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The below article was published in the Volume 6 Number 3 of the Journal of Building Survey, Appraisal and Valuation.

Summary

The incoming Minimum Energy Efficiency Standards (MEES) will make it illegal to grant a new lease for a property with an EPC rating of F or G from 1 April 2018 (and will affect existing leases too by 2023). The F-Gas regulations are increasingly restricting the supply of certain types of refrigerants widely used in air-conditioning systems, resulting in significant price hikes. Both the MEES and the HFC phase-down requirements can be addressed in tandem as upgrading or replacing a property’s air-conditioning system can have a hugely positive impact on its EPC and will eliminate reliance on depleting, increasingly expensive gases.

The input of a specialist M&E consultant in a refurbishment design phase will mean that a number of refurbishment/replacement options can be reviewed to ensure that the property would remain legal to let post 2023 (and so avoiding having to re-enter to carry out disruptive – and more costly – works mid-lease) whilst also potentially reducing future service charge/repair works and operational/energy costs.

With careful planning, and by being pro-active rather than reactive, the costs involved – although admittedly higher in the short term – will be lower overall over the long term.

Author

Michael Cunningham is an Associate at Malcolm Hollis based in the Birmingham office. He has over ten years’ experience in undertaking building services engineering instructions including projects, technical due diligence and planned maintenance. He started out as a project engineer, monitoring and problem solving installations on site for contractors. Now, as a consultant at Malcolm Hollis, he is also an expert in the field of dilapidations, where he advises clients on how the Minimum Energy Efficiency Standards (MEES) and the phasedown of hydrofluorocarbons (HFC) could affect dilapidations claims.

MEES and HFCs – burden or opportunity?

Much has been written about the implications both the incoming Minimum Energy Efficiency Standards (MEES) and the Fluorinated Gas (F-Gas) Regulations 2015. In this article the impact of these two pieces of legislation will be explored from a mechanical and electrical engineering point of view – and why this is important for both landlords and tenants.

Before going any further this is a good point at which to provide a brief overview of the legislation:

Minimum Energy Efficiency Standards (MEES)

From 1 April 2018 it will be illegal to grant a new lease for a property with an EPC rating of F or G. From 1 April 2023 the regulations will also extend to existing leases.

MEES is mandatory and, whilst the penalty for not complying is a fine rather than a prison term, a landlord must be able to demonstrate repeated attempts to undertake the works at least every five years or otherwise demonstrate that the payback period for the improvement works exceeds seven years – i.e. that the cost of carrying out the work is greater than the projected energy cost savings over seven years.

MEES are already active legislation in Scotland, although the requirements differ from England and Wales.

Fluorinated Gas (F-Gas) Regulations 2015 and the HFC phase-down

HFCs (hydrofluorocarbons) are widely used as refrigerants in air-conditioning systems. There are a number of different types of HFCs – some with a much greater carbon equivalent (and hence greater global warming potential) than others. Their use is being phased down over the next 13 years through the introduction of CO2 equivalent allowances, which means that far less of the ‘worst offenders’ can be manufactured. In 2016 (through to 2017) a 7% reduction in the baseline CO2 allowances was implemented. From 2018 there will be a further 30% reduction and by 2030 only 21% of the baseline quantity of HFC refrigerants will be available to the market. Additionally, there have been changes to leak detection requirements and from 2020 refrigerants with a global warming potential greater than 2,500 will be subjected to further restrictions.

The impact of the HFC phase-down is already becoming apparent with sharp price rises over the past two years in some of the most widely used refrigerants including R404A – a refrigerant that is representative of the primary target for the HFC phase-down. The price of R410A (which has been commonly used in variable refrigerant flow – VRF -systems for over a decade) has also nearly doubled in the last two years. These steep prices hikes mean that inevitably maintenance costs for these systems are also increasing. The problem is set to escalate as the availability of refrigerant is reduced as maintenance contractors and end users begin to stock pile supplies to keep their installations operational.

