Ben Strange begins a three-part series on the impact of MEES, by highlighting some unexpected dangers for landlords
As we approach two years since the Minimum Energy Efficiency Standard (MEES) Regulations came into effect, enforcement of the legislation appears to remain absent and landlords may reasonably consider that they have no cause to take steps towards compliance.
However, landlords risk paying a far greater price than the proposed enforcement penalties when well-advised tenants can use MEES to their significant advantage.
‘Sub-standard’ property
The regulations mean that it is now unlawful to grant a new commercial or residential letting – or renew or extend an existing letting – of a property which is deemed sub-standard.
The regulations state that, from 1 April 2020, it is unlawful to allow an existing residential letting to continue if it is of a property which is sub-standard.
From 1 April 2023, it will be unlawful to allow a commercial lease to continue where that property is deemed sub-standard.
The current definition of a sub-standard property is one which does not achieve an energy performance certificate (EPC) rating of E or better.
As the recent government consultation Non-domestic Private Rented Sector minimum energy efficiency standards: future trajectory to 2030 suggests, this minimum standard is due to be revised, with the suggestion live (at the time of writing) that this will result in a minimum lettable standard of an EPC rating of B by 2030.
Inaccurate EPC issues
The question of whether EPCs are accurate remains very much at large, with the latest government consultation – Energy Performance Certificates in buildings: call for evidence – having ended in October 2018, but no outcome measures yet identified. It is therefore a valid question as to whether EPCs are the most appropriate tool on which to base the MEES Regulations.
It remains a legal requirement for there to be a valid EPC in place at the point of sale, construction or letting of a building (other than those which are exempt). Lodgements of non-domestic EPCs have continued to increase in recent years, with 93,226 reported in 2019 (the highest number since 2012). What has changed starkly, however, is the spread of ratings of those EPCs.
As shown in the graph below, non-domestic EPC lodgements of F and G ratings have dropped dramatically since 2012, down from an annual proportion of 20.2% in 2012 to just 3.02% in 2019. On the assumption that this reflects the true improvement made to the building stock in question, this significant change would presumably reflect in a respective energy consumption reduction. Instead, however, energy consumption in the “services” sector has in fact continued to increase over this same period. While other factors may influence such statistics, there is a stark disparity presented here which may for some suggest that the accuracy of the EPC ratings lodged could be called into question.
This is particularly of relevance in a landlord and tenant setting, where a tenant – able to evidence that the seemingly compliant rating of their subject property is in fact inaccurate and should be sub-standard – will seek to use this to their significant advantage at many instances throughout the leasehold lifecycle.
MEES and construction
While there are various non-statutory mechanisms and schemes in place to measure the sustainable credentials of new construction (BREEAM, SKA, LEED, etc), these do not necessarily correlate with EPC ratings (which are based on the Building Regulations).
While all such construction has to comply with Building Regulations (and hence is highly likely to achieve a MEES-compliant EPC rating), and many are specifically designed to achieve a certain sustainability rating, such a building may prove a liability in its first few years, as shown in the following example.
A multilet 140,000 sq ft office building, originally constructed in the 1960s, is fully refurbished, specified with on-site facilities and policies achieving it a coveted “good” sustainability rating. On completion in 2020, the EPC rating achieved is a C. One of the tenants occupying the space gives notice to exercise a lease break in 2025. As part of their dilapidations strategy, they produce evidence that the EPC rating of the property is – based on the respective revision of the Building Regulations – now a D.
As of 2025, based on current proposed trajectories, a D-rated EPC may prove sub-standard under the MEES Regulations. In this instance, lodgement of this EPC by the tenant may render the whole of the property in breach and invite enforcement action and penalties of up to £150,000 on each of the continuing lettings.
With the suggestion of the MEES minimum standard being a B rating by 2030, coupled with the fact that EPC assessment fluctuates according to revisions of the Building Regulations, it is essential for parties investing in construction (be it new-build, conversion or refurbishment) to make the as-built EPC rating a key and specific requirement in their building contract and to ensure this rating is the optimum achievable, so as to best future-proof the property.
