Matthew Bonye and Frances Edwards discuss wrapping up claims for dilapidations before a lease expires.
Claims for terminal dilapidations are often a nuisance for landlords and tenants alike. Tenants expect a painful negotiation. This can drag on for years and may require provisions in company accounts reflecting liability.
Landlords suffer cash flow issues if works need undertaking before settlement, letting voids while claims are negotiated, and complex processes for assessing and capping damages. Landlords may not enjoy the lack of control: a tenant may decide to do works before lease expiry that the landlord would prefer either to do itself, or not to have done. Landlords, unsurprisingly, rarely decide what the tenant does or does not do.
We find that landlords and tenants increasingly look to knock dilapidations claims on the head by agreeing deals before lease expiry. There are attractions for both parties. It avoids the above issues, and settlement frees the landlord to do what it wants with its property at lease expiry, without risk of its intentions having an impact on a claim. Conversely, tenants, knowing that such freedom and certainty appeal to landlords, will factor this in when negotiating quantum.
However, there is far more to think about when settling dilapidations during the lease term than for a terminal claim. The following is a checklist of important points.
Ongoing liability
Take the example of a dilapidation settled a year before lease expiry. What obligations are there on the tenant for the post-settlement period of the term? A settlement usually involves parties agreeing on a reduced yield-up obligation, removing the requirement for reinstatement or redecoration.
The landlord may, however, want to retain some tenant obligations for the residual term, for example: not to cause deliberate harm to the property; to keep the property safe for occupiers; and not to allow the property’s condition to deteriorate so that it causes a nuisance to other tenants or neighbours, or voids any buildings insurance.
A deal may require the tenant to yield up the property in the same condition as at the settlement date, perhaps allowing for inconsequential fair wear and tear. Where this option is used, consideration should be given to the evidence available of the current state of the premises.
A comprehensive schedule of condition, preferably with a photographic and/or video record attached, is ideal but may be unattractively expensive. Any such options will likely require variations to the lease.
Binding on successors
Care also needs to be taken to bind successors in title to the deal. It is no good if the tenant pays a settlement sum to a landlord who then sells its reversion and the new landlord argues that the settlement was not binding on it. This will need thought at the drafting stage: is a settlement letter sufficient or do the parties need a deed of variation baking the release of obligations into the lease terms?
Timing
A landlord negotiating a settlement must not let its contractual rights fall away before the deal is done. Most critically, if the lease requires notice to reinstate to be served, for example, six months before lease expiry, the landlord must serve that notice if it has not already completed its deal. Otherwise, a tenant will spot that reinstatement is unenforceable, and alter its negotiating position.
More broadly, the tenant should consider well in advance of lease expiry whether to approach the landlord to try to negotiate an early deal. There may be works that the tenant would prefer to carry out itself during the term at lower cost if a settlement deal cannot be struck.
The (effective) threat by the tenant, that it may carry out the works, may also improve its bargaining position: the landlord may prefer that the tenant does not attempt to do those works, for example if the landlord has in mind that it may want to refurbish to a more modern standard.
Critically, the tenant’s threat to do the works will only be effective if it has time during the residue of the term actually to undertake the work.
Landlord protection
Settling dilapidations in advance of lease expiry can involve the landlord accepting payment for loss and damage that has yet to crystallise. The landlord cannot say what its actual loss will be: the condition of the property at the expiry of the term is not yet known. Section 18(1) of the Landlord and Tenant Act 1927 provides that the landlord’s claim for damages is dependent on its own intentions at lease expiry and also on the demise’s capital value assessed at that expiry date, in and out of repair.
A landlord may have no claim, at least for disrepair, if it firmly intends at expiry to redevelop. Similarly its reinstatement/redecoration claim can reduce, following similar common law principles.
