From April 2018, a new legal standard for minimum energy efficiency will apply to rented commercial buildings. The new legal standard brings threats and opportunities for landlords, freehold investors, developers and lenders.
This briefing explains how the new legal standard will work, the impact it will have on landlords, freehold investors and lenders and steps that can be taken now.
What is the minimum energy efficiency standard (MEES)?
The minimum energy efficiency standard (MEES) was introduced in March 2015 by the Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015. The MEES Regulations originate from the Energy Act 2011 which contained the previous Coalition Government's package of energy efficiency policies including the Green Deal.
From 1 April 2018, landlords of buildings within the scope of the MEES Regulations must not renew existing tenancies or grant new tenancies if the building has less than the minimum EPC rating of E (unless the landlord registers an exemption – see below).
After 1 April 2023, landlords must not continue to let any buildings which have an EPC rating of less than E (unless the landlord registers an exemption).
Why is the Government introducing MEES?
The built environment has been identified by Government as a major contributor to Greenhouse Gas (GHG) emissions and thus poses a threat to the UK meeting its carbon reduction targets for 2020 and 2050. Government estimates that 18 per cent of commercial properties hold the lowest EPC ratings of F or G. While Building Regulations ensure that new properties meet current energy efficiency standards, MEES will tackle the UK's older buildings.
It is important to note that the minimum standard could rise in future.
Which buildings and tenancies does MEES apply to?
Working out if a building and tenancy are caught within the scope of MEES is not always straightforward. MEES does not apply to:
- buildings which are not required to have an EPC: such as industrial sites, workshops, non-residential agricultural buildings with a low energy demand, certain listed buildings, temporary properties and holidays lets
- buildings where the EPC is over 10 years old or where there is no EPC
- tenancies of less than 6 months (with no renewals)
- tenancies of over 99 years.
Determining whether a building and tenancy are within scope requires owners to look at two sets of regulations: Energy Performance of Buildings (England and Wales) 2012 and the MEES Regulations. The interplay of the regulations is complex and creates some potential loopholes.
What are the exemptions?
Landlords can let a building to which the MEES Regulations apply but which is below the minimum standard if any of the exemptions apply. These are:
- The ‘Golden Rule’: where an independent assessor determines that all relevant energy efficiency improvements have been made to the property or that improvements that could be made but have not been made would not pay for themselves through energy savings within seven years. There are numerous examples of "relevant" energy efficiency improvements which include double-glazing and pipework insulation which need to be considered; wall-insulation measures are not required where an expert determines that these would damage the fabric of the property.
- Devaluation: where an independent surveyor determines that the relevant energy efficiency improvements that could be made to the property are likely to reduce the market value of the property by more than 5 per cent.
- Third Party Consent: where consent from persons such as a tenant, a superior landlord or planning authorities has been refused or has been given with conditions with which the landlord cannot reasonably comply.
Exemptions must be registered on the central government PRS Exemptions Register. The register was intended to go live in October 2016 although, at the time of writing, an amendment has been tabled to delay this to April 2017.
The exemptions are valid for five years only and cannot be transferred to a new landlord.
What are the penalties for non-compliance?
The MEES Regulations will be enforced by Local Weights and Measures Authorities (LWMAs). LWMAs will have powers to impose civil penalties which are set by reference to the property's rateable value.
The penalty for renting out a property for a period of fewer than 3 months in breach of the MEES Regulations will be equivalent to 10 per cent of the property’s rateable value, subject to a minimum penalty of £5,000 and a maximum of £50,000. After 3 months, the penalty rises to 20 per cent of the rateable value, with a minimum penalty of £10,000 and a maximum of £150,000.
Where a property is let in breach of the MEES Regulations or where a penalty is imposed, the lease as between the landlord and the tenant remains valid and in force.
What are the threats and opportunities for landlords and what should they do now?
Landlords are likely to be the most affected parties because the key obligations and restrictions in the MEES Regulations fall on them.
The most obvious threat to landlords is the financial cost of upgrading non-compliant buildings and the potential loss of income if a property cannot be rented out.
The provisions in existing leases may affect the statutory obligations of landlords under the MEES Regulations and may affect the position of the Landlord in dealing with the MEES Regulations. For example:
- for a landlord hoping to delay compliance for as long as possible, standard leases may not contain sufficient restrictions on tenants subletting which could trigger the landlord's obligations
- lease provisions on service charges, yielding-up, statutory compliance and rent reviews may not allow a landlord to recover the capital expenditure required for improvements from the tenant
- for a landlord looking to make improvements, the landlord's rights to enter may not extend to entry for installing energy efficiency improvements or there may be restrictions in a headlease to consider.
