How EPCs Will Impact Lease Renewals, Rent Reviews and CRE Value

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What impact will Energy Performance Certificates have on lease renewals, rent reviews and CRE value with the introduction of MEES?

Our white paper, Minimum Energy Efficiency Standards (MEES): The Implications for Rent Reviews, Lease Renewals and Valuation has identified that MEES risks are real. The paper considers the implications of MEES on rent reviews and statutory lease renewals and the knock-on effects of this on to commercial property values.

The Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015, better known as the Minimum Energy Efficiency Standards (MEES) Regulations prohibit a landlord from letting a sub-standard property from April 1st 2018 and from continuing to let a sub-standard property from 1st April 2023. A sub-standard property is one that fails to meet the minimum energy efficiency standard set at an Energy Performance Certificate (EPC) rating of an E. If a property fails to meet this minimum standard, an assessment must be undertaken to identify relevant energy efficiency improvements. These improvements must then be implemented before the property can be let, even if the EPC rating does not improve.

“A sub-standard property is one that fails to meet the minimum energy efficiency standard set at an Energy Performance Certificate (EPC) rating of an E”

Clearly, in many cases there will be a financial cost to compliance and this should be understood and considered in the context of rental valuations at rent review and lease renewal. As MEES has been well signposted since 2011, the property industry has had time to debate its effect and the current expectation is that it will potentially suppress rental levels at rent review or lease renewal. If rental growth is suppressed then, all things being equal, growth in capital values will likewise be suppressed. This could manifest itself through both the complexities and nuances of rent review and lease renewal negotiations, or through transactional evidence becoming available showing buildings that are compliant with MEES achieve higher rents or sale prices than those that are not.

“If rental growth is suppressed then growth in capital values will likewise be suppressed.”

These hypotheses are not new, but were tested by engaging arbitrators and solicitors to identify and quantify risks using a realistic case study building and lease paper. The research paper was peer reviewed by former Director & Head of Research at PRUPIM, Dr. Paul McNamara OBE, RICS fellow, Ian Feltham, and Chartered Surveyor, Sue Elwood. The research used a hypothetical G rated EPC building with a 7% yield, a base capital value of £13m and four tenants at the point of either a rent review or lease renewal. It analysed the range of possible rents assuming the tenants made energy efficiency improvements, with and without landlord consent. It simulated a range of landlord and tenant valuations and the resulting capital values fell by a sum slightly in excess of the cost of relevant energy efficiency improvements, to one considerably in excess of those costs, leading to a reduction of over 10% in the building’s capital value.

Rental and Capital Valuations

Comparable evidence may arise in the future proving that the implementation of MEES provisions affects rental values. This will undoubtedly impact rent review and lease renewal negotiations and therefore capital values.

It is feasible that rents at rent reviews or lease renewals will be discounted to reflect the cost of improvement works and/or to hypothetically compensate occupiers for disruption. Therefore, even without direct comparable evidence to prove that MEES affects rents, one can identify immediately the risk of discounts being negotiated which will negatively impact capital values.

Through the application of capitalization rates, the effect of discounts are potentially amplified meaning the impact on value can exceed the cost of work. Potentially by considerable sums. Given that the cost of works may have a uniform impact on decreasing rents, capitalization could affect lower yielding prime buildings more that higher yielding secondary buildings.

Key Findings

  • Valuers will be able to develop highly polarized arguments in rent negotiations, depending on whether they are appointed by the landlord or the tenant.
  • Reductions in capital value were found to be between 0.7% and 11.6%.
  • It is unlikely that leases ‘inside’ the 1954 Act will escape any impact from MEES. However, the main impacts on value will tend to follow statutory lease renewals. Leases inside, or indeed, outside the 1954 Act might only be affected at rent reviews if transactional evidence proves the existence of a rental discount.
  • Central to this debate on value impacts are the typical lease covenants relating to the hypothetical letting and the provisions of section 34 of the 1954 Act.
  • The regulations place a great deal of importance on the accuracy of the EPC, therefore inaccurate Energy Performance Certificates could have serious and expensive consequences for a landlord.

Potential Impact on UK Property

The July 2016 IPM report on size and structure of the UK property market estimated the total worth to be £871bn.

2014 research figures from Landmark Information Group showed that 19% of Energy Performance Certificates in England and Wales are currently F or G rated. The figures were cited in The Green Construction Board, Mapping the Impacts of Minimum Energy Efficiency Standards for Commercial Real Estate, August 2014.

Therefore £165.49bn of total commercial UK property is estimated to be not complying with MEES legislation and therefore at risk.

 

 

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