Will MEES and F-Gas affect me?

So, with the law set out, will it require your attention as a landlord or a tenant of a building? The answer – for both landlords and tenants – is a resounding yes. Take this very typical example involving existing office stock:

  • The landlord is looking for a new tenant for a newly vacated floor in a multi-let property. After completing a not inexpensive cosmetic refurbishment (including redecoration, carpets, ceilings and LED lighting) the property is put on the market. The obligatory glossy brochure and the enticing website ads soon attract an initial enquiry from a prospective tenant. So far, so good.
  • After some negotiation over a number of headline agreements the tenant then brings on-board their building consultants to complete a due diligence survey. All being well, closing the deal is within sight.
  • But what happens when the tenant’s team of building surveyors and mechanical and electrical (M&E) consultants begin looking beyond the glossy photos, opening the ceiling, looking under the raised floor and in the plant room? It will certainly not escape their notice that the space is heated and cooled with individual VRF systems that are some 13 years old. The landlord’s been rumbled and it is plain to see that, beyond the lights, the landlord has done little more than clean up the existing engineering services installations, which are operational, but also almost obsolete. Also, in respect of the EPC, the installation of the new LED lighting may have improved its rating from a G, but it is still just an F.
  • In an attempt to offset this, at this point the landlord may consider offering rent-free periods or reducing the rent by a few pence, possibly even softening break clauses. Another option is to contribute to the tenant’s fit-out or even for the landlord to carry out additional works. Getting to the point where the deal can be tabled and the Heads of Terms agreed can be a challenge and it is certainly not unusual for some or all of these concessions to be offered in order to coax the tenant towards committing to the deal.
  • Whilst not all of the options above involve a capital outlay, they do all have something in common: they will all cost both the landlord and the tenant in the longer term. They will cost the landlord in the form of reduced income and they will cost the tenant as further works (to remain compliant with statute) will be necessary in the not-to-distant future. Further, such works may well disrupt the tenant’s future business operations.
  • But were works to upgrade/replace aged engineering services put forward by your M&E consultant and then dismissed as being too expensive and omitted from the project? Was it decided that the 13-year-old VRF system could instead be serviced and its life extended for a further five to 10 years because the £150/m2 to install a new system seemed disproportionate to the value of the rest of the works?

Whilst it is perfectly possible to agree a letting in the above scenario before 1 April 2018, will the tenant really want their landlord to have to re-enter the property after 1 April 2023 to make the mandatory MEES improvements? The level of disruption and inconvenience that would cause is likely to be an issue for many tenants. But let’s say that the tenant agrees for the works to be done: at least then the property will be MEES compliant and lettable. But consider this: the increase in cost to the landlord to complete the works out of hours or to relocate tenants during the works could add 30% to the cost of replacing the air conditioning system. Such work often means also that the new suspended ceiling and carpets may well need substantial replacement – another £60/m2 to budget for. So, what could have cost in the region of £150/m2 to complete whilst the office was vacant, is now looking more like £255/m2, excluding any rent-free periods that tenants may request in respect of the disruption. Food for thought?

Time to assess

The timetabling dictates that MEES and the HFC phase-down are due to have significant impacts at similar times. Coupled with the fact that upgrading/replacing a property’s air-conditioning system can have such a positive impact on its EPC rating is this not a golden opportunity to ‘kill two birds with one stone’ whilst also saving money in the longer term?

When your M&E consultant proposes making a greater investment as regards services installations when refurbishing a property their advice should not be dismissed out of hand. Take the longer term view.

It is important to bear in mind too that the increased initial cost of a scheme might not necessarily arise from the cost of works but the investment (i.e. fees) in the expertise that an experienced M&E consultant provides. Their skills may alone drive the required energy efficiency improvements, perhaps in developing a detailed performance specification and reviewing contractor’s proposals to ensure what is needed to achieve compliance is delivered. Or in developing a fully designed scheme that delivers what is required and removes any contractor’s design elements from the contract (and therefore reduces risk to the employer and the contractor) resulting in sharper costs being provided at tender stage. A comprehensively designed scheme could result in plant selections that don’t need excessive design margins and would allow lower capacity equipment to be installed. Smaller plant also means smaller capital costs.