There are, however, opportunities for landlords to engage with tenants to enter green leases where the environmental management and costs of the property, such as energy efficiency improvements and utility bills, are shared for the benefit of both parties.
There are also opportunities to explore the potential to increase rental and asset value through making energy efficiency improvements and combining these with other refit upgrades.
Landlords can prepare now by:
- auditing their portfolios to understand which properties are within scope of the MEES Regulations and whether exemptions might apply
- carrying out energy assessments to check whether the EPC ratings for their properties are correct
- understanding how lease terms, break dates, renewals dates and planned refit periods fit with the MEES timetable above
- reviewing their leases to understand their rights.
What is the impact on freehold investors and developers and what should they do now?
Freehold investors who own reversionary freehold assets will not be landlords for the purposes of the MEES Regulations where the term of the headlease is over 99 years. However, the MEES Regulations will still have an impact.
The key issue for freehold investors is that there is a threat of reduction in value of any property assets which do not meet the minimum standard. Further, freehold investors may struggle to find new tenant landlords willing to sub-let a property if it means they will need to carry out improvements.
On the other hand, freehold investors with tenant landlords already in place will benefit from having energy improvements made to their reversionary asset paid for by the landlord tenant.
Freehold investors may themselves be landlords for the purposes of the MEES Regulations where the term of the headlease is less than 99 years (and therefore within the scope of the MEES Regulations). Where a property has more than one landlord, the question of which landlord is required to pay for installing energy efficiency improvements is likely to depend on the terms of the headlease.
Developers who own freehold assets awaiting development could face similar issues to freehold investors and could find that the timetables of their future development programmes are affected by the MEES Regulations. However, the MEES Regulations may also create opportunities for developers through reducing the acquisition costs of property below the minimum standard.
Similar to landlords, investors and developers can prepare now by auditing their portfolios to identify which properties may be within scope of the MEES Regulations and understanding how the terms of the headleases and future development programmes fit with the MEES timetable above.
What is the impact on lenders and what should they do now?
Lenders will also be affected by the MEES Regulations.
There is a threat to lenders where a building does not meet the minimum standard leading to a reduction in value of their security and ability to let the property thereby affecting the ability of a landlord borrower to make repayments due to loss of rental income and additional capital expenditure costs.
There is a further threat to lenders where they take possession of a property following default and become freehold investors or landlords and, thus, subject to the MEES Regulations themselves.
In the absence of a Government scheme to provide finance for landlords (which had been the intention of Government in 2011), the MEES Regulations also provide opportunities to lenders where landlords need to borrow to bring their properties up to the minimum standard.
Lenders can prepare now by reviewing their lending criteria and conditions to check:
- whether they are obtaining sufficient information on valuation of the asset to; understand the impacts of MEES on their security, correctly price the risk and cost of borrowing and enable them to monitor the risk adequately
- whether loan monitoring procedures need to be adapted to take account of the potential risks; (e.g mandating that EPC certificates are provided by the borrower on all non-exempt lettings and/or requesting borrowers undertake and provide an MEES audit/strategy plan prior to the 2018 deadline)
- whether the undertakings and representations in their facility agreements provide suitable protections and rights against borrowers who fail to comply with their statutory obligations under the MEES Regulations.
What happens next?
On 30 June 2016, the Government will release the data held in respect of EPCs of commercial property. Making this data publicly available in bulk is intended to encourage the property industry to scrutinise and compare the energy efficiency ratings of buildings more closely and influence the decision making of tenants, landlords, investors and lenders. From this, we are likely to see the beginnings of the market response to the approaching MEES Regulations.
Amendments in 2015 to the Energy Performance of Buildings (England and Wales) Regulations 2012 now require local authorities to report to Government, on an annual basis, on enforcement activities undertaken in relation to EPCs. This may deliver more interest in EPCs and more active enforcement from LWMAs.
Since the General Election in May 2015, doubts have been raised as to whether the Government will actually implement MEES in 2018 due to opposition to the policy from the property industry. In addition, Brexit could provide the opportunity to repeal the Energy Performance of Buildings (England and Wales) Regulations 2012, which underpin the MEES Regulations, because these implement the EU Energy Performance of Buildings Directive 2010. Nevertheless, the underlying policy for the MEES Regulations originated in the UK not the EU and the MEES Regulations remain on the statute books. Parties should therefore assume that MEES will apply from 1 April 2018.
Parties who have been following the development of the MEES Regulations closely will be aware that the Government intends to issue detailed guidance on the application of the MEES Regulations. At the date of writing, this guidance has yet to be issued. Bodies such as the Law Society are waiting for this guidance before issuing revisions to their standard form leases.
However, landlords, freehold investors and lenders are well advised to start preparing for the MEES Regulations as failing to understand the MEES timetable and make decisions now could lead to increased costs and fewer options later.