MEES: Don’t get caught out at the end of a lease

Using a hypothetical scenario, Ben Strange considers how the energy efficiency rating of a property may have a bearing at lease-end. The Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015 mean it is now unlawful to grant a letting (including lease renewals or lease extensions) of a property which does not achieve the current minimum standard of an EPC rating of E (ie a “sub-standard” building). It has also now been confirmed that the UK government intends to raise the minimum standard to be a an EPC of B by the year 2030. This has a bearing on a wide array of leasehold property matters, but in a lease-end scenario on a high-profile property, may have a vast impact on the dilapidations claim and the landlord’s ability to relet. Here, I look at an example of how a high-profile, seemingly modern and well-designed building may pose an issue to owners when the lease comes to an end. Lease breaks Lease break options are often contentious; with a recipient landlord party seeing a clear financial impact of losing their rental income to term, and tenants driven to exercise their breaks often for financial reasons themselves, each party looks to means of mitigating loss and expense associated with the process. The contractual mechanism of exercising a break of course rests on the wording of the lease, but a variety of recent case law puts paid to the suggestion that even the most transparent of break conditions will be non-contentious. The matter of vacant possession (so often a condition) provides for sufficient uncertainty among the parties. This well-debated element itself, however, becomes all the more complex on consideration of the MEES Regulations in conjunction. Vacant possession Take an example of a single tenant occupying a high-profile central London office building since 2001 and breaking their 25-year lease early in 2021. In the course of their occupation, they sought to improve the energy efficiency of the building to reduce their utility bills and undertook a programme of measures including works to upgrade the HVAC systems. The works were subject to landlord consent, with the landlord retaining a right to request reinstatement of the same on lease determination. The tenant seeks to engage the landlord prior to the break to agree the extent of strip out works they must undertake to satisfy the break condition for vacant possession. The landlord – not contractually required to do so – does not engage and leaves it to the tenant’s judgment. The tenant undertakes an extensive project intended to do works sufficient to provide vacant possession. Through an abundance of caution, they elect to remove the HVAC systems they had themselves installed, justified by their concern that it would otherwise be cited as the cause for vacant possession not being given. After the break date, the landlord has the property inspected to assess whether vacant possession has been provided. While they note that physically the property has been thoroughly stripped out, they note the absence of the tenant’s HVAC systems and advise the tenant that the break is ineffectual because they have not provided vacant possession. On challenge, the landlord specifies further that – through the unauthorised removal of the tenant’s HVAC system (the presence of which would not have breached the requirement for vacant possession) – the tenant fundamentally altered the property in that it adversely impacted its EPC rating. On assessment by the landlord, it was identified that the EPC of the property as yielded up by the tenant (without the improved HVAC system) worsened to a “sub-standard” F rating. The landlord therefore asserts that the tenant’s unauthorised removal of the HVAC systems resulted in the landlord being unable to resume its intended use of the property (ie they cannot relet it due to the EPC rating) and therefore vacant possession was not given and the lease continues to term. Tenants’ works While the previous example depicts a scenario where a landlord may seek to cite the MEES Regulations in their favour, the majority of unintended consequences of MEES provide tenants with the upper hand. One such pitfall for landlords again relates to tenants’ works and how they are consented. A substantial proportion of leasehold commercial property has been subject to some form of tenant alterations, be that an office fit-out, works to form a retail shop, a kitchen installation within a restaurant unit, etc. While landlords typically see it as in their interests to allow such works, it is now vital that they protect their position when it comes to reinstatement requirements for such works. Take the office fit-out, for example. A high-profile central London office building is remarketed to let in 2022. It was constructed in the year 2000 and has fully glazed façades. It used to be a single-let building but the landlord is seeking to let it out on a floor-by-floor basis. The previous tenant removed the building’s HVAC system and the landlord is proposing granting leases with a CAT A contribution to allow incoming tenants to install their own HVAC. Under the MEES Regulations, the granting of such a lease may pose