Service charges

The real cost for most tenants in occupying space is the total amount of rent, rates and service charges. Rent alone can be a misleading indication of the real cost of occupying an office, shop or factory building when service charges are a significant element of most occupiers’ costs.

Service charges have been defined as:

… the cost to tenants of indemnifying landlords against actual and anticipated expenditure on the protection, maintenance and replacement of those parts of the structure, finishes and equipment of the property for which no tenant is directly responsible. Such costs being calculated in accordance with and to the extent provided in the terms of the lease between the landlords and the tenants in each case. (CALUS Guidance note 1985)

Service charges have evolved over the past 30 years or so. They were first introduced and used in the management of residential property, especially multi-tenanted blocks of flats where landlords were having to introduce better facilities such as central heating, porterage and security. To recover their costs, landlords began to collect service charges separately from the rent. The practice spread to commercial property where initially a service charge clause would make provision for a few items such as lighting and cleaning. However, over the years, tenants’ needs and the desire for more services have grown, along with requirements for a higher standard of appearance and functional performance in the buildings which they occupy.

Institutional insistence that letting of commercial properties should be on “clear” leases to ensure a net return on their investment has further encouraged development of the service charge. A clear lease requires that tenants not only pay a full market rent but also meet the entire cost of maintaining, servicing and renewing the property. Such leases are now the norm rather than the exception, inclusive rents being increasingly rare.

Tenants who used to pay relatively small contributions towards a limited range of services are increasingly being asked to pay for items such as roof renewals, refurbishment of common parts and other heads of expenditure which were traditionally met by their landlords. The service charge clause is now a vital element of the commercial lease, the contents of which will vary according to the bargaining strengths of the landlord and tenant. As with any other aspect of the lease, the service charge clause must be given careful consideration if it is not to give rise to dispute and litigation.

General considerations

The fact that services are provided to a tenant does not automatically require the tenant to pay for those services. If the service charge clause in the lease is ambiguous, there is a tendency for the courts to apply a fairly narrow interpretation in favour of the tenant. It is important, therefore, that the precise wording of the service charge clause is given careful consideration and that any items intended to be covered are given express mention. Such mention of items in the clause may, of course, impose contractual obligations on the landlord to provide those services.

If an item is covered by the wording of the service charge clause then it is prima facie chargeable irrespective of whether it is an item of repair, improvement, replacement, renewal, inherent defect or refurbishment. Managing agents’ fees would not normally be included unless the wording of the clause provides for this.

The landlord is contractually obliged to carry out the services specified, and is required to fund the expenditure. Payment by the tenant for the services will not normally be a precondition of provision. Interest payable on funds borrowed by the landlord for the undertaking of service obligations can be charged only if so specified in the agreement.

In the case of residential leases, variable service charges are subject to an implied term that the landlord will include an item of expenditure in a service charge only if it is incurred reasonably. There seems to be some doubt about whether this implied test of reasonableness applies to commercial leases. In view of this uncertainty it would seem sensible to assume that such a test might be applied by the courts. If the service charge clause contains such a provision, the landlord must take steps to avoid extravagance at the tenant’s expense.

Service charges are payable either as rent or simply under a covenant. If the service charge is reserved as rent or recoverable as rent, the remedy of distress will be available to the landlord to recover any arrears due, which may also be subject to interest payments. Otherwise the payment will fall to be considered in the same way as any other covenant under the lease. If the service charge is reserved as rent, it will be taxed as rent under Schedule A for income and corporation tax purposes and only those items that the landlord is legally bound to expend, rather than discretionary items, can be deducted as allowable expenditure in computing the tax liability.

Service charge clause

The service charge clause should include four main elements:

(a) how and when payment is to be made;

(b) which items are to be included;

(d) how the charge is to be apportioned.

Examples of items to be included

(a) wages of staff employed in cleaning, maintaining and administering the building, including receptionists, porters and caretakers;

(b) provision of uniforms, tools, equipment and materials;

(d) cost of water;

(e) rates and other outgoings payable in respect of the building as a whole or common parts;

(f) cost of provision of towels and laundry for lavatories;

(g) cost of and cultivation of plants and flowers;

(h) cleaning and maintenance of forecourts, roads and footpaths;

(i) cost of leasing or hiring plant and equipment in the building;

(j) cost of complying with statutory provisions and byelaws, eg Office Shops and Railway Premises legislation and Fire Precautions Acts;

(k) inspecting, maintaining, repairing, overhauling and servicing plant and equipment;

(l) all liabilities in respect of party walls, fences, roads, pathways and other common structures and facilities;

(m) cost of employing managing agents;

(n) cost of supervision and execution of works;

(o) solicitors and other professional costs arising from the management of the building;

(p) bookkeeping costs and accounting costs;

(q) VAT;

(r) cost of maintaining bank accounts.

Sweeping-up provisions

The above list is not intended to be exhaustive and, when a lease is drafted, the landlord and his solicitor cannot be expected to foresee every conceivable item of expenditure that should be covered by the service charge. To avoid the risk to the landlord of incurring costs which might fall outside the services or works listed in the clause, many service charge clauses contain a sweeping-up provision. This entitles the landlord to charge not only for the services listed but also for other services which he may decide to provide. The sweeping-up clause may contain a reasonableness provision, but if not it will give the landlord a wide discretion.