Alternatively, it could simply be modelling the impact of a number of options being considered so that an assessment of value can be determined. Taking the example given earlier, had a draft EPC been modelled during the initial stages of the works it would have been possible to confirm if replacement of the lighting alone would improve the EPC sufficiently. If it wasn’t, the engineer could examine the impact of a range of other packages of work necessary in order to achieve a rating which ensures that the property would remain legal to let post 2023 and avoid the need to offer incentives in response to the points raised by the tenant’s building consultants.

Landlords should also be mindful that what works for one property to improve the EPC may not deliver the same results in what might be considered a similar scheme. Recently we prepared draft EPCs for nine city-centre multi-let properties that, on the face of it, might be considered to only vary in size. The drafts returned surprising varied results: some properties would have benefitted significantly from replacing the perimeter LTHW systems for VRF systems, whilst others achieved better results in retaining the DX comfort cooling systems and installing high efficiency condensing boilers. The point being that a generic specification for an entire property portfolio will not guarantee the best returns on the investment.

Speculate to accumulate

Rarely, if ever, has an M&E consultant been asked to consider the idea of spending more money on the initial refurbishment works in order to deliver a project that excels in areas many tenants may overlook. Landlords are missing a trick there. For example, new, energy efficient equipment will reduce potential service charge works, contribute to an improved EPC, reduce energy costs and lower the frequency of repair works. Whilst initially the rental rate required to generate a return may appear high compared to other spaces, the inclusion of the service charge and comparison of the total cost per square foot may actually offer a saving compared to other properties that are reliant upon less efficient and less reliable equipment. Surely, there is also added value to a tenant in knowing that the landlord will not need to re-enter the property in four or five years’ time to undertake additional works?

Of course, the opposition to increasing capital expenditure is that it will extend the contract programme, reduce the return on investment, tie up cash flow for the next purchase and ultimately increase risk. Whilst these views are representative of what can happen, they are also somewhat short-sighted views and neglect the fact that the property market is a long game. The risk can also be mitigated by instructing a project team that can develop the specification and designs and manage the contractor to ensure what was paid for is delivered to the highest achievable value. Nevertheless, the thought of “what can I save today” rather than “what can I make in five, 10 or 20 years” nearly always wins out – currently anyway. Has the commercial property industry forgotten the saying “you have to speculate to accumulate”?

Be proactive, not reactive

Perhaps this is one of the reasons why Britain’s existing building stock is subjected to reactive, rather than proactive, action when it comes to changing legislation? The phase-out of hydrochlorofluorocarbon (HCFC) refrigerants (e.g. R22) and the Heat Network Regulations 2014 are both examples of this. We are still encountering a significant number of properties that use R22 air conditioning systems and many people are not aware of the Heat Network Regulations and their implications. The root of this reactive culture? Keeping costs down. Both MEES the HFC phase-down appear to be the latest changes in legislation that are being brushed under the carpet to avoid capital expenditure.

When MEES comes in to force for new leases in 2018 it is expected that there will be an increase in demand for contractors to complete refurbishment works. At a time when contractors are already requesting extensions to tender periods or simply declining to tender due to current commitments, it seems inevitable that in order to manage the influx of enquiries, project costs will increase and M&E contractors will be looking to pick and choose which projects they work on. When that happens, contractors will begin to either set aside or charge premiums for the enquiries relating to quick turn-around projects for new lighting or air conditioning systems. Instead, they will favour comprehensive multi-disciplinary projects and full refurbishments that provide opportunities for them to increase their contract values and grow their business. The situation will be compounded further when the second key date for MEES is triggered in 2023.