its own difficulties. In the face of a “base-build” office floor with no lighting, HVAC, etc, an EPC assessment would have to be calculated on worst-case assumptions for the property type; when coupled with a fully glazed façade, this is highly likely to yield a “sub-standard” rating and thus the lease will not be permitted to complete. Instead therefore, the parties will be required to negotiate an agreement for lease, which details the intention of the parties to enter into a new lease subject to completion of the tenant’s works (including the CAT A works paid for by the landlord), the consent to which is conditional on them resulting in an acceptable EPC rating. Caution, however, should still be taken on how those works are documented and consented. This becomes all the more relevant in light of the recent confirmation from the UK government that the minimum EPC rating for lettings (currently E) will be increased to B by 2030. Therefore, a landlord granting a 10-year lease of a floor of the subject building conditional on the CAT A works being completed may need to consider more carefully their position on reinstatement. On one hand, having made a substantial contribution to the HVAC installation via the CAT A contribution, they may naturally want to insist on it being yielded up complete with those works, but in full repair. However, if the introduction of that HVAC system results in the EPC rating being, say, a D it would be well advised to at least reserve its right to ask the tenant to remove it on lease end. As explained below, such elements can have a substantial impact on the landlord’s position on dilapidations. Dilapidations While this impact plays out across the full spectrum of property types and construction, it is arguably heavily glazed office buildings which are the most susceptible to unexpectedly poor EPC ratings. When coupled with leasehold offices generally being subject to the highest quantum of dilapidations claims, this harbours significant grounds for dilapidations disputes. Here we take a mooted example of City Hall on the South Bank in London; a fully glazed, modern, architect-designed landmark building currently accommodating the Greater London Authority. In this instance, we take the scenario where the lease is set to reach an end through the tenant’s break option in 2021. Following supply of the break notice, the landlord consequently instructs a dilapidations claim be prepared, that based on the tenant’s requirement to yield up the demised premises in full compliance with the tenant’s lease covenants to repair, redecorate, reinstate, etc. The demised premises are clearly defined in the lease, and the landlord’s surveyor duly prepares a claim based on that definition; ie including the yielding up in repair of not only all building fabric, but also all demised building services. The surveyor has been provided with the current EPC for the property from 2013 and the rating shows as a D – a permissible rating under the MEES Regulations currently. The property is approximately 180,000 sq ft in total and the claim amasses to nearly £11m. This includes claims for new floor finishes, replacement suspended ceilings, a full programme of redecoration and fully repaired building services systems as demised, including lighting, HVAC, fire alarm systems, etc, and the claim has been declared as taking account of the landlord’s intentions to relet the demised premises. The tenant, anticipating such a claim, reviewed their position in light of the MEES Regulations. With no lease covenant preventing them from doing so, and the knowledge that the existing D-rated EPC from eight years ago was likely to prove inaccurate, the tenant commissioned their own EPC at the point of lease expiry. This yielded a rating of F – this falling below the minimum standard required for the landlord to relet the premises. The tenant refutes the whole basis of the landlord’s claim, stating that the demised premises (as the landlord specifically requested it be yielded up through their dilapidations claim) is incapable of being lawfully relet upon the claimed works being undertaken and therefore the claim is flawed on two grounds: Supersession – the accurate EPC of F shows that the landlord would need to undertake works of improvement to the demised premises to bring it up to the minimum standard. Consequently, much of the requested work under the dilapidations claim would be superseded or rendered valueless. Diminution in value – under section 18(1) of the Landlord and Tenant Act 1927, it would be argued that there was effectively little or no impact on the value of the reversion due to the claimed dilapidations items, because this perceived impact on value was overridden by the inability of the landlord to relet the demised premises (irrespective of its condition). This example of heavily glazed office properties, particularly where they have been constructed in the early 2000s or before, will become increasingly prevalent as we see the incremental increase to the minimum EPC rating over the course of the decade. Landlords and tenants respectively are urged to consider MEES carefully. Ben Strange is a director of Mobius Building Consultancy