Giving dilapidations the green light

The environmental impact of the dilapidations process is under the spotlight as the net zero deadline draws closer and leases become shorter. Alison Hardy and Mike McChesney review current practice and suggest how it could become greener. The recent RICS dilapidations conference 2022 focused on what real estate professionals can – and arguably must – do to reduce the environmental impact caused when a tenant vacates a property. The built environment sector is directly responsible for 25% of UK emissions. There is a lot of industry focus on the carbon footprint of construction works, the embodied carbon of the built environment, and energy performance of buildings in use.  As EG highlighted in its podcast How to make the dilapidations process greener (November 2021), published in November 2021, we must not forget the opportunity to reduce waste and drive efficiency at lease expiry, not least because 80% of buildings standing today will still be in use in 50 years’ time. With lease terms becoming ever shorter, we are seeing a faster rate of tenant churn, and if each tenant fits out premises, only to be discarded a few years later, the environmental impact is concerning. “Green dilapidations” is a relatively new phrase and green lease clauses are largely confined to offices and voluntary schedules. So what are the opportunities for industry to drive change in this area? Is it reasonable to take environmental factors into account?  One suggestion we recently heard was that when considering an application or consent to alter premises, landlords could reasonably consider the environmental impact of the proposed alteration, including impact on energy performance, the types of materials being proposed, and the long-term use of the proposed alteration. We often see perfectly good quality fit-outs being removed for the purposes of marketing a property, only for the incoming tenant to install their own fit-out.  This is clearly wasteful and both environmentally and financially expensive. It would be interesting to see whether a court would hold that a refusal of consent relying on environmental impact was reasonable. Currently consents to alter and obligations to reinstate tend to be dealt with as a single application rather than assessing the individual components and their environmental impact.  Is it appropriate for all alterations to be reinstated at the end of the lease term or could leases and licences to alter be structured differently with certain relatively standard alterations, for example a comms room, not being required to be reinstated and some reinstatement being limited to where reasonable having regard to the environmental performance of the building? If tenant alterations have improved the EPC rating, can it be reasonable to require reinstatement? Could the common approach of automatic reinstatement of alterations be turned on its head to a presumption of not required unless reasonable? We are seeing fitted space being much more commonly offered in the market either as a second-hand option or direct landlord provision, so current drafting precedents may be becoming outdated. Changing designs We are seeing many occupiers moving towards a more open-plan and relaxed working environment, as part of the role of the office has become to encourage people to travel in and collaborate. Much of this can be achieved via furniture rather than fixtures, so we may see more standard accommodation rather than bespoke fit-outs. The design of office fixtures needs to evolve to become more sustainable, for example, most demountable partitions are rarely demounted and reused and we are seeing prefabricated meeting rooms or pods being much more commonly used in office fit-outs, which can be more easily relocated and reused. Mechanical and electrical services are notorious for parts no longer being available for older components; perhaps this needs to change with longer-term repair and retention becoming the norm, rather than a 15-year lifespan. An opportunity for industry to work together  What effective change could we all make to really see a difference? Some of the challenges here are down to the contentious and sometimes combative nature of dilapidations negotiations. Professionals acting for landlords are incentivised or encouraged to recover the maximum payment from tenants, and so it is in their interest to argue that items are at the end of their useful life and should be replaced. Former tenants have no ongoing interest in the property and, similarly, their representatives are incentivised to reduce the financial payment. Perhaps if landlords and tenants rewarded professionals for reducing the environmental impact caused by a change of tenant at lease expiry this would change outcomes.  Many occupiers will be considering making environmental performance changes to buildings, driven by their own corporate agenda. They will be much more willing to invest for the long term, with consequential benefit to landlords, if they do not need to build a reinstatement cost into their appraisals. The joint Property Litigation Association and RICS pre-action protocol on dilapidations actively encouraged parties to work collaboratively and significantly reduced the number of dilapidations claims reaching the courts. However, the protocol was developed long before the UK committed to net zero by 2050 and it could be updated to take into account the environmental impact. For example, the protocol could require the parties to consider the carbon footprint of removing significant elements such as alterations/fit out. Perhaps the parties should be encouraged as part of the protocol to appoint an expert to advise on the carbon impact of the landlord’s proposed works? For landlords and tenants who have made public energy commitments, this will change their focus from the bottom line and encourage greener solutions, greater reuse and recycling rather than replacement.  Do we need greater legislative intervention to drive behavioural change?  The Whole Life Carbon Roadmap, published by the UK Green Building Council, recommends that government review the Landlord and Tenant Act 1954 to require by law that all new business leases include green lease clauses, the standards of which should be developed with industry. However, the Law Commission’s current proposals for amendments to the 1954 Act do not pick up this theme. Perhaps the wide-ranging review of commercial landlord and tenant legislation announced by government in December 2020, but which has not yet been launched, is an opportunity to progress UKGBC’s proposal. Arguably we do not need any further consultation; what we need is action. The government could simply require that the net zero-aligned clauses drafted by the Chancery Lane Project are adopted on a 1954 Act lease renewal, including, from a dilapidations perspective, Aatmay’s clause – sustainable and circular economy provisions for the repair, alteration, yielding up and decoration covenants in a lease which encourage landlords and tenants to reuse goods and materials.  Section 18 of the Landlord and Tenant Act 1927 and common law already limits a dilapidations claim to loss in value and landlords are obliged to mitigate their loss. As the need to enhance the environmental performance of buildings in order to relet them increases, landlords will be forced to undertake more upgrading works, which may lead to lower dilapidations settlements. Should landlords just accept this or should tenants share some of the burden? Perhaps via enhanced rents for watered-down lease-end obligations? Will EPC ratings lead to stranded assets?  EPC ratings are already changing as a result of recent government consultation and the Energy white paper. From 2030 it is likely that those leasing a building will need to have an EPC rating of B. 2030 is only eight short years away, and investors are already carrying out audits of their properties to consider what works need to be undertaken to achieve that standard, whether those costs can be recovered through the service charge and the extent to which the works fall within tenant repairing and reinstatement obligations.  Reaching an EPC B rating could result in landlords carrying out works which supersede the tenant’s contractual repair and reinstatement obligations. Further, the works could be so disruptive that they can only be carried out when the property is vacant, causing liquidity issues that will particularly impact highly leveraged buildings. There are many funders that are looking to provide capex lines of funding for green building improvements and landlords should engage early with their lenders, working collaboratively to ensure that real estate assets retain their value. However, landlords who bury their heads in the sand, leaving it until the last moment to carry out works, may well find their asset becomes stranded – with no tenant willing to lease the space, an EPC rating that prevents the landlord from letting it, and no funder willing to refinance.  We are already seeing tenants who have made net zero commitments considering their existing footprint and seeking either alternative greener options, or significant improvements to their existing buildings. Any tenants weighing up the balance should also consider the environmental impact of vacating a property and relocating versus staying, whether they can reuse their existing fit-out in any new building and, if not, the environmental cost of it being discarded. The current industry measures, such as EPCs or BREEAM, do not entirely capture this in one index. Do we need a new or combined process of measurement which becomes the benchmark? Alison Hardy is a partner at Ashurst and Mike McChesney is a partner at Gerald Eve Photo © Pawel Czerwinski/Unsplash