A big change is about to affect property in England and Wales. From 1 April 2018, under The Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015 (MEES Regulations), it will be 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 initially apply only to new lettings, 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 landlords, tenants and lenders.
A substantial proportion of greenhouse gas emissions comes from energy use in buildings. Under the Climate Change Act 2008 and various subsequent EU initiatives the UK government is committed to making significant reductions in these emissions. The MEES Regulations are a vital part of its strategy to improve energy efficiency in buildings to help achieve these reductions. The Clean Growth Strategy issued in October 2017 showed that the drive to improve energy efficiency is only likely to increase and suggests that minimum energy performance standards for buildings may rise in the foreseeable future.
Is it just lettings which are affected?
Yes, the MEES Regulations only apply to lettings. They do not apply to sales.
Are all commercial and residential lettings affected by the MEES Regulations?
Not all, but the majority. 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 (for instance industrial sites and workshops with low energy demand and temporary buildings with a planned life of two years or less).
Assuming an EPC is required, the next question is whether the letting is affected by the MEES Regulations. They will apply to commercial lettings except those for very short or very long terms (six months or less or 99 years or more). The most common type of residential tenancy is an assured shorthold tenancy (AST). These are affected along with other forms of assured tenancy under the Housing Act 1988, regulated tenancies under the Rent Act 1977 and some types of domestic agricultural tenancy. This means the MEES Regulations will apply to most residential and commercial lettings.
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". 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 a temporary reprieve as the MEES Regulations will eventually affect existing lettings anyway.
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 improvements" and/or register an exemption if one is as available (see below for further details). It will otherwise be granting the tenancy in breach of the MEES Regulations and expose itself to financial penalties and other enforcement action (see below for information on these areas).
What works does the landlord of a sub-standard (EPC band "F" or "G") property need to do?
The MEES Regulations do not impose an obligation on landlords to take steps to improve the EPC rating to "E" or above. They work on the basis that landlords will be incentivised to do relevant works so they can lawfully let the property and avoid the risk of penalties.
The MEES Regulations do 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:
1. Energy efficiency improvement works to residential property
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 also involving no cost to the landlord. However, problems with the Green Deal, which was to be the main source of funding, mean that it will not be able to deliver the stream of funding originally hoped for. The government is therefore currently consulting on replacing the "no cost to landlord" principle with a capped cost of £2500 per property. Landlords would need to invest in relevant energy efficiency improvements up to the level of the cap (or whatever lower figure was required to bring the property up to an EPC rating of "E"). If these proposals go ahead they are likely to take effect in April 2019.
2. Energy efficiency improvement works to commercial property
The landlord can be required to carry out works to a commercial property if they can be paid for under the Green Deal or 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).
It's easy to focus on the minimum standards set by the current MEES Regulations but, as minimum energy performance standards are likely to increase over time, some landlords may feel it makes commercial sense to take a longer-term view and carry out more extensive works which would bring the property comfortably above the current minimum standard.
Penalties and other enforcement measures
Landlords who let sub-standard property (EPC band "F" or "G") but have not registered a valid exemption will be liable to financial penalties and other action by the enforcement authorities, (the local authority for residential property and local trading standards officers for commercial property).
Each commercial letting that breaches the MEES Regulations could result in a fine of £10,000 or 20% of the rateable value of the property whichever is the higher, up to a maximum of £150,000. The equivalent residential penalty is a maximum of £4,000. On multi-let properties these penalties will mount up.
Landlords may also be named and shamed through "publication penalties" which can be imposed as well as 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.
Only time will tell how stringently the MEES Regulations will be enforced in practice. Although the position is not yet clear, local authorities may well be allowed to keep the financial penalties rather than return them to central government. If this happens, the enforcement authorities will have the incentive to invest in staff and systems to enforce the MEES regime much more strictly than the EPC regime ever has been.
Exemptions and how they work
There may be good reasons why it would not be reasonable to expect energy efficiency improvements to be carried out, or at least not immediately. The MEES Regulations therefore set out four exemptions:
1. Consent - where, despite reasonable endeavours, the landlord cannot obtain any necessary third party consent to carry out the works (for example where the lease does not give the landlord the right to enter the property to carry out the works and the tenant does not agree to the landlord doing so);
2. Devaluation - where an independent surveyor states that the relevant works would devalue the property by more than 5%;
3. Temporary exemption - 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;
4. Nothing more to be done - all "relevant energy efficiency improvements" have been carried out, or there are none which can be made.
