A big change is about to affect property in England and Wales. From 1 April 2018, The Energy Efficiency (Private Rented Property) Regulations 2015 (MEES Regulations) come into force and set new minimum energy efficiency standards (MEES) for property in England and Wales, making it unlawful for a landlord to grant a new tenancy of any property which has an energy performance certificate (EPC) rating lower than band "E" unless an exemption applies and has been registered. If this rule is breached the landlord will be vulnerable to financial penalties and other enforcement action.
The MEES Regulations will only apply to new lettings initially, but existing lettings will soon be caught too (from 1 April 2020 for residential property and 1 April 2023 for commercial property). With 1 April only a few weeks away, we focus here on some key issues for lenders and their customers.
Are all commercial and residential lettings affected by the MEES Regulations?
The MEES Regulations only apply where the property is required to have an EPC or is part of a building required to have one. An EPC is generally required when a property is sold or let. However, certain properties are exempt from the requirement to have an EPC so will by definition not be caught by the MEES Regulations. The first thing is therefore to check whether an EPC is required (one may have been obtained voluntarily but this will not trigger MEES).
Assuming an EPC is required, the next question is whether the letting is affected by the MEES Regulations. Most commercial lettings are caught as only very short or very long tenancies are excluded (tenancies for terms of six months or less and terms of 99 years or more). Most residential lettings will also subject to the MEES Regulations. So the upshot is that the majority of lettings will be affected.
Will a letting granted in breach of the MEES Regulations still be valid?
Yes. Although a letting granted in breach of the MEES Regulations will have been granted unlawfully, it will still be valid and legally enforceable.
What should landlords do to prepare?
Landlords who have not already done so should review their portfolio to identify any property with an EPC rating of "F" or "G" and consider their position. If any existing EPCs are old it would be worth obtaining new ones to make sure the rating is up to date (new EPCs may show a different rating from old ones as the software and methodology has improved since EPCs were first introduced nearly ten years ago). The energy assessor will recommend energy efficiency improvements which can be made and the landlord will then be much better informed about the situation and its options going forward.
If new lettings are being negotiated, it makes sense to try to complete them before 1 April, but that will only give the landlord a temporary reprieve as the MEES Regulations will eventually affect existing lettings as well as new ones.
If it is not possible to complete the letting before 1 April the landlord should (before the new letting is granted) either carry out any relevant energy efficiency improvement works and/or register an exemption if one is as available (see further below). It will otherwise be granting the tenancy in breach of the MEES Regulations and expose itself to financial penalties and other enforcement action (see further below).
What works does the landlord of a sub-standard (EPC band "F" or "G") property need to do?
It's important to appreciate that the MEES Regulations do not actually impose an obligation on landlords to carry out energy efficiency improvement works to raise the EPC rating to "E" or above. They instead work on the basis that landlords will be encouraged to do relevant works so they can lawfully let the property and so avoid the risk of penalties and other enforcement action. The MEES Regulations do, however, identify what works a landlord may need to do before it can lawfully let (or continue letting) the property. These are called "relevant energy efficiency improvements". They need to have been identified as a recommended improvement for that property in a Green Deal report, a recommendation report attached to an EPC or a report prepared by a surveyor and they need to meet payment criteria which differ according to whether the property is commercial or residential:
- Energy efficiency improvement works to residential property
The MEES Regulations say that energy efficiency improvement works to residential property only have to be carried out if they can be paid for under the Green Deal or by certain other forms of finance involving no cost to the landlord (the "no cost to landlord" principle). However, the Green Deal was to be the main source of funding and problems with it mean that it will not be able to deliver the stream of funding originally hoped for. The government is therefore currently consulting on removing the "no cost to landlord" principle and replacing it with a capped landlord contribution of £2500 per property.
- Energy efficiency works to commercial property
The works which a landlord can be required to carry out to a commercial property are works that can be paid for under the Green Deal or that will pay for themselves within seven years or less (there is a formula in the MEES Regulations for calculating whether the cost will be less than the projected energy cost saving).
