Risks To Lenders, Landlords And Tenants

From 1 April 2023, it will be unlawful to let out a commercial property with an EPC rating of F or G.

The Minimum Energy Efficiency Standards (MEES) legislation came into force in April 2018 and applies to properties in England and Wales that are required to have an Energy Performance Certificate (EPC).

The standards set out how the energy efficiency of commercial properties must be improved over a period of time. As a result:

• From 1 April 2023 it will be unlawful to continue to let a commercial property on an existing lease if that property has an EPC rating of F or G.
• By April 2030 all non-domestic rented buildings must have an EPC of A or B.

Ten per cent of non-domestic rented stock has an EPC rating below E, according to the latest government statistics.

The timescales for improving minimum standards for commercial rented properties lag those in the private rented sector; from April 2018, private rented homes were required to meet the minimum standard of EPC E before they could be let on a new tenancy and, since April 2020, the requirement applies to all rented homes, even when there has been no change in tenancy.

The responsibility for compliance with the MEES legislation rests with landlords and they will be liable if there is a breach. Financial penalties ranging from £5,000 to £150,000 could be enforced by local Trading Standards, and repeat penalty notices can be served for a breach, so multiple fines could be incurred.

As Environmental, Social and Governance (ESG) and green credentials become ever-more important, avoiding the reputational risk associated with occupying or renting out properties with poor EPC ratings will be increasingly important to many businesses. There is also the risk of stranded assets, as investors seek to ensure that their investments are sustainable.

What is an EPC?

An EPC gives a measure of a building’s energy efficiency. The grading is A–G, with A being the most efficient. An EPC is required when a building is constructed, sold or rented out and is valid for 10 years.

Several EPCs may be required for a single building divided into different components and with multiple tenancies and uses. It is important that specialist advice is taken in this regard.

The EPC ratings/status of properties in England and Wales can be checked online.

Please note that the MEES legislation does not apply in Northern Ireland or Scotland.

There are certain exemptions to the requirement to have an EPC, including where the:

• ability to undertake improvement works is prevented by third party restrictions;
• improvement works would reduce the market value of a property; and
• cost of carrying out the improvement works is more than the expected value of energy savings over a seven-year period.

All exemptions need to be registered on the Private Rented Sector (PRS) Exemptions Register, a national register that is open to the public.

The impact on:

Landlords

• Properties held for rental purposes will usually meet the definition of an investment property, and as such can be carried in the accounts at fair value. Fair value reflects the amount that willing and knowledgeable parties would accept in an arm’s length transaction.
• If a landlord’s property does not meet MEES requirements, the property’s value could be reduced until it is upgraded. The amount of the reduction may be more substantial when the lease is due for renewal, because the landlord cannot grant or renew a lease until the property is upgraded.
• A reduction in property value will impact a company’s balance sheet and may impact banking covenants (for example loan to value, asset cover). In addition, repairs that are expensed rather than capitalised may adversely affect interest cover calculations.
• Any potential buyer of a commercial property will know that they need to invest funds upgrading the property and are therefore likely to deduct the cost of the upgrade from the purchase price.
• There may be a void period while the property is upgraded and no rental income is being generated.
• Financing/refinancing options are likely to be limited, as any new lenders are likely to take into consideration the EPC rating.
• Funding may be required for the necessary upgrades, which will either come from cash reserves or additional borrowings.
• Landlords should consider whether any upgrade expenditure will be eligible for capital allowances tax relief and take specialist tax advice.
• Fines may be levied by local Trading Standards if properties are deemed non-compliant.
• The reputational risk of having non-compliant properties should not be underestimated.
• Where a landlord has charged the property to support cross guarantees, for example to other group companies or possibly to a pension scheme, the strength of this guarantee may be diluted and funders may require additional assets, or personal guarantees, as security.
• Tenants may seek shorter lease terms to mitigate occupation in lower grade properties as they will have net zero targets, therefore landlords wanting anchor tenants will need to offer attractive terms and conditions.
• Landlords should consider and plan for the longer-term requirement for an EPC rating of A or B from 2030.

Tenants

• Unless an exemption applies, it is unlawful for a landlord to continue to let a commercial property with an F or G EPC rating, even if the lease was granted prior to the introduction of the regulations in 2018.
• Tenants may also assume responsibilities under MEES regulations if they have sublet part of the property.
• There may well be an interruption to trading if significant work is needed and compensation may be required.
• Tenants may, in a worst-case scenario, be left without premises or have to seek alternative premises.
• Landlords may seek to pass on costs of any upgrade via an increase in rent or service charge which will have a cost implication for the tenants.
• Tenants’ funders are likely to require information about the tenant’s premises, and may factor this into any lending decisions.
• There is a reputational risk for tenants if they are occupying a non-compliant building.

Lenders

• Banking covenants may be affected, so they may need to be reviewed and reset to reflect any impact on asset value.
• Property values may be reduced, which will dilute lenders’ security.
• As it is unlawful for a property to be let from 1 April 2023 if it has an F or G rating, a landlord may have difficulty in servicing loans if rental income is reduced.
• The reputational risk to the lender of lending to non-compliant landlords will need to be considered.
• There may be opportunities for lenders to lend additional funds to enable properties to be upgraded to meet the requirements.
• The value of any cross guarantees may be impacted if property values are impaired.

Call to action for:

Landlords

• Identify those properties that are F and G rated, and either consider exemptions or look to upgrade properties as necessary. Specialist advice is likely to be required.
• Discuss with your accountants the potential impact of any reduction in value of investment properties in the financial statements.
• Discuss any likely reduction in property value with lenders in advance, including any reviews or revisions of covenants.
• Consider loan serviceability issues that may arise as result of a potential drop in rental income.
• Consider how any necessary property upgrade work will be funded.
• Talk to your tax advisors about whether any property improvements will qualify for capital allowances tax relief.
• Discuss sustainability-linked loans with the funder if you’re looking at a property purchase or refinancing.
• Take advice around standard lease wording to ensure that tenants are obliged not to undertake work that could negatively affect an EPC rating.
• Discuss with your insurance broker what impact any old or non-compliant properties will have on the insurance premium, and if cover will be offered.
• Ensure detailed records are kept of all upgrades to the property to ensure EPC ratings are maximised.

Tenants

• Speak with your landlord about any building upgrades and whether this will lead to an interruption in trading.
• Review your business interruption insurance cover to ensure any potential losses are covered.
• Look at whether you have responsibilities in respect of any subleases.

Lenders

Review your customer portfolio and actively engage with your landlord customers. Consider:

• the impact of any non-compliant properties on your security;
• loan serviceability;
• additional funding requirements; and
• potential breaches of covenants.

For more information, please contact Lindsey Cooper or Stacey Eden.