Of note also on this point currently is the proposal in Scotland to prohibit from 2024 the sale of houses which do not achieve a minimum EPC rating of C, hence suggesting that inefficient buildings may shortly become unsaleable, as well as unlettable.
MEES and acquisition risk
Commercial property acquisitions can be undertaken with a variety of strategies in mind, be it redevelopment, asset management or occupation. Where the purchase of a leasehold property is being considered, the perceived value of that asset is based largely on its rental income. The MEES Regulations directly impact on a landlord’s ability to let (or continue to let) a property, depending on the EPC rating it achieves.
EPCs can be lawfully valid for up to 10 years, so a property can still be sold in 2021 based on an EPC from 2011. The MEES Regulations currently do not prohibit the sale of a sub-standard building, but the vast majority of stakeholders are immediately live to the risk of investing in an F- or G-rated asset.
Significant risk remains, however, where a property is acquired without specific due diligence relating to its EPC rating. For example: a single-tenanted office building of 86,000 sq ft is marketed with an EPC rating of C with a sitting 5A1 covenant occupier with seven years remaining on its current lease.
A prospective purchaser commissions a building survey and undertakes further due diligence, none of which returns any material considerations affecting the purchase and it proceeds in 2021 at a price reflective of the rental levels and covenant strength, secured with significant bank funding.
The EPC in this case was carried out in 2011 and, while still within its 10-year validity period, was wholly inaccurate, not only due to changes to the Building Regulations in the interim, but also due to it having been cheaply commissioned and hence undertaken at the wrong “building complexity level”.
As part of its corporate sustainability criteria, the tenant has its own EPC commissioned which now shows that the property’s accurate rating is F, thus sub-standard under the MEES Regulations.
With a break option five years from lease-end falling in 2022, recognising that the landlord cannot lawfully continue to let the property from April 2023 (without undertaking disruptive improvement measures), the tenant submits its break notice and vacates in 2022. The property is no longer rent-bearing, but also it is in an unlettable condition just a year after the new owner has purchased it.
With improvement requirements on such an asset likely to run to millions of pounds, and zero rental income, defaults in this scenario look highly likely, particularly on highly geared acquisitions. The question of liability in this instance may be levelled at a number of parties (the valuer, the building surveyor, the original EPC assessor, the vendor’s agent, etc), but ultimately the investor is likely to face a significant and unassailable loss.
Specific due diligence, including MEES advice, must be sought in such a scenario, including lease assessment and tenant engagement, to safeguard against such pitfalls.
MEES and long leases
Some lease entities are not required under the MEES Regulations to meet the minimum standard, including:
1. Where a tenancy is granted for a period of six months or less (provided there is no provision to renew or extend the term beyond six months in total).
2. Where a tenancy has been granted providing the tenant a term certain of 99 years or more.
The latter exception may hand an unintended and significant opportunity to freeholders of long-lease properties.
Another example: a public sector entity holds the long lease of a mixed-use property and rents it out as accommodation, retail and business space. It has 80 years remaining of an original 125-year term.
The freeholder has made several approaches to the headlessee in the past in an attempt to redevelop the property, all of which have been rejected.
The freeholder undertakes an inspection of the property and consequently produces a draft EPC recording the whole property as G rated.
While the EPC has not yet been lodged, it shows that the property is sub-standard and therefore would render the property unlettable. The headlease is not unlawful due to it having been granted for in excess of 99 years, whereas the underlettings would be caught and respective penalties levied at the leaseholder as follows:
- existing residential lettings would be unlawful from 1 April 2020
- existing commercial lettings would be unlawful from 1 April 2023
- new lettings (or lease extensions/renewals) would be unlawful immediately.
On presentation of the draft EPC, and the resultant ramifications if it were lodged, this may provide sufficient grounds for the leaseholder to entertain surrender negotiations and allow the freeholder its opportunity to develop.
In the coming issues, further instances of unexpected opportunities and risks are presented, including for rent reviews, implications of tenant’s works, service charge issues and dilapidations.
See also: MEES: Issues and opportunities for the 2020s
Ben Strange is a director at Mobius Building Consultancy
