MEES Regulations and the EPC lottery

From 1 April 2018, it will be unlawful to grant a new lease, a renewal lease or a lease extension to an existing or new tenant of a property with an EPC of F or G. From 1 April 2023, it will be unlawful to allow existing lettings of F- and G-rated property to continue. This is now law and is set out in the Energy Efficiency Regulations 2015 (the Regulations). If a landlord grants a new letting of such a “sub-standard” property to an existing or new tenant from 1 April 2018, they will be liable for local authority enforcement, including: penalties of up to £150,000 per three-month infringement; publication of details of the infringement; and further ongoing fines if they subsequently fail to comply with the enforcement action. Why should commercial landlords be concerned? Well-advised tenants are now seeking to ascertain whether their rented property will be in breach of the Regulations. While the Regulations apply to properties with EPC ratings of F or G, there is increasing evidence that existing EPCs are inaccurate and many properties with ratings of E and better are being downgraded to F or G on reassessment. While many landlords are reacting to the Regulations by instructing new EPCs across their portfolios (in some cases rendering compliant properties unlettable), the primary source of these reassessments to non-compliance appears to be well-advised tenants, alive to the benefits of showing that their rented property is “sub-standard”, including: dilapidations: where they will seek to show that non-compliance will render a landlord’s dilapidations claim subject to supersession due to required upgrade works; new lease negotiations: where tenants will demonstrate that a landlord of an F- or G-rated property will have a significant liability post-1 April 2018 and use this to negotiate favourable terms on a new lease prior to the Regulations being enforced. rent reviews/lease breaks: where tenants of an F- or G-rated property (or a property that they can show would be reassessed to F or G) will use lease events to their favour, eg threatening to lodge a new F rating and exercise their break, leaving their landlord with an unlettable property unless favourable terms can be agreed. Are lease renewals/extensions caught by the Regulations? The Regulations are in place to prohibit a new letting of a sub-standard property – this includes renewal leases or granting of extensions to an existing tenant. When considering the potential cliff-edge presented on 1 April 2018, we anticipate a surge of lease activity in the coming months where landlords of F- and G-rated buildings can seek to avoid incurring MEES penalties by agreeing a new lease prior to 1 April next year.  While landlords would be well-advised to lead these negotiations, with increasing awareness among tenants of the impact of the Regulations, it is anticipated they will seek to capitalise on the vulnerability of the property in question, pushing for highly favourable lease renewal terms in exchange for enabling the landlord to avoid the fines (in the short term at least). The dynamic of this negotiation will largely be set by which party is first to approach the other. How can tenants have a rating downgraded? Commercial EPCs were first undertaken in 2008 in response to the Energy Performance of Buildings Regulations 2007. These set out that an EPC is required when a property is constructed, sold or let. Until the MEES Regulations, EPCs had little bearing on property leases or values and were largely seen simply as red tape. As a volume-driven industry, EPC assessment was arguably under-regulated and many assessors, forced by work volume and depressed fees, undertook assessments without due focus on accuracy. As the industry has matured, assessment has become more closely regulated, the software used to produce EPCs has evolved and concurrently the Building Regulations (part L) have tightened to make it more difficult than ever to achieve the minimum E rating. Therefore, a reassessment of a property rated D in, say, 2010 is likely to produce a lower rating and possibly fall to non-compliance.  How many are affected? Some 65% of non-domestic EPCs registered are D or below (DCLG). While there are several examples of existing C and B ratings dropping to non-compliance as well, landlords of the near 225,000 D- and E-rated properties should be most wary of a re-rating exercise. The graph shows the downgrading effect on reassessment carried out by Arbnco on its own portfolio of 3,500 EPCs completed since 2012. While these figures do not account for the earlier, less accurate EPCs, Arbnco reports that “33% of D and E ratings have dropped to F or G”. Who will MEES affect? As detailed in EG, the repercussions of the Regulations will be felt across the property industry. Landlords: faced with options of incurring penalties or vacant properties unless they invest in improvement. Tenants: significant potential to use MEES to their advantage in lease negotiations, rent reviews, dilapidations, etc. Freeholders/investors: potential impact on capital values – are investors unwittingly buying properties that they cannot let? Lenders: potential risk of defaults through diminishing rental incomes and over-valued assets. Property advisers: are surveyors, valuers and solicitors going to be facing PI claims for advising clients poorly on unlettable properties? What happens next? As tenants and investors become aware of the benefits of a property failing MEES compliance, a quick uptake in re-rating exercises is expected with potentially devastating effects on landlords faced with empty and unlettable properties. This is exacerbated by the fact that the early EPCs are reaching the end of their 10-year validity, with many of these reassessments expected to result in properties falling to non-compliance. Ben Strange is head of professional services at Ingleton Wood