The effectiveness of these clauses depends on their wording. In the case of Mullaney v Maybourne Grange (Croydon) Management Co Ltd 1985 277 EG 1350, a clause entitling the company to recover the cost of “providing and maintaining additional services and amenities” was held not to cover the cost of replacing wooden window frames with maintenance-free frames, since the window frames were neither “services” nor “amenities”.

It is clear that sweeping-up clauses are being interpreted by the courts as literally as other charging provisions.

Sinking funds

A tenant may also be required, under the terms of the lease, to contribute to a reserve and/or a sinking fund for the purpose of meeting recurring expenditure and unusual items. These will include long-term renewal of plant and machinery, boilers and lifts, as well as major items of repair. Contingency items, such as the redecoration of the exterior and common parts of the building and other repairs, may also be covered by reserve funds. Such costs can be provided for in a number of different ways. The cost could be charged to the tenant as part of the service charge for the year in which the expenditure is incurred.

While this may present few problems to the larger tenant, for smaller occupiers the unevenness of such expenditure might give rise to cashflow difficulties. The landlord could, of course, meet the initial cost and then spread this by charging the tenant over two or more years, but that places the burden on the landlord to finance the costs himself. For certain items the landlord might enter into long-term maintenance contracts; this would be appropriate for items of plant and machinery, and the cost of this can be charged to the tenant. Generally, though, it is preferable for foreseeable repairs and renewals to be planned in advance and an allowance included in the normal service charge to cover the anticipated cost. Money can be collected from the tenant each year and placed in a reserve fund or a formal sinking fund can be set up.

Reserve funds were established to meet recurring expenditure, and sinking funds for expenditure which might be incurred only once or twice during the term of the lease. The usefulness of such funds is that they tend to even out the annual cost of service provision so that tenants are not faced with large expenditure in any one year.

For periodic items of expenditure, such as decoration, it is usually possible to draw up a plan of estimated future expenditure which is reasonably quantifiable in advance. It will, of course, be necessary to take account of future inflation as well as any interest earned on the contributions into the reserve fund by the tenant.

For long-term capital expenditure, the replacement of items of plant and machinery for example, the amounts are more difficult to predict. This is because of the longer time periods involved, the effect of inflation on such items and the uncertain effects of depreciation and obsolescence. Even so, estimates should be made and kept under constant review so that the effect of any change can be taken into account at an early stage.

Suppose a landlord anticipates having to replace the lift in an office building in 10 years’ time. The current cost of replacement would be £25,000. It is assumed that inflation will average 7% and that interest will accrue at 6% net. The sinking fund required can be calculated as follows:

It would be good practice to review this calculation periodically, making any adjustments to the sinking fund that might arise as a result of changes in costs, the rate of inflation and interest rates.

It is possible to base the contributions to the fund on a variable payment by taking the existing replacement cost and inflating the annual payments. The advantage is that payments made by tenants will then tend to rise in proportion with other costs such as rent and rates as well as turnover and profit.

The fund should be invested in an appropriately safe bank or building society deposit account to earn interest, which will normally be taxable especially where the service charge is collected as rent.

Machinery for payment

Service charges normally apply to buildings in multiple occupation so that provision needs to be made for the apportionment of the total service costs. The percentage of costs to be borne by a particular tenant will be identified in the service charge clause as a fixed percentage of total costs and this, in turn, will be based on some equitable measure. This is normally either the rateable value or the floor area of the property occupied by the tenant in relation to the property as a whole. If the rateable value is selected it has the advantage of being determined independently, but all the proportions will need to be adjusted every time there is a change in the rating assessment of any of the hereditaments comprised in the property as a whole. If floor area is used, the definition of what is to be included must be consistent and clearly identified. Proportions will have to be recalculated every time there is a change in the letting area taken by any particular tenant.

Problems can arise, particularly in the case of mixed-user buildings, shops and offices for example, where not all tenants will make the same use of the same range of services. In such cases it may be necessary to treat the services separately and provide different apportionments.

Whatever approach is adopted, it should be clearly set out in the service charge clause. It is also advisable to include a variation clause to enable the apportionment of the charge and the means of apportionment to be altered should the circumstances demand it.

It is normal to provide that the amount of the contribution is to be certified by the landlord’s managing agent, accountant or surveyor, and it is upon the issue of such certificates that the tenant’s liability to pay arises.

At the beginning of each accounting period, normally the forthcoming year, the landlord will prepare an estimate of the cost of providing services for that period. A statement of the costs will be forwarded to the tenant, who is required to make interim payments, usually quarterly in advance. The landlord will then keep detailed accounts of all expenditure during the accounting period as well as a statement as to the amount of any reserve or sinking fund. At the end of the accounting period, when actual costs are known, the landlord will provide the tenant with a statement of the service charge payable for the accounting period, interim charges paid on account and the amount, if any, by which the service charge exceeds or falls short of the total interim payments made.

In the case of non-residential properties there is no statutory requirement for consultation on proposed expenditure, but it would seem to be good estate management practice for landlords to ensure that tenants are made aware of any major proposals and that they should be given the opportunity to inspect accounts and other relevant documentation.

This article refers specifically to commercial leases. In the case of residential property the position is further complicated by statute, in particular the Landlord and Tenant Act 1985 as amended by the Landlord and Tenant Act 1987. Among other things this legislation requires consultation, includes an implied test of reasonableness, a statutory repairing obligation, limits on interim payments and a set certification procedure. A useful outline of these provisions is provided by Delyth Williams in Estates Gazette.