Can landlords recover any loss at lease expiry on change of use from offices to flats? What is the dilapidations position in the context of residential conversions?

Residential conversions

Since 30 May 2013, when the government widened the scope of permitted development rights ("PDR"), an option for landlords at the end of an office lease has been conversion from use class B1(a) (offices) to C3 (dwellinghouse). This may represent the most attractive option in some secondary or tertiary locations with little demand for office buildings.

When negotiating dilapidations in such buildings, outgoing tenants commonly assert that the buildings are as valuable out of repair as in, since their highest open-market value will be achieved by conversion to housing. The tenant's position is that, with no diminution in value, the landlord has suffered no loss pursuant to section 18(1) of the Landlord and Tenant Act 1927 and that any repairs that were to be carried out would be superseded by the conversion. Is this correct?

The diminution of value argument

The position is not new. In Ultraworth Ltd v General Accident Fire & Life Assurance Corp [2000] EWHC 172 (TCC); [2000] 2 EGLR 115 it was considered by the Technology and Construction Court in relation to an office block in New Barnet with planning permission for residential conversion. The court found that the value of the reversion was not affected by the disrepair and awarded no damages for this.

A landlord may assert that it intends to retain the existing use when the lease expires in the hope of establishing a greater diminution than if the building is converted and the use changed.

This will not have any effect if there is a better market for conversion to residential than for offices; the market value will be calculated by reference to a hypothetical willing seller in the open market, regardless of the landlord's actual intentions.

If a landlord intends to utilise PDR by demolishing and rebuilding or by carrying out structural alterations, no damages may be awarded for dilapidations because of section 18(1). If an owner or developer is retaining parts of a building within its conversion, what, if anything, can be recovered for dilapidations?

The position is set out in Latimer v Carney [2006] EWCA Civ 1417; [2006] 3 EGLR, where the judge commented that a landlord would have to show that specific repairs would survive refurbishment to be entitled to be able to claim in respect of them. 

The landlord's loss if it carries out the work is the cost of the method of repair that a reasonable, practical surveyor would choose. Where there is more than one option, the tenant, as covenanter, is entitled to choose the cheapest. Diminution in value is likely to be calculated by reference to the cost of these repairs.

In such a case it is necessary to identify those aspects of disrepair for which a tenant is liable and which would also need to be remedied for conversion to residential. Commonly these will include repair to the exterior of a building and sometimes core elements such as lifts and lift shafts.

The supersession argument

In addition to asserting no diminution in value, tenants may deny that any loss has been caused because any repairs will be superseded by development works.

This would mean that the disrepair was not the effective cause of any loss. Although the tenant is in breach of covenant, the landlord has lost nothing from the tenant's breach of covenant and can therefore recover nothing.

For items of repair, such works will be caught by both the section 18(1) cap and the supersession concept. For reinstatement and decoration, they may not be.

In an office building with numerous tenant partitions, part of the cost of conversion to residential will be for the removal of the partitions and associated alterations.

If a tenant covenants to reinstate office floors, it will be liable for the cost of removing partitions. This may also require replacement of carpeting and movement or replacement of air-conditioning units. These will be superseded in a conversion. Because of this, in the conversion of an office building, the recoverable cost of reinstatement may be lower than the full cost of reinstatement required by a lease or licence for alterations. As section 18(1) does not impose a cap on the cost of such non-repair items, the landlord is entitled to recover the reasonable cost of works for these.

Betterment

Certain works may improve items for which the tenant is responsible. Recovery of any damages for these will depend on the wording of the repair covenants and the condition of the items.

Where repair is not possible without renewal or by using a modern, improved equivalent of the original item, a landlord may be able to treat renewal works as part of a tenant's repairing obligation. For example, where a single-glazed window is in such a state of disrepair that the only economic remedy is replacement, the cost of a double-glazed replacement can be fully recoverable in a conversion.

Assessment

Landlords can still recover damages for dilapidations when the best open-market value for an office building is for conversion to residential use. To identify how much may be recovered, they need to assess:

  • what repairs would survive conversion;
  • what decorative and reinstatement works will not be superseded; and
  • what items in the offices can properly be substituted with more modern items needed for housing.

This article was first published in the Estates Gazette on 2nd October 2017.