There are 12 months to go until private sector landlords of commercial property portfolios will be prohibited from granting new leases of property with energy performance certificate (EPC) ratings of F and G, subject to certain exemptions. While many landlords are considering the risk the 18% of properties that are F and G-registered pose, few have considered the 47% of properties that are D and E-rated, which may also become caught by the regulations in the next 12 months.
What are the MEES Regulations?
The Minimum Energy Efficiency Standards (MEES) came into force in 2016 under the Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015.
From 1 April 2018 landlords of non-domestic private rented property are prohibited from granting a new lease of any “sub-standard” properties (ie those that have an EPC rating below E). From 1 April 2023, these requirements will also apply to all existing lettings.
There are a number of exclusions and exemptions that will enable a landlord to let, or continue to let, a sub-standard property. These include leases of less than six months or more than 99 years, and properties where an EPC is not required.
Otherwise, a landlord may be able to register an exemption. The key exemptions are:
- The seven-year payback test: where the capital cost of required energy efficiency measures is not cost-effective within a seven-year payback period.
- Third-party consent: where despite “reasonable endeavours” (see comment on the new government guidance below) necessary third-party consents to carry out the energy efficiency improvements cannot be obtained.
- Property devaluation: where the measures proposed would reduce the value of the property by 5% or more.
- Recently becoming a landlord (a temporary six-month exemption): this applies in limited circumstances, including the grant of a lease due to a contractual obligation, pursuant to the Landlord and Tenant Act 1954 (the “1954 Act”), or the grant of an overriding lease under the Landlord and Tenant (Covenants) Act 1995.
Exemptions will need to be registered before 1 April 2018; otherwise landlords in breach could be subject to a publication and/or financial penalty. The exemptions register opened on 1 April 2017.
Why is so much of rented commercial property at risk?
EPCs were first required for commercial property in 2008 where a property larger than 50m2 with fixed services for conditioning the interior environment was built, sold or let. At that time, the creation of EPCs was in its infancy both in terms of the software used for the assessments and the scrutiny applied to the assessments. Two fundamental things have since changed:
- The technology, training and regulation of EPC assessment has become far more refined. This has resulted in the process of EPC assessment being far more accurate and detailed.
- As reflected in regular revisions of the Building Regulations (Approved Document L) the efficiency requirements of buildings and their services have enhanced significantly since 2008.
The combination of these two factors has been regularly shown to result in EPCs on the same property dropping up to two ratings upon a new EPC being created.
Therefore, where landlords may consider a number of D and E-rated properties on their portfolios to be “safe”, the effect of the above will be that those same properties could be downgraded to F and G ratings.
MEES – a tenant’s advantage?
An EPC is valid for 10 years if the subject property has remained largely unaltered during that time. Usually, however, there is nothing stopping a tenant from having a new EPC carried out and registered, which will supersede a landlord’s existing EPC. This could cause a fundamental shift in the relative bargaining position of landlord and tenant. Overleaf we examine a few different scenarios.
Source: Green Construction Board
• MEES and dilapidations
Scenario: A tenant’s lease expires in November 2018. The landlord holds a grade D EPC. The landlord has an estimated £2.9m dilapidations claim. Prior to the lease expiry the tenant obtains a new grade F EPC.
The landlord cannot lawfully let the property and the tenant has a strong argument that the dilapidations claim is diminished as the works to comply with the MEES Regulations supersede any repair works it is liable for. The landlord is left with a “triple effect” of: i) an unlettable property; ii) a property in disrepair; and iii) little or no dilapidations claim.
The landlord’s counter-argument to this supersession point would be that, while more extensive works may now be required to bring the property up to MEES compliance to re-let, this does not prevent a landlord from recovering underlying costs of repairs necessary to remedy any disrepair. Dilapidations could become extremely contentious in the post-MEES Regulations world.
