Regulated by RICS

Nicholas Dowding QC and Philip White consider the potential impact of MEES on dilapidations, alterations and rent reviews (published in Estates Gazette in the Legal section on 02 December 2017).

The impending nature of the Minimum Energy Efficiency Standards (MEES) raises big questions about how building improvements will be made, what impact they will have on landlord and tenant relationships and at what point in the discussion the word “MEES” will arise.

The Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015 (the Regulations) restrict new or continued lettings of a commercial property after prescribed dates (1 April 2018 for new tenant lettings and 1 April 2023 for the continuance of existing leases), where the relevant property has an EPC rating of F or G.

The sensitive issue of MEES is very likely to arise in the context of (among other possible scenarios) lease end and contractual break discussions. If so, there may be much to consider regarding the effect on terminal dilapidations claims by landlords. MEES may also come up in relation to applications for licence to alter, and as regards rent reviews.

Before looking in more detail at what effect there could be on each touch point, there are three general points that need to be noted.

First, what the Regulations do is prohibit the landlord from letting after the relevant dates. What they do not do is impose on landlord or tenant any direct obligation to carry out improvement works. So, a property with an F or G rating does not of itself infringe the Regulations: a breach only occurs once the property is let (or a letting is continued) after the relevant date and no exemption applies.

Second, the Regulations provide that a letting or continuance of a letting in breach of the Regulations does not affect the validity or enforceability of any provision of the tenancy. So, a lease granted in breach of the Regulations is nonetheless a valid lease, and the parties cannot rely on the fact of breach in order to escape their respective obligations.

Third, the Regulations further provide that nothing in them affects any duty to carry out works to a property (including works to repair or improve) imposed on landlord or tenant by the terms of a tenancy agreement, or by any other enactment.

Claims for terminal dilapidations

A building which has an EPC rating of F or G will not generally be in disrepair by reason of that fact alone. Thus, for example, energy-inefficient halogen spotlights in an office building may result in, or contribute to, the building having a low EPC rating. But if they are nonetheless in a perfectly acceptable state of repair, the usual form of tenant’s repairing obligation will be complied with, and no further works will be required. Equally, a covenant to comply with statutes and regulations will not generally oblige the tenant to carry out energy improvement works, because, as noted above, the Regulations do not require (at least directly) the carrying out of works. Absent specially drafted provisions in the lease, therefore, it seems unlikely that a tenant can be compelled to carry out energy improvement works simply because the property has an EPC rating below E.

However, disrepair may exist to parts of the building fabric, or m&e services, whose performance directly impacts on the EPC rating. Returning to the above example, suppose the halogen lighting is defective to the point where it needs to be replaced. Energy efficiency standards apart, the tenant would be entitled to install new halogen lighting. Is the tenant nonetheless liable to install energy-efficient LED lamps (which are more expensive) in order to increase the EPC rating of the building to at least an E? The answer is likely to be no. As noted above, the Regulations do not impose any obligation to carry out works, still less to carry out repair works in any particular way, nor do they affect any duty to carry out works imposed by the tenancy agreement. Of themselves, therefore, they do not prevent the replacement of an energy-inefficient item with one that is equally energy-inefficient. The position is therefore not the same as a case where the effect of, for example, building regulations is that remedial work cannot lawfully be done other than in a particular way.

That said, there may be cases where the remedial works required by the repairing obligation will coincidentally produce an improvement in energy efficiency. Take, for example, a defective 30-year-old boiler which has reached the stage where the only sensible course is complete replacement and where the only practical way in which the obligation to repair can be discharged is by installing the nearest modern equivalent. The new boiler will inevitably be much more energy-efficient than the original. But that will generally just be the landlord’s good luck.

The principal area where the Regulations are likely to impact on terminal dilapidations concerns diminution valuations under section 18(1) of the Landlord and Tenant Act 1927. A notional buyer of the landlord’s interest on the valuation date who intends to relet the premises after 1 April 2018 will inevitably have regard to the Regulations when deciding what he is prepared to pay for the premises. If the building would have an EPC rating of F or below even in repair, then questions of supersession are likely to arise, because the repair works may be superseded by the energy efficiency improvements. To return again to the defective lighting example, the easiest and quickest way to improve the EPC rating may be to replace the halogen spotlights with LED flat panels. If that is what the buyer of the premises in repair and in disrepair would do, then the repairs to the existing lamps (the installation of new halogen lights) will be superseded, and the cost will not feature in the diminution in the value of the reversion.

The Regulations may also affect loss-of-rent claims. In cases where the landlord needs to carry out energy efficiency improvements before being able to relet, there may (depending on the facts) be an argument that the repair works could be done within the same timescale, and therefore that the disrepair has not resulted in any greater loss of rent than would have occurred if the premises had been in repair.

Alterations

The main impact of the Regulations on initial tenants’ fit-outs or alterations during the term is likely to be in cases where the landlord perceives that the work will or may reduce the EPC rating of the building, or (if already carried out) has reduced it. Depending on the facts, it may well be reasonable to withhold consent (or require reinstatement) in such cases, particularly where the reduction is to an F or G.

Rent reviews

Virtually all rent reviews operate by reference to the hypothesis of a letting of the premises on the open market between willing parties on the same terms as the actual lease. What happens where the EPC rating of the premises is an F or G, and the valuation date falls after 1 April 2018? In the real world, the effect of the Regulations is that the premises are unlettable unless energy efficiency improvements are carried out. How does that translate into the valuation hypothesis? Here are four points to consider:

First, most rent review clauses provide, expressly or impliedly, that the tenant must be assumed to have complied with its covenants. Where such compliance would result in an increase in the EPC rating to an E or above (for example, because the required repairs would improve energy efficiency, as in the boiler example), then there will be no difficulty, because the premises in their assumed state will be lettable under the Regulations.

Second, where that is not the case, can the tenant argue the reviewed rent ought to be nil, because the willing landlord would be unable lawfully to enter into the hypothetical letting? Or can the landlord argue for a higher rent on the ground that the relevant improvements must be assumed to have been carried out prior to the notional letting? Both of these seem wrong. The valuation hypothesis requires one to assume a letting, and that necessarily entails an assumption that the premises are capable of being lawfully let, even if that is not the case in reality (see IRC v Gray [1994] STC 360). But there seems to be no need to go further and “rentalise” work which does not exist in reality.

Third, it may be that a future subletting by the willing tenant under the hypothetical lease would be caught by the Regulations. If so, and if the right to sublet would otherwise be a valuable one, the rent may be depressed if: (a) the tenant will have to carry out energy efficiency improvements before being able to sublet; and (b) the comparable properties have EPC ratings of E or above. Not only will the works cost money, but they may require the superior landlord’s consent (although an inability to obtain consent on reasonable terms despite reasonable efforts may give rise to a temporary exemption from the letting restrictions).

Fourth, in those cases where the cost of energy improvements is recoverable by the landlord under the service charge provisions, the reviewed rent may be depressed (by comparison with the comparables) if the likelihood of work being carried out is a high one, such that the willing tenant would factor his potential liability into his rental bid.

Inevitable impact

In principle, the Regulations will certainly have an impact on dilapidations, alterations and rent reviews – but, as always, the extent of the impact will depend on the particular circumstances and will rely on the unpicking of the situation by a team of experts.

Nicholas Dowding QC is the in-house QC and Philip White is the Partner in charge of Energy and Sustainability services at Malcolm Hollis.