Penalties and other enforcement measures
Landlords who let sub-standard property (EPC band "F" or "G") and have not registered a valid exemption will be vulnerable to financial penalties and other action by the enforcement authorities.
The financial penalties are not insignificant. A breach of three months or more on a letting of commercial property could result in a fine of £10,000 or 20% of the rateable value of the property whichever is the higher, up to maximum of £150,000. The equivalent residential penalty is a maximum of £4000. On multi-let buildings these penalties could mount up.
Landlords may also be named and shamed through so-called publication penalties which can be imposed in addition to the financial penalties. Publication penalties carry the risk of reputational damage as they will be registered on a publicly accessible part of the PRS Exemptions Register.
Exemptions and how they work
There will sometimes be good reasons why it would not be reasonable to expect relevant energy efficiency improvements to be carried out, or at least not immediately. The MEES Regulations therefore set out three exemptions to deal with this:
- Consent - where, despite reasonable endeavours, the landlord cannot obtain third party consent which is required before the works can be carried out
- Devaluation - where an independent surveyor states that the relevant works would devalue the property by more than five per cent.
- Temporary exemption - of six months following certain events such as a new landlord having acquired the property or the grant of a renewal lease under the Landlord and Tenant Act 1954.
Where an exemption applies and has been validly registered the landlord will lawfully be able to let the property even though it does not meet MEES. Both the consent exemption and the devaluation exemption last for five years. To register any of these exemptions a landlord has to enter certain required information in the PRS Exemptions Register.
Finally, where a landlord has made all "relevant energy efficiency improvements", or there are none which can be made, it will lawfully be able to let the property provided it registers certain required information in the PRS Exemptions Register. The landlord will then be safe from enforcement action for five years so in that respect this operates in the same way as the consent and devaluation exemptions.
Issues for new landlords acquiring sub-standard let property
Landlords acquiring sub-standard property subject to existing lettings face additional challenges. They can register a temporary exemption but cannot inherit any exemption registered by the previous landlord. They will therefore need to use the time granted by the temporary exemption to carry out any relevant energy efficiency improvements and/or register their own exemption. MEES compliance will therefore need to be factored into due diligence on investment acquisitions.
Who bears the cost of energy efficiency improvement works?
This is a matter for negotiation between landlord and tenant but the reality is that the cost of works is in most cases likely to be down to the landlord. With existing leases that do not contain any special MEES drafting the landlord could only expect the tenant to pay if the works concerned fell within the scope of the tenant's repair covenant, which is not likely to be the case as works to achieve MEES compliance will tend to be improvements not repairs. Similarly, with a lease of part where there is a service charge, it would be unusual for the service charge to be widely enough drawn for the landlord to be able to include the cost of these works, as they are more in the nature of capital improvements than maintenance and repair.
Lenders will be concerned about the MEES Regulations. A sub-standard EPC rating is likely to affect capital value, marketability and rental value, which will impact adversely on the value and marketability of the lender's security. Lenders may be concerned that the possible adverse effect of a sub-standard EPC rating on rental value could affect the reliability of the borrower's income stream to service the borrowing, and/or the extent of the capital expenditure required to bring the borrower's properties up to the standard necessary for MEES compliance. Lenders may, in some cases, be concerned about the potential reputational risks of being associated with landlords that may be "named and shamed" in the future.
Financing or re-financing does not in itself trigger any requirement for an EPC but lenders will be concerned to check the energy performance position because of the potential impact of the MEES Regulations. They may therefore wish to insist on an up-to-date EPC being obtained. It is also worth remembering that EPC software and methodologies have become more sophisticated over time, so the rating on an old one may not reflect the rating that would be obtained if a new EPC were commissioned now.
We are already seeing some commercial lenders routinely imposing conditions precedent requiring an EPC at band "E" or above or, where the property is currently sub-standard, conditions subsequent requiring the borrower to carry out works that will result in the energy efficiency rating being increased. This is entirely sensible to help protect a lender's position. We have also seen instances of lenders requiring an EPC rating higher than "E", presumably to future-proof the security to some extent. It will be interesting to see if this becomes more common.