PLC Property Lease Code Seminar: Service Charges

Practical Law UK Articles 4-379-0691 (Approx. 8 pages)

PLC Property Lease Code Seminar: Service Charges

by Carrie Faller and Yvette Bryan, Trowers & Hamlins

Introduction

We have been asked to say a few words about Service Charge and issues between landlords and tenants and what's happening in practice.

Service charges are treated in a different way from the other provisions of the Lease Code. The Lease Code says very little in the way of service charge recommendations. Basically the Lease Code requires the landlord to give prospective tenants best estimates of service charge and to disclose irregular events that would have a significant impact on the amount of future service charge. Most importantly the Lease Code states that landlords should observe the guidance in the far lengthier and detailed 2006 RICS Code of Practice Service Charges in Commercial Property.

The RICS Service Charge Code (Service Charge Code) is a voluntary code of practice, which was launched on 26 June 2006 and affects service charges from 1 April 2007. The Service Charge Code has been prepared by the RICS and will be used in the main by surveyors who will be operating the service charge funds.

Why is the Service Charge Code relevant to you as lawyers?

So why is the Service Charge Code relevant to you as lawyers? Well, if your landlord client says that he doesn't care about the Service Charge Code and he is going to run his property as he wants then you can perhaps ignore it other than to warn your client that this approach might affect the marketability of the property or, if you don't give that warning, then you might want to tell your PI insurers that you didn't.

Conversely, if your landlord client asks you to prepare a Lease Code compliant lease you can't just insert a bald statement in the lease that the landlord will comply with the Service Charge Code. You actually have to think in detail about whether the structure of the service charge does comply in practice and point out to your landlord client what needs to be changed so that it complies.

Your client may be very surprised to find that some approaches which to date have been perfectly normal do not necessarily comply with the Service Charge Code. It isn't always easy to be certain if a practice does or does not comply.

One issue to be aware of is that the Service Charge Code states that service charge monies in respect of reserve or sinking funds should be held by landlords on trust for each tenant. Trusts carry onerous fiduciary duties for the trustees and need specialist advice and explicit drafting as there can be painful results. There are tax consequences and specialist tax treatment for trusts, which need to be considered, as well as the impact of FSA legislation.

If your client is a tenant then he will expect you to get the best deal on service charge for him and quite possibly if you accept a "standard" service charge clause without thinking about the Service Charge Code you won't have done this. Is that negligent? It is possible.

I should make it clear that we are not going to be looking at the recent regulations on the provision of information for residential leaseholders. In this talk, we are only considering commercial property.

Caveat to the Service Charge Code

So what is the Service Charge Code?

It is an attempt to establish best practice for the structuring and running of service charges. It doesn't override existing leases but urges property managers to comply with the Service Charge Code so far as possible. For new leases it recommends that the Service Charge Code's provisions should be reflected in the service charge clause.

It is not a black and white list of do's and don'ts. It is guidance only and it should not be slavishly followed.

It is clear that if you comply with the practices recommended in the Service Charge Code then you are unlikely to have been negligent but it is up to the practitioner to decide when it is appropriate to follow the guidance and when it isn't. Following the guidance in an inappropriate case could well be wrong. Equally, not following the Service Charge Code may well be fine in all the circumstances.

Fundamental tension between landlord and tenant

There is a fundamental tension between what landlords and tenants want from their service charge.

The landlord wants to achieve a "clear" rent with all expenses paid by the tenant.
For the tenant, the primary purpose of the service charge is to set out the landlord's duties in relation to the services it will provide. The tenant will not want it to include any items that it thinks should be paid for by the landlord.

What should be included in the service charge will of course depend on the type of property and all the circumstances. There are likely to be more issues at larger properties such as shopping and multi-use centres.

Effect of Service Charge Code on lease negotiations

We have been asked to discuss the effect that the Service Charge Code has had in practice so far.

Tenants' approach to the Service Charge Code

Our experience is that few tenants' solicitors are raising the Service Charge Code as a whole as an issue, but that more of their amendments are reflecting the ideas and guidance in the Service Charge Code.

Different types of tenants have different approaches to the service charge:

Some smaller tenants focus more on historic costs and the maximum potential service charge rather than the items comprised within it. Their main concern is to make sure that the "bottom line" service charge is reasonable and they are less worried about what may happen in future.
Larger tenants with more bargaining power are more concerned about which items are included within the service charge, and which are excluded. These tenants often have standard form amendments, which have now become headline requirements for them.

