Landlord alert: Letting of properties with poor EPC ratings to be severely restricted from April 2018.
The Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015 (S.I. 2015/962)
Back in September last year, we put out a briefing on this topical subject on the back of draft regulations published following completion of a public consultation. Now that the actual regulations have made their way onto the statute book, we feel that the time is right to update our analysis to help landlords and investors make initial assessments as to what they might need or want to do in response. The regulations cover both residential and commercial properties; but our analysis relates only to the provisions dealing with commercial properties.
Who and which properties the regulations apply to and those to which they don't apply
The first essential point to note is that the regulations only apply to landlords of tenanted properties, not owner-occupiers or tenants, but it is important to be aware that an occupying tenant, who has no responsibilities under the regulations in that capacity, can become a landlord with responsibilities if, for instance, it becomes an "accidental" landlord by subletting surplus space. Use of the word "tenanted" also effectively excludes properties occupied under a licence from the effect of the regulations.
The second essential point to note is that the regulations do not apply to leases granted for a term of 99 years or more, or 6 months or less subject to caveats relating to successive short term tenancies.
The regulations only apply to properties that need to have an Energy Performance Certificate, which might not be the case for a number of reasons. If, for instance, a property has not been transacted since EPCs were introduced in April 2008, then there would have been no obligation thus far to have commissioned an assessment leading to a certificate. If a property was let under a lease for 25 years in 2007, then it might not need an EPC for many years yet, and so not be caught by the regulations at all, despite the "hard start" that kicks in on 1st April 2023 (about which, more below).
Other properties that do not currently need to have EPCs include places of worship, many listed buildings, those that are not heated or ventilated using power, buildings below a certain size, buildings that people do not ordinarily visit, buildings scheduled for demolition, industrial workshops with "low energy demand", and most agricultural buildings, amongst others.
Transactions that do not currently require a landlord to obtain and provide an EPC to the prospective tenant include lease renewals under the Landlord and Tenant Act 1954, and lease extensions, although it must be pointed out that this analysis is to be found only in DCLG guidance notes rather than in the black letter EPC regulations, and that this will conflict with these new regulations which clearly say that they will apply to lease renewals and extensions after a short exempt period of 6 months following the grant or extension in question. Maybe the conflict will be rare and of only short term relevance as it will only arise if a lease has been successively renewed since before the EPC regulations came into force so that no EPC has thus far been required.
Where they do bite, the regulations require at least some response in respect of properties that are "sub-standard" in terms of energy efficiency. "Sub-standard" is defined in Regulation 22 as a property with an EPC whose energy performance indicator is below "E", estimated to affect about 18% of the commercial property stock in the UK. Landlords need to be aware that this letter might change (and inevitably only in one direction) in future years, as might the level of energy efficiency that needs to be achieved to reach the level "E".
The practical effect of the regulations, subject to the caveat and exemptions explained below
Under Regulation 23, in respect of a property that is sub-standard, a landlord cannot:-
- grant a new tenancy on or after 1st April 2018, which includes the renewal or extension of an existing tenancy
- allow an existing tenancy to continue after 31st March 2023
NB. Pursuant to Regulation 30, a tenancy in breach of Regulation 23 does NOT affect the validity or enforceability of any of the provisions of a tenancy, so tenants can never be required by the regulations to vacate their property because it is sub-standard or to enable works to be done to upgrade them and, crucially, landlords will still be entitled to the rent.
The big caveat, not for some reason categorised as an exemption, is that a sub-standard property CAN be let, or an existing tenancy allowed to continue, if all "relevant energy efficiency improvements" have been made or none can be made to it (Regulation 29). The improvements that qualify as "potentially relevant" are listed in the Schedule to the Green Deal (Qualifying Energy Improvements) Order 2012 and Table 6 of the Building Regulations Approved Document L2B, and are self-explanatory.
Improvements that actually have to be carried out are those potentially relevant improvements that can be wholly paid for pursuant to a Green Deal plan or "financed by such other financial arrangement as the regulations provide".
The improvements listed in the Schedule to the 2012 Order are those that may form part of the Government's totemic Green Deal, which ignores the inconvenient truth that, as at the date of writing (April 2015), there is no "Green Deal" for commercial properties, only residential. This gap will have to be filled somehow, and soon, as the Government's stated policy throughout the gestation of the regulations has been to eliminate the "split incentive", where the landlord would pay the cost of improving the energy efficiency of a property and the tenant would then enjoy lower energy bills as a result.
Under the Green Deal scheme, assuming that it is transposed wholesale from the residential arena, the cost of the improvement works would be financed by a commercial Green Deal (or equivalent) lender who would then collect the financing cost through the energy bills paid by the tenant, which are artificially increased to cover it. Crucially though, the overall amount of the tenant's energy bill would not exceed the amount that it would have paid for energy if the improvement works had not been carried out, the so-called "no cost" improvement. If an improvement does not pass this test, the regulations do not require it to be carried out even if it means that the property remains sub-standard. This is the "Golden Rule" much heralded by the Government.
