extra value and greater certainty and so could provide a good opportunity for a seller to release value, but also for a buyer to come in with a predictable income in place.
The Pension's View
What are the broad benefits of owning commercial property as part of a diversified portfolio?
Commercial property is an important asset class for diversifying risk in an investment portfolio, as generally property doesn’t highly correlate with other asset classes such as equities, fixed income (bonds and gilts) and cash. Property values move independently of other assets and aren’t typically affected by what’s going on in the stock market.
Why do you think some private investors are put off of commercial property – despite the obvious higher yields than residential property, equities and bonds over the last 10 years?Although they share the obvious characteristic of being physical buildings, residential and commercial properties are very different animals. Different rules and regulations apply to commercial landlords and market principles are quite different. Tenancies tend to be for longer periods, but the market for new tenants is considerably smaller.
What are some of the restrictions and considerations in acquiring commercial property in a SIPP through auction sales?
The key restriction is the timescale. Completion is usually required within a short timeframe – typically 28 or 42 days.
The process of acquiring property through a SIPP is the same as you would follow in a personal capacity. However, the SIPP operator will need to approve the property as acceptable ahead of the auction. The SIPP will need to be in place before the auction and the funding put in place.
All SIPPs operate a statutory cancellation period on SIPP establishment and on funds transferred in from other pension schemes, which prohibit use of the money until the cancellation period has expired.
Property must also be wholly commercial. Residential property can be accepted on occasion but the circumstances that permit this are extremely rare. SIPP operators’ service and turnaround times are also critical, so it would be worthwhile sourcing a SIPP who specialises in commercial property and whose systems for auction purchases are sound.
What advice would you give around keeping cash aside to cover costs such as insurance, renovation and potentially other unplanned expenses?
It would always be advisable to plan cash flow within a SIPP to take account of expected rental inflows – but also against outgoings which could include not only expected items such as SIPP fees, property management fees and insurance, but also the prospect of landlords repairs or renovation.
A rental void also requires insurance and rates to be maintained so there is a balance of retaining liquidity to cover these events against perhaps better returns from tying the funds up into longer term investment. Contributions to the SIPP if possible could also cover some immediate shortfalls.
Holding residential property through a SIPP incurs punitive tax charges, but how would a shop with a flat above it be treated?
HMRC’s interpretation is quite clear and with the exception of a very small number of cases any property that can be used for residential purposes will incur large tax penalties.
Where a shop has a flat above, unless the flat is occupied as a condition of the lease by a third party as a condition of their employment by the tenant, the flat will need to be held as a separate title outside of the SIPP. Even a reversionary interest resulting from the sale of the flat on a long lease can trigger a tax charge.
Owning commercial property isn’t something you can do yourself. You need insurance and a property manager. Will trustees always appoint their own property managers?
Different SIPP operators have different approaches here. Some will insist that their appointed solicitors, valuers, property managers and block insurance contracts are used. Others are more flexible and give the member choices over who is appointed and if they wish to undertake certain property administration functions themselves. The more flexible approach allows the member to better control the costs, as fees can be negotiated with each individual firm appointed.
What are the things you would have to get set in stone before bidding at auction and what could be done after?
Approval of the property ahead of the auction by the SIPP operator is essential, as is setting the maximum limit to which bids can go. Any borrowing should be agreed in principle and cash realised from current investments so that it is available for the deposit. Instruction to proceed to the solicitor and SIPP operator should be made immediately following a successful bid.