Feedback from landlords regarding their experience of the Service Charge Code is that the smaller tenants are not raising the Service Charge Code as an issue, and that they are more interested in the other aspects of the Lease Code (for example, in relation to alienation). This is interesting, because the Service Charge Code is there to protect the smaller tenant who is perhaps not always as well-advised. Perhaps the Service Charge Code is not yet reaching those it was meant to target.

Landlords' approach to the Service Charge Code

In terms of landlords' approaches to the Service Charge Code to date, our experience is again quite varied.

Larger landlords are keen to be seen as "good landlords", but there is perhaps more interest in the Service Charge Code in relation to new developments than existing ones. It is much easier to prepare a new Service Charge Code-compliant lease and service charge regime than it is to introduce the Service Charge Code to an existing development where there are pre-existing leases.

Landlords are wary of creating a two-tier structure, which could be costly and difficult to manage, and, in the worst case, could potentially leave you with a service charge shortfall that could reduce the capital value of the property and make it less attractive to a potential buyer.

Generally, where the service charge is working well in practice without complaint by the tenants, some landlords are taking the view that "if it ain't broke, don't fix it". Others are keen to embrace the Service Charge Code to the extent that this is workable on the ground.

Most common problem areas

So what are the most likely areas for dispute regarding the service charge that you might wish to discuss with your clients?

Inevitably these issues are more likely to be relevant in the more complicated multi-let properties rather than the sort of property that has two or three units with a very simple service charge.

Income other than from let units

The first issue I would like to look at is the question of income other than from the let units. Who should have the benefit of this?

The landlord, of course, is interested in maximising his income but the tenant wants to make sure that this maximising isn't at the tenant's expense. Basically the landlord has a choice: if he wants to keep all the income then he must be responsible for all the costs.

If some of the costs are recovered through the service charge then an appropriate proportion of the income must be paid into the service charge. That proportion needs to be reasonable in all the circumstances and the Service Charge Code doesn't give clear guidelines for calculating the proportion.

Whichever course the landlord chooses the Service Charge Code does make it absolutely clear that the landlord must state his policy regarding the income in a way that is transparent. To quote the service charge code, "transparency is required at all times".

What sort of income does this apply to? The Code refers to income from many areas including telephone kiosks, vending machines, promotional space, children's rides, photo booths, the sale of recyclable waste and other things like that, but perhaps the most important areas are car parks and mall income.

Car parks

Car parks can be an extremely lucrative area. There are instances that I am aware of where the car park fees have exceeded a million pounds a year and the maintenance costs are actually very small. Obviously in this situation, it is in the landlord's interest to pay all the costs of maintaining and repairing the car park so that it can keep all the income.

If however the car park was old, dilapidated and costly to repair then the landlord might prefer to include the cost of repairing it in the service charge, in which case any income it earned would also have to be credited to the service charge.

Mall income

Mall income includes the use of barrows or kiosks set up in the shopping centre malls on a permanent or a semi-permanent basis.

Whilst the principle is clear that if the landlord keeps the income from those barrows or kiosks then it must also pay service charge regarding them, what is less clear is on what basis that service charge is to be paid.

Should the contribution be on the basis of the area taken up by the barrow or on the basis of the actual costs of the services used by it, for example, electricity?

This approach is likely to be different at different centres and there is no easy answer. A landlord might even try to argue that the setting up of temporary barrows or kiosks increases the dwell time of visitors to the centre and therefore it is really a marketing expense, which is to the tenant's advantage and in part ought to be included in the service charge without the landlord having to share any income.

Whilst it is hard to know how an appropriate contribution is to be calculated it is clear that the landlord must make it very plain in the service charge certificate how it made the relevant calculations.

Apportionments, management charges and interest

The next few problem areas that I would like to highlight relate to the way in which the service charge will be run going forward.

Apportionments

Transparency in relation to apportionments is strongly recommended by the Service Charge Code, which requires that the service charge certificate clearly states who is contributing what percentage.

The following effects seem inevitable:

When new tenants are reviewing the existing service charge, they will see details of weighting agreed with other tenants at the development (which is, for example, often applied to larger units on a sliding scale based on floor area), which would remove the possibility of "secret" deals and concessions.
If a tenant has a service charge cap, the landlord is required to "top up" the difference, so a sneaky landlord can no longer require the remaining tenants to pay a percentage of any resulting shortfall. Transparency in the service charge certificate will allow tenants to check that this is actually happening in practice.

