Commercial real estate

It may have been a tough year for commercial real estate, with figures falling globally by 46% in 2023, but London is still holding the fort when it comes to attracting investment. The Knight Frank Wealth Report 2024 found that London led the way for the most invested cross-border city in 2023, with its strong rule of law, long-term value trajectory and investor familiarity appealing to international investors.

Cash-rich family estates and high net worth individuals accounted for 68% of all purchases of commercial property in Britain, clearly taking advantage of market uncertainty and rising rates, ploughing their wealth into offices, shops and warehouses. Of course, ‘snapping up’ commercial property can be a lengthy and complex process, involving everything from investment strategies and disputes, to planning permission and tenants. Ensuring you have expert help on hand is paramount.

Since the global financial crisis, an ever-increasing amount of overseas investment has flowed into the UK commercial property market, with a significant amount of capital coming from family offices and UHNW individuals. While the purchase of offices, hotels or retail in London has traditionally been the focus, those with more extensive portfolios or locally based family offices have been looking beyond London and into other asset classes – such as logistics, data centres or even rewilding.

London’s international status as a leading city – financially, culturally and socially – makes it attractive to international investors. The opportunity to ‘own a piece of history’ in addition to making a return on their investment is a tempting prospect.

Locations such as Old Bond Street and Oxford Street will already be familiar as destination hubs for overseas buyers, but other locations such as the City and the Docklands have also proved to be popular spots as London opens up to new industries, such as life sciences, and in turn offers fresh investment opportunities.

London is expected to continue to grow significantly as a city over the next 20 years. However, the COVID-19 pandemic, hybrid working, inflation and rising interest rates have led investors to question whether London and the traditional asset classes remain the best options for future investment; we have seen a move to what used to be classed as ‘alternative asset classes’.

Despite recent challenges, the UK political landscape is now relatively stable, with both Central and London government of all political colours welcoming international investors to the UK with open arms. In addition, the legal and tax systems are transparent, and unlike some other European countries, there is no tradition of introducing retrospective legislation to increase the overall tax burden.

Regardless of whether a prospective purchaser perceives commercial real estate as an emotional and/or financial investment, there are many issues to consider when thinking about buying commercial real estate.

Commercial real estate has been impacted by a storm of dislocation due to the pandemic and working from home, followed by war in Ukraine and then rapidly rising interest rates to tame inflation. Add to that mix a push for environmentally efficient buildings through ESG criteria, and the picture becomes even more complex. Pricing is already impacted, and buying opportunities will arise with interest rates so high, but there are no easy bets for high returns on capital.

Philip Jeffcock, Managing Partner, Cew Capital

Tax: how to structure an acquisition

The UK tax regime for real estate has evolved considerably in recent years, and while the introduction of capital gains tax for non-residents has diminished the tax advantages of investing in UK property, there are still advantages for non-UK resident investors with careful structuring and attention to detail.

For example, recent changes to the REIT (real estate investment trust) regime have made them more accessible and could offer several benefits.

There are numerous structures that can be used to hold UK real estate. The right structure will depend on the tax analysis and the investor’s intentions for the property. For example, is the property intended for investment or trading? Is the investment with others or as part of a joint venture? Will there be any bank debt or other funding? As such, detailed advice will be needed.

Selecting the right asset

The market for UK real estate has, at least since the Second World War, been cyclical. As a result, investors need advice on the asset classes in which to invest, asset location, covenant strength of tenants and overall timing.

At the bottom of the market, yield compression can look attractive, but at the top of the market purchases can look expensive unless you’re looking to ‘reinvest the family silver’ – that is, to hold a well-located property throughout the current cycle and well beyond it.

In the past ten years, as values have increased, there has been an increasing tendency towards structured investment in real estate – joint ventures or complex fund structures allowing co-investment alongside others.

Managing the asset

Away from macro market trends, commercial real estate assets have a natural life cycle, and the assets need to be nurtured throughout that cycle to maximise returns for investors.

There are several aspects that are important to managing any building, including:

developing appropriate space
attracting the right tenants
managing rent reviews to maximum advantage
appointing the right management surveyors to manage the property and help protect and enhance the value of the asset.

Financing the asset

An investor may wish to finance the acquisition and/or development of a property by raising debt, either at the time of acquisition or by way of refinancing, following the acquisition of a commercial property. Sellers generally perceive procuring debt as slowing down transactions.