Consider MEES and HFC phase-down together

There are clear motivators to address both MEES and the HFC phase-down requirements in tandem with each other. There are clear cost benefits in not having to carry out two packages of work but they do need to be considered hand in hand as one impacts on the other.

Take the multi-let property described earlier. It is unlikely that the existing VRF system’s life can be realistically extended to provide any reliable operation beyond 15-16 years unless it has been meticulously maintained during its life. It is also likely to use R410A, or another refrigerant with a comparatively high global warming potential compared to more modern refrigerants.

If only MEES was to be considered, a new VRF system with heat recovery and possibly variable evaporator temperatures could be enough to improve the EPC to the level required. However, the VRF system would still be wholly reliant on refrigerant and, depending on the refrigerant and charge used, could fall foul of the various thresholds included in the F-Gas Regulations.

What the M&E consultant might instead suggest is a hybrid VRF (HVRF) system which combines the flexibility of water-based fan coil units with a refrigerant condenser via a heat exchanger. This system significantly reduces the amount of refrigerant needed and could bring the system below the thresholds detailed in the F-Gas regulations. However, a comparable HVRF system is unable to achieve the ESEER and SCOP values of a traditional VRF system and therefore the improvement to the EPC may be reduced. It’s a bit of a balancing act.

From a tenant’s perspective however, there are still a number of benefits for the HVRF system to be installed. Firstly, assuming the EPC is an E or better, the landlord will not need to re-enter the property. Secondly, with a new system already installed there should be no need for it to be replaced within a 10 or 15 year lease if it is maintained. Further, the maintenance costs will be less than the VRF system because the volume of refrigerant used is much smaller and any works associated with moving the indoor units can be completed without having to recharge the refrigerant circuit.

From a landlord’s perspective, they will be able to assure the tenant (by reference to the EPC) that they will not need to re-enter the property for the duration of the lease in order to make improvement works. A higher rental rate can be considered which would be offset against the operational savings the tenant benefits from, and with the right approach during the negotiation of the previous dilapidations claim, it could be possible to receive a contribution towards the new system as part of the settlement.

Compliance with MEES and reducing reliance on depleting sources of increasingly expensive refrigerants really do need to be considered together to ensure that the desired balance is achieved. For some tenants, for instance, the desire to occupy a property with an EPC of a B is more important to them than the overall running costs of their air-conditioning systems. Others will prefer the hybrid system and its lower running costs as long as the EPC remains above an acceptable threshold. One should always be aware that refrigerant costs are only going to rise (perhaps exponentially) and that ever-tightening building regulations (to which EPCs are pegged) will mean that greater and greater energy efficiency is demanded of buildings.

Stand out from the crowd

Whichever way you look at it, there are costs associated with both MEES compliance and HFC phase-down. But, with careful planning and by being pro-active rather than reactive the costs, although admittedly higher in the short term, will be lower overall over the long term.

With all of the upcoming changes in legislation and the inevitability that properties with a poor EPC rating will require works to be undertaken from 2023, even with an existing lease in place, does it not make sense for a property’s unique selling point (USP) to already be in place when it hits the market? A USP that is invisible inside the property, in the form of its energy efficiency and upgraded heating and cooling installations, but abundantly clear in the operating costs and to the building consultants that any diligent tenant would instruct to inspect prior to committing to a deal? A USP that is demonstrable with the EPC and service charge costs and a USP that will cost less to achieve now than it will when everyone else is trying to achieve it? In many instances, it will be the landlord, or their agent, who needs to highlight these other areas in their marketing to ensure that tenants are comparing prospective spaces in a holistic manner.

What’s also unique is that, whether you are a landlord or a tenant, each property and each lease will be different in the way that the requirements of MEES and the F-Gas Regulations need to be discharged. By engaging with M&E consultants at each stage of a lease from technical due diligence, through to fitting out the property, settling the dilapidations and completing the refurbishment to start the cycle again, the impact of investments, and their subsequent returns, can be maximised.