The improvements listed in Table 6 are only required to be carried out to a sub-standard property if the cost of the works would be paid back in lower energy bills within a period of 7 years, the formula for the calculation of which can be found in Regulation 28. The regulations do not explain how the split incentive is eliminated in this scenario, and maybe the draftsman assumed that a tenant will pay more rent for a property that has lower energy bills. That is likely to be a hard sell for a landlord in a difficult market.
Provided that it is registered as required by Regulation 36(2) (see below), the caveat explained above lasts for a period of 5 years from registration at which time the position has to be reassessed.
The formal exemptions from the need to comply with the regulations
The restriction on letting, or continuing to let, a sub-standard property does not apply where:-
- in the preceding 5 years, the landlord has been unable to improve the energy performance indicator of the property to "E" or above due to the lack of a tenant's or third party consent, subject to registration as referred to above (Regulation 31)
- in the preceding 5 years, an independent surveyor has advised that a particular improvement would reduce the market value of the property by more than 5%, subject to registration as referred to above (Regulation 32)
A "third party consent" means the consent that is required to carry out any particular improvement and is defined in the regulations as "including in particular":-
- a tenant's consent
- the consent of any person with a charge over the landlord's or a superior interest
- the consent of a superior landlord
- a planning consent under the Town and Country Planning Act 1990
- a consent required as a result of the property being listed (which is odd as most listed buildings won't be affected by the regulations as they don't need to have an EPC in the first place), or a consent required because the property is in a Conservation Area
Use of the phrase "including in particular" suggests that other consents that might be required and are not forthcoming will also give rise to an exemption, and each one will need to be assessed on its merits.
There is a separate temporary exemption whereby compliance can be delayed for the period of 6 months immediately following the grant of a renewal lease under the Landlord and Tenant Act 1954 or the purchase of a property subject to an existing tenancy, subject to registration as referred to above (Regulation 33).
The obvious purpose of the exemptions is to seek to minimise the number of lettable properties effectively taken out of circulation by the regulations in 2018 if they do not achieve an asset rating of "E" and, even though each exemption only lasts for 5 years, it is worth bearing in mind that the exemption might still apply or that a different exemption might be immediately available on expiry of that initial period.
Registration of the caveat and/or an exemption
Those wishing to take advantage of the caveat or an exemption will need to register their entitlement to it on the "PRS Exemptions Register" in accordance with Regulation 36(2). The contents of the register will not be vetted or verified by the enforcement agency (the trading standards department of the relevant local authority), but a landlord must make a formal statement that it holds documents that contain the evidence that entitle it to an exemption, and can be required to produce them on request by an enforcement officer.
The register will be open to public inspection and will therefore potentially create real difficulties for landlords such that they might not take advantage of an exemption to which they are entitled. In particular, they can be required to register a copy of the lease, which will undoubtedly contain confidential and commercially sensitive information, if they claim an exemption or are asked to show that their compliance derives from the fact that the tenancy of a sub-standard property predates 1st April 2018.
To demonstrate that all relevant energy efficiency improvements have been carried out (or that none that comply with the Golden Rule can be carried out) to a sub-standard property, a landlord will need to have an independent assessment of the property carried out and obtain 3 quotes for the improvements identified as "potentially relevant". If challenged by an enforcement officer, the assessment and quotes will have to be uploaded to the register.
Penalties for non-compliance with the regulations
Penalties for breach of the regulations differ depending on when the breach comes to the attention of the enforcement agency. If the "penalty notice" is served when the landlord has been in breach for less than 3 months, the financial penalty cannot exceed the greater of (a) £5,000, and (b) 10% of the rateable value of the property, subject to an absolute limit of £50,000. If the breach has been continuing for 3 months or more, the corresponding numbers are, respectively £10,000, 20%, and £150,000. Appeals against these penalties and their amounts are possible.
In addition to the possible financial penalty, a "publication penalty" can be imposed on a corporate, but not an individual, landlord whereby the landlord is named and shamed as a defaulter on the PRS Exemptions Register.
Points to consider
Compliance will statutorily be the responsibility of the landlord (or intermediate landlord in the case of an undertenancy), not the tenant, but could be passed down to a tenant if it agreed to accept the obligation. Be aware though that, even if compliance is passed down contractually, any penalty for non-compliance will still land on the landlord's desk so appropriate indemnities will be required in the lease.
If they do not expect to be entitled, or do not want, to claim an exemption, landlords have from now until 31st March 2018, or possibly until 31st March 2023, to bring a sub-standard property up to scratch. If there is an existing lease, they can either attempt to pass the liability or cost down to their tenant (possibly through a service charge) if their lease allows them to do so, or meet the cost themselves. In either case, they will need to check their leases to ascertain whether they need the tenant's consent to carry out the necessary improvement works.
In the period up to 1st April 2018, landlords of properties with a low EPC rating that are either currently vacant or will be vacant before the deadline have to decide what to do and how to comply with the regulations, whether that be by carrying out improvement works or claiming an exemption. Landlords with tenants of leases extending beyond 1st April 2023 have more time to make the same decisions but, for all landlords of sub-standard properties, doing nothing is not an option in the medium term.