When reality bites?

The “presumption of reality” is a cornerstone of the open market rent review. Unless the specific assumptions and disregards in the lease require otherwise, the rent review valuation should be grounded in reality. The traditional open market rent review also requires an assumption of an open market letting of the property by a hypothetical willing landlord to a hypothetical willing tenant on the rent review date.

But what happens in the case of sub-standard property when reality (in the form of the MEES Regulations) means that it would be unlawful to enter into a new letting of the property on the review date?

The first point worth considering is whether the subject property would be treated as sub-standard assuming a letting as at the review date in its current condition. Guidance applicable to EPC ratings has changed recently and it is worth considering whether a new assessment would result in a higher rating.

A property which does not have an EPC is not subject to the MEES Regulations at all. If the requirement for an EPC is deemed triggered by the hypothetical new letting, that raises the possibility that the property may fall to be valued as sub-standard, contrary to the actual position. Such approach could potentially be subject to challenge by landlords as being contrary to reality and producing an outcome not driven by the required hypothesis.

Even if the actual property is sub-standard, this does not necessarily mean that the hypothetical property would be. In many cases, tenant’s fit out works can be responsible for bringing down the EPC rating of a property. However, tenant’s improvements (or their valuation impact) are invariably disregarded on rent review. It may be that once the tenant’s fit out has been removed from the equation the property would no longer be considered sub-standard.

Questions are also likely to arise as to whether the hypothetical landlord should be treated as having the benefit of any exemption registered as at the review date on the PRS Exemptions Register. Even assuming not, given that registration is personal to the actual landlord, the hypothetical landlord may be treated as having the ability to register an equivalent exemption, although that is not necessarily so.

For example, in the real world the landlord is likely to be able to rely on the “no consent” exemption where it requires, but does not have, the tenant’s consent to undertake the works necessary to bring the EPC rating up to an acceptable level.

However, this is arguably not the case where the rent review is undertaken on the usual assumption of a letting with “vacant possession” since the hypothetical landlord would presumably not have faced any impediment to carrying out the necessary works before letting.

There are also exemptions for works which would not be cost effective or which would materially devalue the property, although whether or not they apply will be fact specific.

Assumptions and disregards?

In addition to any disregard of tenant’s improvements, other common assumptions and disregards may also be relevant. In many cases, the rent review provisions will include an assumption that the tenant (and sometimes the landlord as well) have complied with their lease obligations. The tenant will invariably have covenanted to comply with statutory and other legal obligations. However, that is unlikely to assist as the obligations imposed by the MEES Regulations fall squarely on the landlord and not the tenant.

The lease is unlikely to contain a corresponding obligation on the landlord to comply with statute, although it may be possible to get to this position by a more indirect route so far as the landlord is required to comply with legal obligations in providing services in respect of which it can recover a service charge. However, the difficulty here is that the MEES Regulations do not contain a positive obligation on the landlord to undertake works, rather they prohibit letting or continuing to let property unless works are undertaken.

Some leases go further and include an express assumption that the premises may be lawfully used for the permitted use. However, it is the act of letting (or continuing to let) the property rather than its use which is made unlawful by the MEES Regulations so it seems unlikely that such an assumption would assist either.

Impact on value

If these approaches do not result in actual or assumed compliance then the impact of the MEES Regulations on the rent review will need to be tackled head on.

Although it is an offence for the landlord to let a sub-standard property, the lease itself is still valid and effective. As such, it is still possible as a matter of law for a hypothetical letting of the property to be assumed to take place on the review date. The question is rather, what is the impact on rental value?

Tenants will no doubt argue that a sub-standard property is simply worth less than a more energy efficient comparable property. In an era of high energy costs, energy efficient buildings are likely to result in tangible savings for tenants and it is not hard to see how this feeds into the rent which a hypothetical tenant would be prepared to pay.

It seems inevitable that disputes will begin to emerge around the need to adjust the analysis of comparables to reflect their greater or lesser energy efficiency when compared to the subject property. In addition, a sub-standard EPC will also fetter the tenant’s ability to sub-let and this may also impact on rent.

Other less obvious considerations may also come into play. A landlord who unlawfully lets a sub-standard property commits an offence and exposes itself to a potential penalty of up to £150,000. Case law is clear that the concept of the open market rent review requires an assumed letting even where, in reality, the property may be unlettable. As such, it seems that one would have to assume the existence of a hypothetical landlord who is willing to let the property notwithstanding the potential sanctions.

However, would the hypothetical landlord argue that the risk of financial penalties needs to be reflected in a higher rent? Such a counter-intuitive outcome could potentially be avoided by applying the principle that a party should not be allowed to benefit from its own wrongdoing.

Alternatively it might be appropriate to assume that the hypothetical landlord would do the improvement works rather than risk the penalty so far as it was able to. Unless a specific assumption or disregard in the lease can be relied on, it is difficult to see how one could assume that the works have been completed prior to the date of the hypothetical letting as that would fly in the face of reality.

In some instances, the MEES Regulations incorporate a grace period allowing landlords to complete works within six months of a letting. Even if that possibility can be assumed, it gives rise to further questions as to how works are to be undertaken and paid for and the impact of the works on the tenant and the valuation consequences of these factors.

In 2022, the government estimated that around 18% of commercial properties in the UK were F or G rated. Some of those may have been bought up to standard to meet the 1 April 2023 deadline but it seems likely that there will still be a large number of properties out there where at least some of the issues we have identified may need to be grappled with.

An earlier version of this article appeared in EG on 27 March 2023

* (a barrister at Landmark Chambers)