Depending on the size of the transaction, buyers may be at a competitive disadvantage if they look to fund an acquisition on day one by using debt.

If an investor is contemplating debt finance, it’s important that the expectations of a lender are always considered to ensure that the corporate structure, tax structure, and title structure will be compatible with the lender’s expectations. This will ensure that if financing is required, the lender’s loan criteria can be met quickly and smoothly.

Purchasing tips

There are a number of important issues you need to consider during the purchase process, including:

The corporate structuring of any acquisition for investment and tax efficiency.

Liaising with surveyors on management contracts.

Reviewing and reporting on the occupational leases (including spotting risks such as service charge recoverability).

Reviewing and reporting on environmental and planning matters, as well as all necessary permissions and operational licences.

Pricing in dilapidation liability if the lease(s) are nearing the end of the term.

Advising on vacant possession strategies if the property is a target for development.

Effective due diligence, bearing in mind the longer-term ownership strategy.

Anticipating taxes such as stamp duty land tax, VAT, capital allowances and other tax issues.

Liaising with surveyors on management contracts.

Verifying tenancy schedules.

Negotiating and agreeing on the form of the purchase contract and ancillary documents.

Long-term hold or exit?

Commercial real estate investors have different investment strategies, driven by unique commercial, family, or geopolitical circumstances.

For some, yield compression and a liquid market are key to their investment strategy. For others, the strategy may be informed by a long-term hold enabling, for example, complete redevelopment or the refurbishment of the asset to increase value (for example, by potential lease regearing). The ability to add value to a property through proactive, effective asset and leasing management can often be overlooked by unsophisticated investors.

Our top tips

Get to know the commercial real estate market – your lawyers can make introductions to leading local agents and financiers.

Decide on your medium-term strategy before entering the market.

Do an initial deal (however small) – there are many international investors in the market and a track record will help you secure more meaningful opportunities.

On commercial real estate deals, try to avoid injecting bank debt into a deal on day one, but ensure that the asset may be leveraged in the future.

The Empire State Building (ESB) in New York City, one of the most iconic commercial buildings globally, had a market value of

USD2.3 billion

in 2019. The average annual growth rate for the market value of the asset has been about 5.3%. It’s also worth noting that, on average, the value of the ESB and the stock market tracked each other for many years, until 1985.

Source: buildingtheskyline.org/tag/empire-state-building

19% of UHNW individuals intend to invest in income-generating property in 2024, with living and healthcare the most targeted sectors. (The Knight Frank Wealth Report 2024)

UHNW individuals and family offices have acquired GBP1.3 billion worth of London office assets over the past 12 months. (WealthBriefing/Knight Frank)

Private capital accounted for 68% of all commercial property purchases in London in 2023. (Knight Frank Wealth Report 2024)

Commercial real estate: when issues arise

Trophy real estate – commercial or residential – often forms the foundation of an UHNW individual’s investment portfolio. Iconic buildings in prime locations can be attractive propositions – but owning real estate can have its issues. Many of these challenges are avoidable if the parties involved are fully aware of the risks before the transaction takes place.

Potential areas of conflict in the real estate market are wide and varied. Contentious real estate matters that investors can face include:

development issues, including rights of light and vacant possession
enforcing the contract
third-party rights
obtaining possession from tenants
disputed rent reviews
construction design and contractor building disputes

party wall disputes
defending or objecting to proposed planned developments
survey and ground conditions
listed building consent.

This section explores some of these key issues in further detail.

Sealing the deal

Transaction volumes will generally fall in a downturn as with less competition the market falls, but the property market in the UK remains extremely competitive, and trophy assets typically attract multiple bids. The ability to move quickly and avoid potential disputes with the seller will give you a competitive advantage.

You can increase your chances of securing a transaction by:

Demonstrating that you are in a good position to complete – which may mean completing in cash and refinancing later when the transaction has completed.

Being aware that a deposit up to 10% is required upon exchange of contracts in the UK – and having the funds available when needed.

Getting any funding structures in place in good time.

Having a clear investment strategy for the property, ie whether to hold onto it for the long term or seek an early exit.

Ensuring that the terms fully reflect all points you’ve agreed with the seller.

Ensuring a lawyer is instructed at an early stage, including to review heads of terms, can help speed up later negotiations.

Checking the headlease/occupational leases for obligations to carry out works on the property and instructing a surveyor to advise on the physical condition of the property and likely ongoing maintenance responsibilities.

