As explained in last week’s article, landlords face particular risk around the Minimum Energy Efficiency Standards (MEES) where their tenants are able to evidence that their leased property – as demised – would be considered “sub-standard”, and hence unlettable under the MEES Regulations.
In turn, tenants will assert that there is no comparable evidence to support a landlord’s claim for an uplift in rent.
MEES and rent review
In addition, however, there remains a risk for properties let with better, compliant EPC ratings. Indeed, rent review risk is arguably greatest in seemingly MEES-compliant properties. Examples 1 and 2 are just a couple of many different potential scenarios which could have a significant impact on rent review. The matter of tenants’ works – and how they are documented – could be hugely important.
MEES and alienation
The ability of a tenant to sub-let or assign its lease can prove hugely important, particularly in times of economic uncertainty. This facility is normally equally valued by landlords, for whom it is preferable for a struggling tenant to pass on its liabilities to another party, as opposed to that original tenant folding and the property being left vacant.
It should be noted that a lease assignment is not considered a lease event which might trigger enforcement action, whereas a sub-lease is such an entity (as is a lease renewal, or indeed a lease extension).
A typical alienation clause within a lease will allow a tenant to sublet or assign, subject to the landlord’s consent (not to be unreasonably withheld). The parameters of reasonableness are of course subjective, but are likely to be tested by the influence of MEES. Example 3 demonstrates how complex MEES could make the matter of alienation, and how much strength it hands to tenants. In particular, well-evidenced draft EPCs will be used to great effect by well-advised tenants.
In setting out its case in example 3, the tenant is able to position two strong arguments to the landlord:
- If you do not allow us an assignment, we will be unable to exercise our right under the lease to alienate (by subletting) and will make a damages claim against you for the same.
- If you do not agree to the assignment, we will lodge the draft EPC in any case; this will render you as the landlord in breach of the MEES Regulations come
1 April 2023.
The latter point here is critical. From the landlord’s perspective, it can either agree to the poor-covenant assignment or risk becoming an offending landlord under the regulations and the existing letting being susceptible to enforcement action for the final nine years of the term.
In either case, the landlord will now be open to the rent review tactics as described above, and will face a substantial challenge in pursuing a dilapidations claim.
MEES and dilapidations
Dilapidations claims, be they at lease end or during the term, will succeed or fail depending on whether they duly consider MEES. A tenant’s ability to evidence that a landlord has no dilapidations position over it hugely bolsters its negotiating position on all manner of scenarios, be it alienation, lease surrenders or lease renewals.
The strength of a landlord’s dilapidations claim is dependent on its ability to evidence that, had the tenant yielded up the demised property in a lease-compliant condition, it would not suffer the monetary loss as defined in the claim. This is typically based on the assertion that the property handed back in repair, redecorated, etc, would attract a replacement tenant at or soon after lease end, and thus be income yielding.
When factoring in MEES, if a tenant can identify that the subject property would be “sub-standard” – and thus unlettable – irrespective of its state of repair, it has a substantial argument in its favour with reference to section 18(1) of the Landlord and Tenant Act 1927 (as shown in example 4).
It is critical that landlords make sure their dilapidations claims are carefully crafted so that they do not fall foul of this kind of argument from their tenants. To this end, landlords must ensure their dilapidations surveyors do not request (through the dilapidations claim) that their property be yielded up in an unlettable form.
Example 1
Thirteen floors of a substantial office building, amounting to c 150,000 sq ft, in Victoria, SW1, were let in 2005 on a 25-year lease with five-yearly rent reviews. The property had no EPC at the point of grant, but the tenant had an assessment carried out in 2012 as part of a proposed sub-letting. The EPC rating then was E.
The landlord seeks a rental uplift from £40 to £65 per sq ft at the 2020 review. The tenant has a new EPC prepared which supersedes the 2012 rating and shows that – through the changes in EPC assessment and the building regulations (on which the ratings are dependent) – the rating
as of 2020 is actually now G, so defined as “sub-standard”.
Accordingly, the tenant refutes the landlord’s evidence of recent comparable lettings supporting its suggested uplift, citing that none of it is actually de facto comparable evidence, because a truly comparable property would not support such an increase as it is incapable of being lawfully let.
One counter to this from the landlord is likely to be to refer to the rent review assumption that the property will be lawfully able to be let. Where significant sums (eg £3.75m per annum based on the above) are at stake, tenants are likely to pursue legally the position that the facts override the assumption in this case – to their significant potential advantage.
Example 2
A 6,000 sq ft retail unit within a shopping centre is let on a 10-year term with an open-market review upcoming in 2020. The unit was let in 2015 with an EPC rating of F, as a result of the “as-demised” property containing the former occupant’s poor-quality fit-out.
On occupation, the current tenant undertook significant improvement and fit-out works which resulted in the property achieving an EPC rating of C.
The landlord seeks a substantial uplift at review based on evidence of recent lettings across the shopping centre.
The rent review terms in the lease include the stipulation that, at review, the tenant’s improvements shall be disregarded. In response to the landlord, therefore, the tenant states:
“The subject property due to be considered at rent review is to exclude the improvements we made at the start of the lease. Therefore, the subject property would achieve no better than an EPC of F. This should be considered as a characteristic to which comparable properties should equate. None of your comparables therefore support your assertion that there should be a rental uplift.”
Example 3
An 8,000 sq ft retail unit was let on a 25-year lease in 2007 to a well-known high street retail brand – no EPC was required for the letting.
In 2020, that retailer is consolidating its estate and so seeks to assign its lease to another party that is willing to take on the remaining 12 years of the lease on the existing terms.
The landlord refuses the assignment, citing that the proposed assignee party is a weaker-covenant party than the current tenant. Instead, it proposes that it would grant consent to sublet.
The proposed subletting is of no interest to the tenant as the property will remain a liability. It therefore contests the landlord’s refusal of the assignment, referencing the relevance of the MEES Regulations, producing a draft EPC showing a rating of F and stating the following:
“While the existing headlease did not require an EPC and the proposed assignment did not require an EPC, your proposal of a subletting would trigger the need for a valid EPC to be produced. The EPC for the demised property renders the proposed subletting unlawful, so it cannot proceed.”
Example 4
A landlord of a 320,000 sq ft prime central London office with glazed facades and a large atrium reception serves a claim against its tenant six months from the end of its 10-year, full repairing and insuring lease. The claim totals £11m.
The tenant does not acknowledge the claim until the landlord issues a quantified demand after lease end. At that point, it reveals that it had an EPC prepared for the property on the day of lease end, and it returned as a “sub-standard” F rating. With the knowledge that the landlord would have required one anyway to effect a new letting, its response to the dilapidations claim refutes it in full, citing both limbs of section 18(1) as follows:
- Supersession – eg, your claim included £2m worth of replacement suspended ceilings where these are damaged. In order to relet the property under MEES, you need to replace the air-conditioning equipment in the ceiling void; this would have rendered the proposed ceiling works valueless.
- Diminution in value – the claim for damages relating to the disrepair of the property is capped at the amount by which the value in the reversion of the property is impacted by the items of disrepair claimed. The effect on value of the elements of disrepair is wholly overridden by the impact of MEES; in other words, what is the difference in value of an unlettable building in repair versus an unlettable building out of repair?
See also: Reasons to be wary of MEES and MEES: Issues and opportunities for the 2020s
Ben Strange is a director at Mobius Building Consultancy
