Commercial and residential landlords of property in England and Wales will be hit by the new Minimum Energy Efficiency Standards (MEES) legislation, coming into effect from 1 April 2018. This could affect financial statements, cash flow forecasts and covenant reviews.
From 1 April 2018, all landlords of property in England and Wales will be required to ensure that the properties that they rent meet a minimum energy performance rating of E on an Energy Performance Certificate (EPC). If the property doesn’t meet this standard, a landlord can’t grant, extend or renew a lease of a property.
The regulations affect:
- all new lets and renewals of tenancies from 1 April 2018;
- all existing residential tenancies impacted from 1 April 2020; and
- all existing commercial tenancies from 1 April 2023.
Find out more on the facts, fines and exemptions.
Should fair value take account of the lessor’s obligations under MEES?
Property held for rental purposes to third parties will usually meet the definition of investment property, and FRS 102 requires (and EU-IFRS permits) such investment property to be carried at fair value, with movements on fair value being booked in profit or loss.
Fair value reflects the amount that willing and knowledgeable parties would accept in an arm’s length transaction, and as such a landlord whose property does not meet the requirements of MEES could suffer a temporary diminution in value until they can upgrade the property. The amount of this diminution may be more substantial where the lease is due for renewal imminently as the landlord cannot renew or grant a new lease until the property is upgraded and hence will not be able to obtain income from the asset.
MEES doesn’t apply until 1 April 2018, can fair value be affected before then?
Consider a property lessor with a 31 March 2018 year end, and that lease is coming up for renewal in July 2018. Whilst the MEES requirements only become effective after the year end on 1 April 2018 (and only then for new leases and renewals), the fair value of a property at 31 March 2018 may be lower than an equivalent property that meets the requirements, given fair value reflects knowledgeable and willing parties. Any potential buyer would know that they would need to invest money upgrading the property and so may be willing to spend less on purchasing the property.
Should improvements for energy efficiency be capitalised?
Any improvements the client makes should be considered for capitalisation and, subject to materiality considerations, be capitalised only where they enhance the investment property, eg allows increased rent to be charged. This should be compared to the rental achieved, and not simply against nil rental if upgrades hadn’t been incurred.
The accounting policy should clearly disclose the treatment adopted, which should be consistent year on year. The accounting selected, may affect lending covenants, particularly where fair value movements have been removed from interest cover calculations. Therefore care should be taken to ensure the most appropriate treatment is adopted, and not simply the most convenient.
Could or should a provision be made for expenditure or fines under MEES?
No, at least not until there is an obligating event, either constructive or legal.
Whilst the valuation of a non-compliant building may be affected (as fair value assumes knowledgeable parties), no provision is required until such time as the entity is required to incur the costs. It could simply choose to sell the property or not extend an existing lease post year end, although this may affect going concern. However, in 2020, the legislation will require all properties under existing leases to meet the minimum requirements under MEES. At that time, a provision may be required, but only in the accounting period following 1 April 2020 (eg year ended 31 March 2021) if the improvements had not been made.
Lessors that do not require to extend or sign new leases have no obligation to make good until 1 April 2020 (or 1 April 2023 for commercial property), unless they have created a constructive obligation.
No provision should therefore be made before 1 April 2020 (or 1 April 2023 for commercial property) as there is no obligating event. After 1 April 2020 any provision should be for the amount required to meet the requirements, including any fine (up to £150,000) for non-compliance where this is probable.
Can MEES expenditure affect cash flow forecasts and covenant reviews?
Additional spending requirements on MEES upgrades should be accurately reflected in cashflow forecasts until at least April 2023 (depending on the type of property). The classification of the spend may also impact upon any lending covenants, since repairs that are expensed could be included in interest cover calculations, whereas fair value movements may not be.
A business at risk of breaching a covenant due to significant repairs, should speak to lenders before they incur the expenditure as well as carefully considering the classification of the spend as either repairs or capitalised enhancements. Being unable to extend a lease or market a property due to the MEES improvements not being made may have a significant impact on how the business is run. Funding may be required to make the improvements or the property may need to be disposed of, or left vacant.
For further information please speak to Howard Freedman or your usual RSM contact.