The Minimum Energy Efficiency Standards regulations (MEES) will implement legislation that could make the potential benefits of "being green" tangible.
I have looked at a relatively narrow area of who will bear any costs of "improving" properties, the landlord and tenant relationship as well as the effect MEES might have on lenders. I will leave the mystery of valuation to the surveyors!
Summary of MEES
MEES provide that where a building's EPC is rated below E, works will have to be carried out to bring the building's EPC rating up to an E. Landlords who fail to carry out such works before entering into a commercial lease lasting between six months and 99 years will be subject to a civil fine.
There are three formal exemptions:
- if the works will not pay for themselves over seven years.
- if any third party refuses consent which is necessary for the works.
- if the works, if carried out, would reduce the property's capital or rental value by over 5%.
Who should pay for the works?
Given that the obligation on compliance rests with the landlord and the current trigger for compliance is on new lettings, it seems that the landlord should be liable for the cost of the works. But ultimately the wording of the lease will decide who will bear the cost.
Most tenants are under a repair obligation. This obligation will be very comprehensive where the tenant has a lease over the whole building. Where it has only rented part of the property the repair obligation will be limited to the internal envelope and the landlord will recover the cost of works to the common areas and the mechanical and electrical equipment etc through a service charge.
A fairly drafted lease will only relate to repair and will not oblige the tenant to pay for any improvements to the property. However the renewal or replacement of subsidiary parts of the building or premises is within the concept of repair and that may then involve the incidental making of improvements.
The test for whether works constitute an improvement rather than a repair is as follows:
- Do the works go to the whole as opposed to just a part of the premises?
- Would the works create a building of wholly different character to the building let to the tenant?
- Are the costs of the works in relation to the value of the property so high as to be disproportionate? Or would the works materially increase the value or lifespan of the building?
So it will be a question of fact and degree as to whether works carried out under MEES would be considered an incidental improvement in the course of carrying out repairs (and so paid for by the tenant) or works that are intended solely or principally to effect improvements so that the tenant would give back to the landlord something different from that which was let to him (and so paid for by the landlord).
Interestingly, the Service Charge Code for Commercial Leases advocates that sustainability and improved environmental performance should be taken into account when carrying out any cost-benefit analysis of improvement costs above the normal cost of repair. The guidance also suggests a fair and reasonable approach to apportioning the cost of works that improve the environmental performance of the building or its sustainability.
Leasehold implications for landlords and tenants
As the implications of a reduced EPC rating are now tangible, it is likely that an obligation that the tenant does nothing to the premises that will affect the EPC rating will become a standard leasehold provision.
Many leases – especially on certain office developments – require the tenant to yield up the property at the end of the term stripped back to a certain specification. In the future, drafting flexibility into the lease so as to allow for improved energy efficiency standards to remain in the property would be sensible and would benefit both the landlord and tenant.
If a landlord wants to comply with MEES and undertake the necessary works then it will also be in his interests to ensure that the lease allows him unilateral entry to carry out the works. In addition, where the landlord is obliged to provide services, carrying out the improvement works may interrupt this provision of services. In such circumstances he would be well advised to reserve the right to interrupt the services so long as there are sufficient safeguards for the tenant.
Ultimately, if we are to see the promotion of energy efficiency, lawyers should ensure that their drafting encourages compliance with MEES rather than just imposing a number of additional obligations on the landlord and tenant.
Implications for lenders
Lenders tend to have a very cautious approach to anything that might affect the value of the property or the income it generates during the term of the loan. Until the market has adjusted, MEES may have an uncertain impact on property values and the income stream derived from the asset. It is interesting that one of the exemptions, the requisite consents carve-out, specifically includes obtaining lender consent to improvements.
In the short term, lenders will be most concerned where they have lent on portfolio transactions where a significant proportion of the tenancies to which secured properties are subject are due to expire during the life of the loan. These properties will have to be re-let and MEES will apply to the new lettings.
In the longer term, future deals are likely to be affected by a lender’s appetite for risk. Lenders may be wary of the following:
- Particular asset classes which are more likely to fall below the minimum standards. For example, old buildings that have not been modernised are unlikely to have been made more energy efficient.
- Assets where the necessary improvements will be expensive (but less than five per cent of the overall value of the property) and so are likely to have an adverse impact on value or where fines for non-compliance would be high (e.g. very old buildings which are difficult to modify).
- Portfolio transactions where a large number of the assets in the portfolio are affected by MEES so the aggregate cost of improvement works and/or fines becomes a more material issue.
There is no doubt that MEES, if fully implemented, will herald a number of changes to how leases are drafted and to how lenders decide whether to invest. However, whilst drafting can be used to facilitate smooth compliance with MEES it is essential to ensure that the resulting leases (and how they are interpreted) provide as few barriers to change as possible rather than simply imposing a new raft of "green" obligations on either party.