Dilapidations In the first of two articles, Dawn Reynolds and David Gilbert consider post-lease events and their effect on the level of damages that a landlord can recover
Section 18(1) of 1927 Act |
Damages for a breach of covenant or agreement to keep or put premises in repair during the currency of a lease, or leave or put premises in repair at the termination of a lease, whether such covenant or agreement is expressed or implied, and whether general or specific, shall in no case exceed the amount (if any) by which the value of the reversion (whether immediate or not) in the premises is diminished owing to the breach of such covenant or agreement as aforesaid |
Whatever the economic climate, the issue of dilapidations at the end of a lease is an emotive one for both landlord and tenant. In a difficult market, the parties’ advisers face greater pressure to achieve the best results for their clients. Where landlords seek to recover every penny and tenants want to retain cash flow for what they believe to be more pressing business costs, it is tempting to draw into the assessment of the dilapidations claim events and situations that occurred after the lease expired. The aim is to create or increase a claim on behalf of the landlord or to reduce or extinguish the tenant’s liability. Such attempts have increased over the past two years.
The effect of post-termination events on a dilapidations claim needs careful consideration. This article discusses such events and how they affect the level of damages. First, it is necessary to consider the relevant date on which the claim for damages is to be assessed.
When are damages to be assessed?
The relevant date for assessing damages in a dilapidations claim is the end of the lease term: see Cunliffe v Goodman [1950] 2 KB 237. This is the point at which the reversionary interest reverts to the landlord. Although the landlord may immediately relet the property, there will always be a point at which the reversion is in its hands: Smiley v Townshend (1950) 155 EG 110. At that point, the rules governing recovery largely follow normal contractual and common law principles, but damages relating to the breach of repairing obligations are subject to a statutory cap, imposed by section 18(1) of the Landlord and Tenant Act 1927. This requires an assessment of the diminution in value of the landlord’s reversionary interest arising from breaches. The cap ensures that the level of damages recoverable at common law cannot exceed the diminution in value to the reversion.
It does not apply to damages for breaches of non-repairing covenants, although details of such breaches and the associated claim often appear in a terminal schedule of dilapidations. An examination of the common law principles that govern damages for breach of non-repairing covenants is beyond the scope of this article. However, the landlord will generally be entitled to recover any loss that is attributable to the breaches, but the test of reasonableness will play a central role in determining the basis of recovery: Ruxley Electronics & Construction Ltd v Forsyth [1996] AC 344. This objective test leads to a position whereby the costs of reinstatement will sometimes be recoverable or damages may be limited to the diminution in the value of the reversion.
The latter is measured by carrying out two valuations of the landlord’s interest at the relevant date: the first assuming that the premises were then in the state they would have been in had the tenant performed its covenant and the second on the basis that the premises were then in their actual state and condition. Any difference between the figures represents the loss caused by the breach of covenant.
When carrying out the section 18(1) exercise, the “relevant date” is always the end of the lease (but such a strict position is not necessarily the case for covenants that fall outside section 18(1)). One line of argument, which can to a certain extent be supported by legal authority, states that post-termination events are not directly relevant to a section 18 valuation. However, this may be misguided. If the events are in motion or contemplated at the end of the lease, they may influence the value of the reversion on the premise that a hypothetical purchaser of the reversionary interest would have acted in a certain way, namely reduced or increased its bid, if it had knowledge of the event on the term date. Post-lease events may also have a bearing on the reasonableness arguments that pertain to other breaches of covenant in the terminal schedule of dilapidations.
If events that occur post-lease can determine how losses or diminution in value are quantified, how should the parties approach the most common of these events? How do events that are predominantly driven or caused by the landlord or the market affect the valuation?
Common events
? Redevelopment
If the landlord redevelops or carries out structural alterations at or shortly after the end of the lease, it is likely to lose part or all of any dilapidations claim. However, redevelopment does not automatically render a claim valueless if part of the demise is retained in the redevelopment. For example, where a landlord plans to refurbish a shop, including a conversion of the upper floors to residential use, and the tenant is required to carry out repairs to the external envelope or services, such repairs do not form part of the redevelopment and are unaffected by the works. Failure to repair is likely to impose a residual liability on the landlord to carry out the works as part of its refurbishment. In value terms, the extra cost will affect the reversion and form part of its loss.
? Supercession and market circumstances
The market conditions for landlords are undoubtedly difficult. Certain types of property have little if any market value, but valuers have to assume a sale between willing parties at the valuation date. The problem is in establishing the future for the property. Parties should therefore obtain not only the views of the valuer but also of market experts in the form of agency reports.
A thorough independent review of the market for the property in and out of repair can help valuers to carry out their own assessments. The review may involve a forecast of any trend, whether upward or downward, following the end of the lease. This may be a factor in the hypothetical purchaser’s bid in the valuation exercise.
The market for certain types of property may never return and only redevelopment or substantial refurbishment will guarantee its future. Many landlords may therefore face major expenditure to render a building marketable, notwithstanding a tenant’s breach of repairing covenants. The tenant may argue that many of the breaches will be superseded by the landlord’s refurbishment works. Thus, in so far as those works supersede items of disrepair they will not form part of the diminution: see PGF II SA v Royal & Sun Alliance Insurance plc [2010] EWHC 1459 (TCC). This can be achieved by excluding their cost from the out-of-repair valuation, reducing the difference between this and the in-repair value.
Many older buildings are likely to be converted to alternative uses. For example, older office blocks in some prestigious areas are being converted to residential use or hotels. In these cases, repair may have little or no relevance to market value.
? Reinstatement
In today’s climate, landlords will not want to reinstate without a beneficial outcome. They will instead await the market reaction to the premises as left by the tenant. Thus, assuming that the landlord does not carry out any work, the tenant can justifiably refuse to recognise any loss unless proven.
In other cases, the request for reinstatement may be academic because the alteration will enhance rather than reduce value. Alternatively, the incoming tenant will expect a degree of strip-out to enable it to fit the demise to its trading style. A tenant’s failure to strip out will have caused no loss and the landlord’s claim under this head may be defeated. If items are to be left in place, it will be necessary to comply with any repair covenants. Building surveyors often overlook this point they will have to undertake additional work to identify and quantify disrepair.
Valuers should be wary of betterment. For example, a retail tenant reinstates, by removal, a stairway in the Zone A area of a high-value location, and the ground- and first-floor areas are increased. Although the value of the upper floor may be lower because of inferior access, overall there may be a net increase in the total rental value.
Dawn Reynolds is a senior associate at Hill Hofstestter LLP and David Gilbert is a director at Lambert Smith Hampton