• MEES and rent reviews
Much will turn on the rent review hypothesis. However, if there is a rent review after 1 April 2018 in an existing lease, at one extreme, tenants may argue that the willing landlord cannot let the hypothetical property because this would be unlawful under the regulations. Tenants may argue that the market value is zero as there is no market because the property cannot be lawfully let. Also, if energy efficiency improvements have to be made to the hypothetical property, tenants may argue that this would lead to a period of disruption so a hypothetical tenant would require a rent-free period and/or a rental reduction as they could not occupy from the start of the term of the hypothetical lease.
Landlords will seek to counter such arguments by relying on the assumption of willing landlord and tenant. Interestingly, the Model Commercial Lease now includes an assumption that the property can lawfully be let under the regulations. Landlords will also argue where they can that the review hypothesis expressly dictates that the property is fit and available for immediate use and occupation. Accordingly, any issue of MEES should be disregarded.
• MEES and 1954 Act lease renewals
Scenario: in 2011, the landlord obtained an EPC which gave the property an F rating. The tenant went into occupation in 2012 and fitted out the property, including a new lighting system and air-conditioning system. Following the fit-out, the tenant obtained a new EPC and the rating improved to an E. The contractual term of the lease expires in December 2018, but the lease is inside Part II of the 1954 Act.
At renewal, the new rent will be determined under section 34 of the 1954 Act. This requires tenant’s improvements to be disregarded unless carried out under an obligation to the landlord. In this situation, a tenant will argue that the tenant’s works should be disregarded. As the property was F-rated before fit-out, the tenant will then seek a lower rent, or a rent-free period to reflect any disruption of the landlord carrying out any energy efficiency works.
The landlord will doubtless counter this by arguing that a section 34 rent valuation requires the actual property to be valued and accordingly, at the valuation date and in reality, the property has a MEES-compliant E rating as the works have been completed.
Landlords obliged to grant a new lease under the 1954 Act will have a six-month temporary exemption to comply with the regulations and should register this immediately. It is not clear how this is going to work on a practical level given the number of lease renewals in any given year.
What should I be doing now?
The MEES Regulations may cause a significant shift in the landlord and tenant balance depending on the property and lease event. The risk potential of a given property can only be judged individually taking into account the validity of the existing EPC, the risk profile of the property failing the MEES Regulations, the ability to recoup upgrade costs from the tenant, and the applicable exemptions, if any. While there could be a temptation to commission wholesale renewal of all EPCs across portfolios this could result in the downgrading of a property in circumstances where it could have been lawfully let for the foreseeable future.
There also needs to be a clear focus on lease drafting. The ability of landlords and tenants to protect themselves through careful drafting will be important to regulate the impact of the MEES Regulations on the relationship and avoid contentious situations as outlined above.
New government guidance
On 23 February 2017, the government published guidance clarifying some aspects of the regulations, including when they apply, how to qualify for an exemption, and the enforcement/appeal process. Some of the key points coming out of the guidance are:
- EPC calculations are regularly updated and properties that are currently E-rated may find that their rating adversely changes in the future.
- If an owner or occupier of the building is not legally obliged to have an EPC, but obtains one voluntarily, they would not be required to meet the minimum standard even if the EPC is registered on the database.
- Exemptions will be made on a self-certification basis. Enforcement authorities will monitor the register and no fee will be charged to register an exemption.
- Listed buildings may not be exempt from the requirement to obtain an EPC.
- If a landlord wishes to rely on the third-party consent exemption, reasonable efforts seeking consent include making attempts on a number of separate occasions and using a number of available means of communication to secure agreement.
- Providing detailed information on how to calculate whether a landlord can rely on the seven-year payback exemption and confirming that a landlord is expected to implement any energy efficiency improvement works that satisfy the seven-year payback test irrespective of financial position.
- If a penalty notice is issued, enforcement authorities are able to bring proceedings against the landlord for the debt unless a review or an appeal is formally lodged.
Ben Strange is an associate director at Lambert Smith Hampton, Nick Wood is a partner and Helen Pickard is an associate in real estate disputes at Nabarro and Danielle Drummond-Brassington is a partner in real estate disputes at CMS Cameron McKenna. From 1 May 2017 CMS, Nabarro and Olswang combine to create CMS Cameron McKenna Nabarro Olswang