So, it is worth ensuring that the settlement records that the payment is a genuine pre-estimate of the landlord’s claim. The risk otherwise is that the deal may be seen as an unenforceable penalty. Following Cavendish Square Holding BV v EI Makdessi; ParkingEye Ltd v Beavis [2015] UKSC 57; [2016] EGLR 15 a provision is penal where it imposes (here, on the tenant) a detriment that is out of all proportion with the landlord’s legitimate interests or if it is exorbitant, extravagant or unconscionable when compared to that legitimate interest. The landlord will also wish to stipulate expressly that it is at liberty to deal with the property as it sees fit. A non-reliance clause may assist in stopping a tenant assertion that the landlord misrepresented its future intentions for the property when negotiating the deal.
Alternatively, the settlement can be agreed as damages for the landlord’s extant loss at the settlement date. This may be advantageous in circumstances where the lease is also varied to delete or reduce the repairing covenants for the residue of the term.
Interaction with break notices
Parties may wish to settle dilapidations in advance of a lease expiring by the operation of a break option – although this may not always be attractive to the landlord. Where a tenant’s break provision operates only where the tenant (say) has left the property in good and substantial repair on the break date, this may be a hefty obligation on the tenant. The landlord may wish not to engage in negotiations that might negate that conditionality. Settling dilapidations in advance would almost certainly amount to a waiver by the landlord of the condition.
Landlords will have in mind that the value of waiving a break condition may be more in negotiations than just the cost of works: it will reflect the risk to the tenant that the break will not operate and that rent and other liabilities will continue after the break date.
Protected business tenancies: Landlord and Tenant Act 1954
For many protected business tenancies, settling dilapidations early will not be relevant. Unless the tenant has served a section 27 notice to bring its rights to an end, it may not be certain that the tenant will leave at the end of the term.
Where the landlord serves a hostile notice quoting grounds under section 30(1), the tenant may wait until it is clear that the landlord can make out its ground before considering dilapidations. Dilapidations may not be relevant at all where, for example the landlord is using ground “f” redevelopment as a reason for termination.
Other interests
If a tenant has subtenants, then early settlement may be a greater challenge. A simultaneous deal that encompasses both superior and sub-interests may be impracticable.
If the tenant settles with its landlord first, a downward claim against the sub-tenant (for example at the sub-tenancy expiry) should still be possible, premised on the quantum paid to the head landlord (applying Biggin v Permanite [1951] 2 KB 314), however the section 18(1) cap may limit recovery. A tenant will need to take care in settling claims with subtenants during the term if there is any obligation to the landlord that forbids variation and/or waiver of covenants.
Similarly, if the landlord is not the freeholder, it must comply with its obligations to the superior landlord not to vary/waive the covenants given by the occupational tenant. The landlord must also consider whether any lender consent is needed either to settle dilapidations or to vary the leases.
Settlement of damages: is tax applicable?
A true settlement of damages has no VAT. But care must be taken if settlement terms are more elaborate as it might be viewed as encompassing separate consideration for the variation of a lease or waiver of a party’s obligations, in which case VAT may be applicable. Assuming the tenant recovers its VAT, there may be little objection if the landlord requires that the settlement sum is exclusive of VAT (if any) and that the tenant is obligated to pay VAT on top of the settlement sum should it be provided with a valid VAT invoice.
Similarly a true dilapidations settlement payment (assuming no variation of the existing lease) is unlikely to have stamp duty land tax (SDLT) consequences. But attention is needed where the settlement is tied in to other land transactions, such as further lease grants; the contractual drafting needs accurately to set out why the various payments are made even if, ultimately, through set off, no money moves. Any apportionment between transactions needs to be justifiable.
Direct tax position
While the focus tends to be on VAT and SDLT, the parties should also understand their direct tax position; in particular whether the tenant gets deductions for its payment and the tax treatment of the payment in landlord’s hands. However, this can be a complex area and specific advice should be sought in each situation.
Matthew Bonye is a partner and head of real estate dispute resolution and Frances Edwards is a senior associate at Herbert Smith Freehills
