BUILT ENVIRONMENT JOURNAL

Why new MEES could complicate commercial lets

With imminent changes to the Minimum Energy Efficiency Standards (MEES) set to tighten letting criteria, the respective liabilities of landlords and tenants remain unclear

Author:

  • Ian Laurie MRICS

30 March 2023

Close-up of commercial offices

Despite the fact that an energy performance certificate (EPC) has until recently typically cost a few hundred pounds, commercial property transactions can run into millions of pounds – so there has been little incentive for owners, or indeed investors, to give consideration to the resultant energy rating.

It has therefore been simply a minor part of the due diligence process. This is in no small degree due to there being no minimum standard at the time EPCs were introduced.

When the Minimum Energy Efficiency Standards (MEES) were implemented in 2018, a rating of at least E was required for all new leases. However, a substantial number of properties have no current EPCs; either because they are let on existing leases, or because of factors such as the expiry of the previous EPC or even the legislation simply being ignored. This system is now about to change.

On 1 April, the first stage of the MEES will extend to all commercial leases. The government is now enforcing the requirements, and sending warnings to property owners about the need to upgrade buildings.

The wider position in England and Wales is also set to change, with incremental increases to the minimum rating over the next seven years. A rating of C will be required for new commercial property leases from April 2025, or 2027 in the case of existing leases, and an anticipated minimum of a B rating by 2030.

It is important to note that the position with residential leases differs, and a current minimum E rating will move up to a C by 2030. The domestic EPC calculation also differs from the non-domestic method, and is considerably simpler in its modelling.

Case seems to reinforce landlord liability

What does the requirement mean in practical terms for commercial property owners and investors?

In considering the implications, it is important to understand the current legal position on the liability for undertaking improvements, and indeed the costs of compliance.

The original legislation made it clear that liability for obtaining an EPC lies with the landlord, and this has been reinforced in Clipper Logistics Plc v Scottish Equitable Plc, an unreported case from Sheffield county court on 7 March 2022.

As with any case, though, the ruling must be taken in context. In this instance, the landlord was trying at renewal to introduce three new, green clauses into a lease protected by the Landlord and Tenant Act 1954 – clauses to which the tenant did not fully agree. As a result of the deadlock, the terms required determination under section 35 of the 1954 Act.

The clauses that the landlord considered essential for compliance with MEES were:

  1. a prohibition clause seeking to prevent any tenant alterations that would adversely affect the EPC
  2. an indemnity clause effectively making the tenant liable for the cost of a new EPC
  3. a reinstatement clause, requiring on termination that the current EPC rating would be retained. 

The landlord largely failed in its application as the court noted that the obligations for EPC and MEES compliance rest with them, the landlord, rather than the tenant. As a consequence, the proposed indemnity and prohibition clauses were thrown out. The reinstatement provisions were accepted by the court, however, and this may have unexpected implications.

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SBEM could put tenants in awkward position

The position in Clipper, however, mainly depends on the 1954 Act rather than MEES, and new leases would not automatically be prevented from including terms of the kind rejected by the court in this instance.

Indeed, so-called green leases – under which the tenant may for example be liable to ensure any works it carries out do not have a negative effect on energy performance, or be required to use only recyclable products – have been around for some time without any such concerns arising.

If the building does not comply with these regulations and requires significant alterations, a lease renewal under the 1954 Act could even be opposed on the grounds that redevelopment to ensure EPC compliance can be achieved under a new lease; indeed, I have recently been contacted by a tenant in these circumstances.

Yet the validity of this position would need to be carefully reviewed, as the grant of a new lease would itself put into question whether the property is currently in a condition to be let – and this would theoretically void the argument for breaking the lease in the first place.

The third proposed clause in Clipper – maintaining the same EPC rating – may appear to the casual observer to be merely a case of the tenant not altering the property in a way that would adversely affect the EPC. However, the critical issue is in fact that the Simplified Building Energy Model (SBEM), which is at the heart of the EPC calculation, is periodically revised.

An EPC produced today on a property that has been unchanged for ten years would be unlikely to equal the rating obtained a decade ago, and could be significantly worse. For longer leases in particular, if the tenant has maintained the building but not undertaken significant works, then the new EPC rating will likely be worse than that at lease commencement.

Can the tenant then reasonably be required to make improvements? Moreover, if the tenant can demonstrate that they have not made significant alterations, this may affect a dilapidations claim, as the works proposed by the landlord may actually constitute an improvement compared with the previously modelled EPC rating.

Distinguishing improvement from repair

In terms of what constitutes improvement rather than repair, English case law – in particular Postel Properties Ltd and another v Boots the Chemist [1996] 2 EGLR 60 – provides a precedent for the tenant taking liability. In this case, the replacement of one building element, namely roofing, with a modern equivalent was not considered by the courts to be an improvement that could, depending on the lease terms, be charged to the tenant.

Given that Postel in effect centred on liability for improvement when replacing a thermal element, it is clear that in certain circumstances tenants would be liable for simple energy efficiency measures. Both parties must therefore walk a fine line in any works they are carrying out and consider whether energy performance improvements need to be taken into account.

On a positive note, though, there are tax allowances – and in some instances super deductions will remain available until the end of March 2025 for projects that commence before the end of March 2023 – that may help in meeting the overall cost of works.

