With the Minimum Energy Efficiency Standard Regulations now in force, Ben Strange questions David Shortall on how implementation will affect capital values
Question
The Minimum Energy Efficiency Standard (MEES) Regulations (the Regulations) bring significant uncertainty for all stakeholders in commercial leasehold property. This includes significant risk and opportunity for landlords and tenants respectively (see EG, 1 April 2017, p60 and 11 November 2017, p81).
With the UK’s commercial property stock worth some £883bn (PIA Property Data Report 2017) in 2016 and the suggestion of 65% of leasehold property being at risk (EG, 11 November 2017, p81) as a result, the seriousness of this matter could not be more clear.
If the Regulations state that a given leasehold property cannot lawfully receive a rental income, what impact will this have on its capital value?
Answer
The capital value of a building is affected directly by the lawful ability to let it in the market and its rental value. If a property cannot be lawfully let or its rental value is reduced or is nil without significant expenditure and modification to make its letting lawful, this will adversely affect rental and capital value.
However, an EPC rating of F or below will not summarily render the value of a property nil. A landlord faced with this circumstance will not simply resign himself to that fact that the property is unlettable. The landlord would almost certainly establish the scope and cost of works required to meet the minimum standard of E or above.
This will, of course, affect the value of the property to the extent of the cost of the works and any consequential delay in achieving a rental stream from letting.
Question
The Regulations will affect a leasehold property at many stages, including at acquisition. What if the pre-acquisition due diligence identifies that the subject property is not actually a D or E rating as described but – when accurately assessed to current standards – is in fact an unlettable F or G? How would the property funder react if the true rating only came to light after completion?
Answer
The market is likely to respond to an unfavourable unforeseen F or G EPC rating through an adjustment in price. This adjustment is likely to be a factor of the cost of works required to achieve a compliant assessment and the cost of any delay or interruption in the rental stream.
Funding institutions are likely to require landlords to comply with their statutory obligations and may require up-to-date EPC assessments at regular intervals as a condition of funding.
Question
During the term of a lease, rent reviews may be undertaken on a cyclical basis, typically upward-only. With the benefit of expert MEES advice, it is foreseen that many well-advised tenants of property potentially at risk from the Regulations will use them to evidence that the review should be a nil increase. If this is successful, how would either a nil increase or rent reduction (when anticipating a market-rate increase) affect the value of the property?
Answer
Rent reviews in leases are usually prescribed at fixed intervals, often five-yearly. If the building has an EPC rating of below E, the tenant may argue on review that the landlord is unable lawfully to let the building to a hypothetical tenant and so its rental value is nil or at least reduced. Some rent review clauses may include an assumption that the premises can lawfully be let by the landlord to the tenant, or that both parties have complied with their obligations, which will include statutory obligations and compliance with the Regulations. This may overcome the tenant’s argument but equally may also face challenge.
In the lead-up to a rent review, the landlord might carry out works to ensure an EPC rating of E or better at the valuation date. However, the tenant’s consent to undertake improvement works may be required and the tenant may seek to impose a condition that the improvements are disregarded on rent review, whether this is reasonable or not.
A tenant may have undertaken fit-out works or improvements, such as the installation of air conditioning, which may adversely affect the EPC rating, potentially taking it below E. Improvements usually fall to be disregarded at rent review. However, when considering granting consent to tenants for alterations and improvements, landlords should consider the impact on the EPC rating and whether or not they wish these to be reflected or disregarded at review.
Question
Dilapidations claims on a given property are typically prepared on the premise that the property as demised at the outset of the lease should be returned in good condition and in the form as it was demised.
If a given tenant can evidence at the point of lease end that that same demised premises will formally be unlettable according to the Regulations (irrespective of its material condition) at lease end, they will challenge the claim accordingly with the benefit of section 18(1) of the Landlord and Tenant Act 1927. What will the effect of the Regulations be on diminution valuations where the property is unlettable?
Answer
All claims in damages for dilapidations are subject to a cap at the amount of the diminution in value of the landlord’s interest. Where an item of remedial work is overtaken by an improvement, this is said to be superseded and the landlord will usually not succeed in a claim for work that is superseded.
Supersession is usually a consequence of market forces that sway a landlord towards refurbishment or redevelopment that overtakes the former tenant’s breaches.
The Regulations will bring into play an additional factor that may require a landlord to carry out improvements of upgrading to components of the building such as the lighting, air conditioning, windows, roof and M&E and which consequently result in supersession of repairs. This is likely to add another dimension to the negotiation of dilapidations claims.
Identify and mitigate
With the continuing uncertainty surrounding the Regulations, and the reported widespread inaccuracy of existing EPCs, all property stakeholders need to take due account and make strident enquiries to ensure that any risk arising from the Regulations is identified, accounted for and best mitigated.
Those not duly familiar or willing to advise their clients of the associated risks do so at their peril; with awareness quickly spreading, many are awaiting the first test case.
Ben Strange is head of professional services at Ingleton Wood and David Shortall is a RICS registered valuer at Alexander Reece Thomson
