As with any major purchase, the devil is in the detail when it comes to investing in commercial property. For the prospective purchaser, thorough pre-purchase investigations will pay dividends several times over.
There are four main areas that need careful attention: the pre-purchase report into the property; the contract of purchase; tax considerations; and whether or not the property is classified as a ‘transfer of a business as a going concern’ (TOGC).
The report
Careful assessment of the leases to ensure they will provide you with a secure, predictable income is probably the most important part of your solicitor’s job. Your solicitor should be looking for upwards only rent reviews, where relevant; and an assurance that you, as landlord, will get a clear rent, a pure profit from the property and that the tenant will pay all the costs. In other words you need to know that any outgoings are kept to a minimum in order to maximise your rental income. Specifically you will want to know about:
- the rent
- any ongoing or future hidden rent free periods;
- any oddities in the rent review clause;
- any service charge shortfalls
- any exclusions from the tenant’s repairing obligation
- any residual construction liabilities arising from a new or recently constructed building
- any break clauses in the leases which weren’t known at heads of terms stage
The contract
The investment sale and purchase contract is a rather particular animal and there are specific things to look out for including:
- Correct apportionment of rents between seller and buyer when completing in the middle of a rent period;
- Tenant arrears –buyers should avoid responsibility for paying the seller any due tenant arrears;
- How ongoing rent reviews will be conducted after completion so that the seller gets its due proportion of any uplift after the rent review is settled;
- Ensuring that the TOGC clause works properly to avoid a VAT charge on the purchase price (see below);
- Any existing service contracts with a multi-let investment (for instance TUPE may apply if there are employees assigned to the property);
- How the service charge between seller and buyer will be treated post-completion. This can be a tricky area to negotiate particularly if income does not exceed expenditure so there is often an element of horse trading before the parties agree the service charge reconciliation.
VAT and transfer of a going concern (TOGCs)
VAT is chargeable on the purchase price of the freehold of a new building before it is fully built, or within three years of its practical completion. VAT also applies if the seller has opted to tax the property (i.e. elected to waive VAT exemption).
If VAT is payable, then stamp duty land tax (SDLT) is payable on both the purchase price and the VAT charged on that purchase price. However, if your purchase qualifies as TOGC, no VAT is payable providing certain conditions are met. Fortunately, HMRC considers the act of letting property and generating rental income as a business, therefore the sale of a commercial investment property is, prime facie, a TOGC and lies outside the scope of VAT. Even if you, as the buyer, opt to tax the property subsequently, the transaction itself is not subject to VAT and so you will not take the additional SDLT hit on the VAT element.
In the context of property investment sales, a TOGC is:
- A freehold sale of a fully, or partially, let property;
- Where an agreement for lease (a pre-let) exists, even if it is conditional;
- A freehold sale with no tenants other than advertising hoardings, or phone masts, or substations. All these scenarios constitute economic activity under HMRC guidance;
- Following revised HMRC guidance, a grant of a long lease can qualify as a TOGC, providing the interest retained by the landlord granting the lease is no more than 1% of the value of the property immediately before the transfer;
- Even more recent guidance indicates a surrender of a long lease back to the freeholder, subject to subsisting occupational leases, to be treated as a TOGC.
When a property investment transaction does not qualify as a TOGC:
- Agreed heads of terms with a tenant, but with no agreement or lease in place at the time of sale, does not constitute a transfer of a letting business, so does not qualify.
- A sale to a sitting tenant is not a TOGC because, at the date of the transfer, the letting business falls away as the new business becomes that of the tenant’s.
- Beware also of sub-sales from seller A to sub-seller B on to buyer C under England and Wales law (not necessarily Scots law). Sub-seller B needs to hold the letting business long enough for him to be a letting business purchaser; if not, the chain is broken and there is no TOGC on either sale.
There are significant pitfalls for the inexperienced commercial property purchaser, not least around taxation and the TOGC requirements. However, with the help of an experienced commercial property lawyer, you will be able to navigate the process and be well on your way to developing your property portfolio.