Where an exemption applies and has been validly registered, the landlord will lawfully be able to let the property even though it is sub-standard. The consent exemption, the devaluation exemption and the "nothing more" exemption all last for five years and the temporary exemption for six months. To register any of the exemptions a landlord must enter certain required information in the PRS Exemptions Register. The register has already been open for registrations for over a year.
Points to note on exemptions
1. They must be registered in the PRS Exemptions Register for the landlord to benefit from them.
2. They don't come cheap. Registration involves administrative and other costs to provide the required information to demonstrate that the exemption applies. For example, to register the consent exemption the landlord must show it has used reasonable endeavours to obtain consent from the third party. As government guidance suggests this may mean making several attempts to obtain the consent, it's clear that more than just a token effort will be required.
3. They don't last for ever. No exemption lasts for more than five years. To protect itself from enforcement action the landlord will either need to register a new exemption before the original one expires, or carry out all relevant energy efficiency improvements in the meantime. The availability of a new exemption is not guaranteed because circumstances may have changed since the previous exemption was registered. For example, works which did not previously qualify as "relevant energy efficiency improvements" may now qualify due to advances in technology or the availability of more cost-effective solutions.
MEES compliance needs to become part of landlords' planned maintenance and refurbishment programmes.
Issues for 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 do not 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 or register their own exemption.
MEES compliance will therefore need to be factored into due diligence on investment acquisitions. The position on any existing exemptions will need to be checked, as will the landlord's ability to carry out energy efficiency improvements under the terms of the leases.
Who bears the cost of energy efficiency improvement works?
The reality is that the landlord will most likely bear the cost of any works.
With existing leases without any special MEES drafting the landlord could only expect the tenant to pay if the works fell within the scope of the tenant's repair covenant, which is unlikely to be the case as the works 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.
With new leases, the landlord may try to impose an obligation on the tenant to pay for the cost of any energy efficiency improvement works which the landlord carries out (or contribute to the costs if there is a service charge). Whilst a tenant should stand to benefit from lower energy costs, most tenants would still resist on the basis that they should not be contributing to capital improvement costs. The final position will be determined by the relative strength of the parties' bargaining positions.
Some commentators have suggested that the standard tenant's obligation to comply with statutory requirements might mean the tenant has to pay. However, this is not the case as the MEES Regulations do not actually impose any obligation to carry out works.
Are there any concerns for tenants?
Draft leases are now likely to include various provisions to deal with the MEES Regulations and to protect the landlord's position. Tenants may need to think about two in particular:
1. The landlord may include a right to access the premises to carry out energy efficiency improvement works if the tenant consents. Tenants might be concerned about the possible disruption that could be caused to their business if they consented, so may wish to limit the right in some way and/or argue for the rent to be wholly or partly suspended for the duration of the works.
2. The alterations provisions are likely to prohibit the tenant from carrying out any alterations which have an adverse effect on the energy performance of the premises. This could cause problems for certain tenants, such as retailers, because shop lighting and window displays make them very high users of energy. A standard fit-out or re-fit could possibly put them in breach of this obligation so some compromise on the wording might be advisable to allow flexibility.
Where a tenant grants a sub-lease it will itself be a landlord and therefore subject to the MEES Regulations which adds an extra layer of complication.
Tenants of sub-standard properties who want to sub-let should consider the points for landlords and exemptions set out above. If its own landlord has already been through this exercise there may be no relevant works to be carried out, but if there are relevant works the tenant will need to check that the alterations provisions in the lease would allow it to carry them out. Bear in mind though that the tenant cannot rely on any exemptions registered by the landlord and will have to register its own exemptions.
Lenders will be concerned about a number of issues:
1. a sub-standard EPC rating is likely to affect the capital value, marketability and rental value of its security;
2. 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; and
3. in some cases, lenders may be concerned about the reputational risks of being associated with landlords that may be "named and shamed" in the future.
Financing or re-financing does not 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, particularly if existing EPCs will expire shortly. 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. 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.
Wider impact of the MEES Regulations
The MEES Regulations only directly apply to lettings, but they will have a wide impact on property and property funding generally. Whether they help achieve the government's aim of substantially reducing greenhouse gas emissions in buildings will depend on how strictly they are enforced and the extent to which the market reacts positively to the call for energy efficiency improvements or resists it through reliance on exemptions.