The Building Regulations also come into play, with their requirement for consequential improvement of the wider property when undertaking large-scale works to thermal elements. However, tenants can avoid this responsibility provided the works result in a property that is otherwise good and tenantable, as per the measure established in Proudfoot v Hart [1890] LR 25 QBD 42, CA that properties should be fit, taking into account their age, character and locality.

For example, a lock-up unit under a railway arch would be unlikely to require the same level of improvement as a recently built office block that had been certified as outstanding by Building Research Establishment Environmental Assessment Method (BREEAM). In turn, though, this brings into question the meaning of good and tenantable for that property, which may in part come back to the EPC rating.

Take a G-rated property, for instance, where it is clear the landlord will need to undertake significant works at lease-end. Is it reasonable for the tenant to carry out minimal works, to avoid the need for consequential improvement and effectively leave the landlord to pick up the wider cost? Or can the landlord reasonably expect the tenant's works to have addressed the MEES requirements?

A good example of such works may be overlaying a roof rather than re-covering it before lease-end. Yes, the overlaid roof will be in repair; but if the wider unit is still technically unlettable due to the EPC rating, is the repair therefore not good and tenantable? Given that the landlord is liable for meeting the minimum EPC rating is the tenant better advised not to undertake works, citing the poor rating as requiring wider work for which they are not liable?

As is often the case, the specific lease clauses will likely affect the wider position. But at some point, further case law is likely to be forthcoming – particularly where a landlord tries to force the tenant to pay for significant alterations.

'Both parties must walk a fine line in any works they are carrying out'

Legislation ratchets up requirements

As stated earlier, each time SBEM is changed it traditionally becomes harder to achieve a higher rating, so the target itself is moving further down the road. Alongside the MEES timetable, legislation and regulations are already changing to place greater emphasis on the importance of energy efficiency improvements. In June 2022, changes were made to the Approved Documents with this end in mind, coming into force on the same day as changes to the SBEM.

In this respect, the model will now in particular favour electric heating over the gas and oil systems previously preferred. This is part of the wider drive in the UK to move away from fossil fuel use.

Software limits potential improvements

It is worth highlighting that the recommendations made in the report that should accompany an EPC, while purportedly tailored to the property in question, are very limited in relation to the improvement options available in SBEM.

The recommendation reports tend to be generated automatically, with assessors selecting from a given list of items such as installing wind turbines, solar panels, different lighting or insulation, when a number of these are often not practical. Coupled with assessors' often limited consideration of the building's context, the recommendations may offer little actual benefit.

By way of example, my employer Watts recently undertook an energy efficiency review for one client, where the recommendation report had included installing photovoltaics – in itself not a bad option. However, the property displayed clear signs of ongoing vandalism to the roof, which meant any panels installed would likely be at risk, leaving little benefit and a continuing maintenance liability.

Understanding the property as a whole, we were at least able to detail a list of specific practical works that could be undertaken, and run various options in the EPC model to show the incremental improvements that could be achieved. Moreover, we were able to link this with the property maintenance strategy, enabling the client to schedule improvements as building elements reached the end of their useful life.

Doubt cast on certificates' fitness

As the industry is already looking at fairly radical works to some existing buildings that will, at least in some cases, reduce their lettable floor area, achieving a rating of B in 2030 is likely to be significantly difficult for some landlords, notwithstanding the discussion about the tenant taking on some of the burden of compliance. This may in itself affect the ability to let certain properties, as a prospective tenant is unlikely to want to run the risk of being responsible for the cost of significant alterations.

At this point, it is important to highlight that temporary exemptions are available from EPC certification for portable buildings or structures intended to have a two-year life, for example, or where there is a clear intention to redevelop. As the regulations become more stringent, the cost of compliance is increasing.

Indeed, the cost of obtaining an EPC is already rising significantly in some instances, and landlords may look more to the seven-year payback exemption – available where the cost of works does not provide sufficient saving within the said period – if they are unable to reclaim at least part of their costs from the tenant. While this does not amount to impunity given the potential wider implications for future investors and occupiers, it does mean that there is a risk MEES may be effectively sidestepped in some instances and leave properties unimproved.

The industry is raising concerns regarding the approach taken in EPC calculation and the resultant works needed to comply with MEES. In November, RICS published its Decarbonising UK Real Estate report, which concluded EPCs are no longer fit for purpose. It called instead for a better method of tracking the carbon emissions associated with the UK's built environment.

The question we perhaps need to ask is whether, to achieve better measurement and control of carbon output, the onus for energy improvement works in future should shift so it is at least shared between the parties rather than falling solely on the landlord.

'We are already looking at fairly radical works to existing buildings that will in some cases reduce their lettable floor area'

Scotland and Northern Ireland lack MEES

It should be noted that the MEES regulations do not extend to either Scotland or Northern Ireland, each of which has its own specific energy performance legislation.

Generally speaking, this legislation is not as well defined as the MEES regulations; neither does it align with the same timescales to which England and Wales have committed for rating improvement. It is also yet to be seen whether investors in Scotland and Northern Ireland will simply seek to apply the English and Welsh model during their transactional decisions.

In my next article, I will – together with colleagues at Watts – therefore focus on the current energy performance regime in these two nations.

 

Ian Laurie MRICS is a technical director at Watts
Contact Ian: Email

Related competencies include: Construction technology and environmental services, Legal/regulatory compliance

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