One of the most significant areas of dispute between landlords and tenants is the condition in which premises need to be handed back at lease expiry. Repairs, reinstatement of alterations and redecoration, together with the associated costs of any claim, form the basis of a tenant’s dilapidations liability. Careful consideration of its options as the lease expiry draws closer means that a tenant can develop a strategy for dealing with and mitigating its potential liability that reflects its needs and circumstances.
As most tenancies will end with a dilapidations claim, what should a well advised tenant do?
Read the lease
The starting point is to understand what the lease requires by reference to the precise wording of the lease covenants relating to repair and yielding up. A surprisingly large number of disputes arise because one or both parties do not read the lease carefully, do not understand what it means, or do not apply that understanding to the premises. The absence of an accurate understanding of the obligation, coupled with differences of opinion between landlord and tenant, can make the approach to terminal dilapidations very difficult to predict for a tenant wishing to move on and settle its liabilities with its old landlord.
The standard of repair and the notion of possible replacement of parts of the premises are often at the heart of many disputes. We live in an age of widespread technological progress and obsolescence is thrust upon us at an increasingly rapid pace. Often, repair isn’t economically feasible and replacement with a modern equivalent is the most effective option; however, this often feels like an unfair proposition for a tenant with no future interest in the premises once its lease ends.
Assessing damages
If the conclusion is reached that the tenant is in breach of its obligation, what then? At lease expiry the landlord’s remedy is limited to a claim for damages and tenants need to understand and take into account how such damages are assessed when deciding what to do. Damages are generally the reasonable cost of putting the premises in repair and, where appropriate, loss of rent and other losses during the period needed to carry out repairs. Section 18(1) of the Landlord and Tenant Act 1927 however, imposes two qualification on this:
■ Damages cannot exceed the amount by which the value of the landlord’s reversion is reduced as a result of the breach. This requires an assessment of the difference between the value of the premises in disrepair on the lease expiry date and the value if there had there been no breach of covenant.
■ No damages are recoverable where the premises are to be demolished or structural alterations are to be carried out after the end of the term. This is a subjective test looking at what the actual landlord intends to do at the term date and the tenant should investigate this if redevelopment or refurbishment of the premises would be a sensible course of action. The tenant will need to gather sufficient and persuasive evidence of the landlord’s intention if a dilapidations claim is to be mitigated or avoided. Has the landlord served a section 25 notice offering renewal? Is the landlord seeking possession and, if so, on what ground(s)? Have any planning applications been submitted?
The tenant may also be able to mitigate liability if it can be shown that all or part of the works required would not survive any upgrading necessary to bring the property up to modern standards for reletting. This may be particularly important if the premises have a borderline EPC rating where the landlord needs to undertake improvements in order to relet.
Almost invariably a terminal schedule of dilapidations will include works required to reinstate alterations carried out by the tenant during the term. The provisions of any licences for alterations should be checked to see whether any works are excluded from the reinstatement obligation. Damages for failure to reinstate are measured by reference to the landlord’s loss and whether the reinstatement is a reasonable requirement. The section 18 limitation on damages does not apply but this does not necessarily mean that a landlord is able to recover the cost of reinstating all works.
What can a tenant do to mitigate its exposure to terminal dilapidations?
There are several strategies available, but all are most effective if deployed in good time before termination:
Undertaking the works
Uncertainty of outcome means tenants are often reluctant to do the work necessary to comply with the lease. This, however, should be the first option to consider since it avoids a breach of contract if executed correctly. There are other benefits too: costs are controlled by the tenant, and the least expensive option to comply with the covenants can be selected; the risk of a loss of rent claim is minimised; and the tenant is seen to be acting responsibly should a dispute arise at a later stage.
Financial settlement
Many tenants opt for a financial settlement instead to overcome the uncertainty issue. This approach can take into account any landlord’s improvements or alterations and, for the commercially aware, the financial disposition of the landlord. The tenant stays in occupation up to the last day of the term, and doesn’t worry about moving out early while works happen. Timing is crucial to striking the best deal, and it should always be done on a “full and final” basis. Don’t be too surprised if the landlord’s intentions change after the settlement has been agreed.
Part works/financial settlement
The tenant does those works that are straightforward and uncontentious, leaving the remainder for a financial settlement. This option can be considered when there may be uncertainty around the landlord’s intentions for the premises, limited time available to undertake the works, or just a low appetite for complex works. Care is required to make sure the items of work left undone don’t affect those that are completed – for example, don’t replace floor finishes if the tenant’s partitions have been left in place.
Alternative dispute resolution
Although dilapidations cases rarely go to court, should negotiations fail there are various forms of alternative dispute resolution (ADR) available that offer the parties a cost-effective way to resolve matters without litigation. For example, RICS offers its Dilapidations Dispute Resolution Scheme, which is especially suited to smaller claims where costs can easily become disproportionate to the claim value.
Strategy and timing
The Dilapidations Protocol has had a significant effect on the behaviour of the parties in terminal claims, but the uncertainty of the final outcome remains. A tenant needs to be proactive to protect its position, especially if its landlord shows little sign of engagement before termination.
Preparation, planning and timing are essential components to a successful outcome in dilapidations for tenants. The key advantage the tenant has during the term is that it can undertake the works, and it should use this to full effect. The tenant should plan to vacate early enough for this to happen and engage a surveyor who can deliver the works to the required standard.
Having protected its position, the tenant can then attempt to agree a financial settlement if the landlord engages, secure in the knowledge that “no deal” means it falls back on the plan to instruct its contractor.
Commercial circumstances will also influence a tenant’s course of action. A common example is the recovery of a rent deposit which may be withheld at the end of the term to cover alleged dilapidations in full or in part. In practice obtaining the release of the deposit can be time-consuming and costly, even where the basis for holding the deposit is questionable.
If the tenant is unable to settle before termination and chooses to do no work, it must collect all the evidence it may require at a later date to defend its position. It may also consider buying insurance to cover all or part of the claim, although these policies are a new development and largely untested.
Five top tips for tenants
■ Prepare for the exit in advance, leaving sufficient time to do the works before lease termination.
■ Engage a good surveyor and solicitor, preferably ones who have worked together on similar cases.
■ Negotiate a settlement prior to termination, setting a clear deadline for conclusion and leaving enough time to do the work
■ Do any works to the best standard possible and don’t cover up any defects that may be unearthed during the works.
■ If there is a residual dispute, don’t ignore the landlord in the hope the claim goes away. Actively engage and consider making an offer to participate in ADR.
For more on dilapidations insurance, see “A dilapidations repair revolution?”, EG, 18 November 2017:
Teresa Edmund is a real estate partner at Bristows LLP and Paul French (BSc MRICS) is a surveyor at Set Square Surveyors and a member of the RICS panel of experts specialising in dilapidations