Third-party rights

Any third-party rights registered against the property should have been disclosed at the time of the purchase. However, disputes can arise later concerning the exercise and extent of those rights.

These can include:

Access rights: Any party able to use your new property to access neighbouring land might decide to change or intensify its use (for example, by developing a hotel). Complex rules govern whether such situations are permitted. Essentially, it will depend on the wording of the rights but good advice at the outset can anticipate challenges before they arise.

Rights of light: The flow of light to a property can be significantly restricted if a neighbour wants to build a higher property on adjacent land. In this situation, the owner will need immediate advice to preserve their rights. Similarly, a developer should take early advice on the strategy to adopt concerning such claims.

Obtaining possession from tenants

Where a property has been purchased as a long-term investment, attracting the right tenants is critical to its success. Renting to a third party can come with challenges, so you will need to ensure the property is properly managed.

If a tenant breaches the terms of their lease, the owner may need to recover possession through the process of forfeiture. Different rules apply to commercial and residential tenants in this situation.

Commercial tenants: In most cases, the owner has a right to terminate the lease when a tenant is in breach. However, all tenants have an automatic right to remedy their breach and, if they do so, the lease is reinstated. This might sound simple, but there are complex rules and statutory procedures to follow so it is crucial to obtain proper advice. In some cases, it is possible to simply change the locks.

Dilapidation disputes

Dilapidations can cause complex disputes, particularly when a property is sublet to a third party.

The allocation of liability is often an area of contention. The law differs for commercial and residential properties.

Commercial tenants

There is normally an obligation on the tenant to leave the premises in good repair and decorate at the end of the lease. They are also obliged to return the building to its original state if they have carried out any alterations.

If the tenant does not comply, the owner can claim damages. The damages due can depend on how great an impact the disrepairs have on the value of the building.

If the value is not affected, the owner might not have a claim. For example, if the premises are acquired by a developer and demolished or substantially refurbished, the value of any repairs is lost.

The first step in claiming damages is for the property owner to appoint a building surveyor to assess the extent of disrepair. Pursuing a claim involves following a court-prescribed protocol. Obtaining advice early can give the owner a better chance of maximising the damages recovered.

Residential tenants

The normal obligation is that the tenant simply keeps the property in the same condition – but is not responsible for fair wear and tear.

Generally, there is no obligation to decorate at the end of the lease or carry out substantial repairs.

Disputes with the design and build team

Investing in prime property, whether it’s a dream home or a trophy commercial asset, usually involves a renovation or refit. It’s advisable to seek input from specialists at the outset.

Getting the right contracts and structures in place from the outset and reviewed by construction lawyers avoids problems later.

Once the correctly appointed expert team is in place, the owner needs to seek the right insurance and guarantees.

These include:

adequate insurance for design liability
bonds and parent company guarantees to provide additional security
protection against defects and liquidated damages.

Common problems with designers and contractors include:

appointing a team lacking the requisite skills and understanding of the quality required in high-end development
choosing the wrong procurement strategy – at considerable cost
breaching legal requirements as to what can be built, leading to disappointment and, at worst, demolition
poor or non-performance due to incompetence and insolvency
a lack of options to change the project or the team
not getting the result that was expected.

If problems do arise, it’s important to have the ability to terminate or suspend the project, to have the appropriate dispute resolution provisions in place, and have an experienced dispute resolution team who can resolve issues quickly and effectively.

Asset performance

It was a challenging 2023 for the global commercial real estate market, with investment volumes falling by 46% to USD698 billion as investors grappled with elevated interest rates and higher debt costs. However, with interest rates and inflation set to decrease, the environment for real estate investment is likely to become more favourable. Meanwhile, The Knight Frank Wealth Report 2024 revealed London as the leading city for cross-border commercial real estate investment flows in 2023, up 7.6%.

Key points to remember

Ensure you fully understand the asset that you’re looking to purchase.
Be clear on your intended use of the property and your ultimate investment strategy. Do you plan to rent the property to a third party? Do you anticipate undertaking refurbishment or renovation work? Will planning permission be required?
Consider your neighbours, communicate any planned works in advance and consider the impact of party wall disputes.
Work together with any tenants to avoid potential dilapidation disputes and ensure effective management of the property.
Ensure you have an appropriate team of experts around you, including lawyers, designers, architects, contractors and builders to ensure a successful investment and development.
Identify where disputes, like the ones highlighted in this chapter, may occur and take appropriate steps to mitigate the risk of potential litigation.