The Energy Act 2011 and its impact for real estate

Ian Daniels, Head of Real Estate at haysmacintyre explains the issues for landlords and tenants presented by the Energy Act 2011.

By April 2018 you may be prevented from letting, or continuing to let, your building if it has an energy performance certificate (EPC) lower than an “E”. Although four years away, there are issues for landlords and tenants to consider and, possibly, address now.

Background

The Energy Act 2011 (“the Act”) placed an obligation on the Secretary of State for Energy and Climate Change to introduce regulations that would prevent a landlord letting a property which had an EPC below a rating set out in, as yet unpublished, regulations. This minimum energy rating is widely expected to be set at “E” and is the rating referred to on the Department of Energy and Climate Change (DECC) website. Similar legislation applies to domestic and non-domestic property, with both having a backstop date for the enabling regulations to come into force of no later than 1 April 2018.

Regulations will also be brought in no later than 1 April 2016 to give tenants of domestic properties the ability to make certain energy efficient improvements with landlords being unable to unreasonably refuse consent to the improvements. It is thought that landlords might be able to refuse consent if the improvements would have a negative impact on the value of the property.

It is interesting to note that the definition in the Act of “let the property” is explicitly defined as to “maybe include “continue to let the property””. We could therefore be faced by 2018 with landlords and tenants having to be in properties with an EPC of no worse than an “E” rating. In the meantime there are many issues to consider, such as, who should pay for the improvements, the timing of any improvement work, the potential for businesses disruption during improvement works, the effect on property valuations, whether dilapidation provisions need revisiting and the effect on rent reviews.

However, there is some good news in that it is likely that the requirements will be subject to there being no upfront cost to landlords. Landlords are expected to have fulfilled their responsibility if they have reached the minimum energy rating or have carried out the maximum package that will be funded under the Green Deal and/or the Energy Companies Obligation schemes, both of which are designed to support the energy efficiency improvements. It is also expected that certain buildings will be exempt from the regulations, such as listed buildings where improvements would unacceptably alter their character and buildings that are due to be demolished.

The Government had intended to withhold details of the regulations until closer to implementation but thanks to lobbying and representations from interested parties, the DECC has set up two working parties to consider the practical implications of the regulations. It is expected that the working parties will submit their findings shortly with a public consultation late this year.

It is estimated that at present about 20% of commercial property falls below the “E” energy rating and will therefore need to be improved. However, changes to the assessment of EPCs in the next few years is likely to mean that property that is currently just in the “E” rating will fall into the “F” or “G” category by 2018. Therefore landlords need to consider likely future changes in regulations if they are not to be faced with more than one round of improvement expenditure in the next few years.

Financing the improvements

The preamble to the Act sets out one of its objectives as being “to make provision for the arrangement and financing of energy efficiency improvements to be made to properties by owners and occupiers”. Accordingly there are provisions within the Act to enable landlords and tenants to apply for funding support through the “Green Deal”.

Under the Green Deal the cost of upgrading the property is paid back through increased energy bills in the future but, unlike a loan, the “liability” is attached to the property rather than the person arranging the improvements. Therefore, when a new occupier comes into a property which has benefitted from the Green Deal the new occupier will face increased energy bills. However, the implicit interest rate in such deals has already been heavily criticised as being too high and unattractive and, at the end of 2013, just over 1,100 had successfully applied for funding under the scheme compared to an earlier Government estimate that 10,000 would have signed up by then. To date, the financing element appears a very wizened carrot to the stick being wielded on property requirements!

Impact on landlords

Clearly having a property that can be let is fundamental to protecting its value. Landlords will therefore need to assess the extent to which they will have to enhance their properties in order to be able to continue letting them once the regulations are enacted. If substantial improvements are required, landlords will need to consider the timing of the works and indeed whether a fuller refurbishment or rebuild might prove more profitable to the landlord in the longer run.

The landlord will also need to consider the terms of the lease – not just as to who is liable for the cost of the improvements but whether the landlord is liable for costs of disruption to the tenant(s) during the works. If the lease provides quiet enjoyment to the tenant, and the works breach this covenant, who picks up the cost? This will depend on the terms of the lease which may yet be overridden by reliefs in the regulations when they are published.

The need to undertake enhancement works is likely to depress the property’s value until completed which may have implications on bank arrangements with covenants over loan to property values. Landlords will also need to consider the impact of expenditure on their financing and redevelopment plans.

Impact on tenants

Tenants need to consider whether they will face unexpected costs as a result of works undertaken by their landlord and the implication that the regulations will have on their dilapidation liabilities. Some have suggested that tenants might find themselves liable for improvements as a result of the creeping up of the conditions to each EPC rating. For instance, a tenant might have taken on a property with a “D” rating which at the end of the lease is rated “E”, not through any deterioration in the state of the property but just through a rebasing of the EPC ratings. Depending on the lease terms that tenant might find themselves responsible for handing back the property in the new definition of a “D” EPC.

Tax impact

Depending on circumstances landlords and tenants could be faced with extensive capital expenditure, whether it be to meet the minimum requirements and/or to upgrade. It is always sensible to review proposed capital expenditure to ensure that tax reliefs are maximised as part of the planning process.

We currently have an Annual Investment Allowance (“AIA”) of £250,000, which provides 100% relief in the year of expenditure for eligible capital expenditure.  The AIA will increase to £500,000 from 1 April 2014 until 31 December 2015 after which it is currently planned to fall to £25,000.. For larger companies the enhanced capital allowance (“ECA”) regime may be attractive by providing a 100% capital allowance on qualifying energy efficient assets with a list of eligible assets being maintained on the Energy Technology List (“ETL”) at https://etl.decc.gov.uk/etl/site/etl.html. It is important to ensure that when specifications are being drawn up the assets used are on the ETL if it is intended to make use of the ECA regime.

The changes to buildings may also involve dealing with contaminated items where tax relief of 150% of the expenditure incurred on dealing with the contamination may be available. Early identification of such costs is advised in order that any associated tax reliefs can be appropriately claimed.

Conclusion

Although the detailed regulations have still to appear, it is clear that in the next few years the real estate sector will not escape the Government’s focus on carbon reduction and energy efficiency. Additional costs for some landlords and/or tenants are inevitable but with planning and advice these can be minimised.

haysmacintyre website: www.haysmacintyre.com