This is good news for tenants, but probably not for landlords.

The Service Charge Code suggests that, during the life of the lease, it may be appropriate to change the tenants' percentages from time to time to reflect the reasonable position on-site. This is fine where the tenant's percentage is drafted on a "fair and reasonable" basis, but if there are older existing leases that contain a fixed service charge percentage, this may not allow the landlord to be flexible.

Management charges

It is common for leases to include a 10% management charge, but the Service Charge Code clearly states that the total charge must not be linked to a percentage of expenditure as this is a disincentive to value for money.

The Service Charge Code states that the total price for management services must be a fixed fee for a reasonable period of time, say three years, maybe subject to indexing. The Service Charge Code requires transparency in the management fee charged, which must be reasonable for the work properly done.

This does not prevent a landlord from carrying out the services itself and charging a management fee, but again this fee must be appropriate in the circumstances and not based on a fixed percentage.

Interest

The Service Charge Code requires that interest on advance service charge payments is credited to the service charge account. Some landlords are probably already doing this where the service charge is held in a separate account and interest is automatically credited, but some may not be.

The Service Charge Code's principle seems reasonable, as the landlord should not be able to profit from demanding advance payments from the tenants. You should, however, bear in mind that at some developments the service charge may be very high, and the interest accrued could be significant. If you act for a landlord who is used to receiving the interest himself, he may be reluctant to comply with the Service Charge Code and lose his windfall.

If you act for a tenant you should ensure that the lease addresses the question of interest, as in a development with a high service charge your client will be keen to offset the interest against its service charge liability.

Excluded items

An area which is becoming increasingly important in negotiations for new leases is those services which are excluded from the service charge.

The Service Charge Code recommends that only the costs of the operational management of the property should be recoverable. That would include the sort of costs that aren't usually contentious, for example, the reasonable costs of maintenance repair and replacement (where beyond economic repair) of items such as fabric, plant, equipment and materials necessary for the property's operation. The Service Charge Code also sets out specific areas of costs that should not be recovered through the service charge, for example:

The original set-up costs of the property (including leasing of initial equipment)
The cost of improvements above and beyond normal maintenance repair and replacement.
Future development costs. The reason for these exclusions is to protect tenants from unscrupulous developers or landlords who would effectively be making tenants pay twice both for the item or improvement and then in increased rent to reflect the fact of the upgraded property.
Costs between the landlord and individual tenants (for example, breaches of covenant, rent review, rent collection and consents). The reason is to prevent the landlord from passing the risk of unsatisfactory tenants.

An interesting issue arises regarding the leasing of major and expensive items of equipment, for example, escalators, lifts, cherry pickers, CCTV systems.

The cost of purchasing this equipment for a new centre is an initial cost so on the basis of the heads of exclusion it should be excluded from the service charge. That may not, however, be the most cost effective way of dealing with the equipment and accordingly may not be in either the landlord's nor the tenant's best interests.

If a landlord chose cheaper equipment in order to minimise its initial costs, that equipment may fail and need replacing or repairing far sooner than the more expensive items. The tenant will ultimately end up bearing the cost of replacing or repairing those items and, potentially, could have to deal with this in one hit, which would be very difficult for smaller tenants. It might actually be more efficient and fairer to all to have a leasing contract, which included an obligation on the provider to replace the major item at the end of its useful life.

Sinking or reserve funds

Sinking funds and reserve funds are another frequent source of conflict between landlords and tenants. They are also an area where lawyers should tread carefully following the recent Court of Appeal decision in the Brown's Operating System case (Brown's Operating System Services Limited v Southwark Roman Catholic Diocesan Corporation [2007] EWCA Civ 164). This decision related to the return of surplus monies to the tenant at the end of the lease term. The landlord had demanded on account payments, which exceeded its expenditure, and the lease allowed the landlord to retain the excess against future service charge expenditure. However, when the tenant exercised its break, it requested that the excess be returned to it.

The Court of Appeal agreed that the excess should be returned to the tenant. The Court held that the lease had not properly created a reserve fund (covering regular major expenses), nor did it create a sinking fund (covering repair or replacement of major items). The Court held that the landlord was only, therefore, entitled to charge for likely future expenditure arising during the lease term only and not beyond. This decision turned upon the lease wording, but the Court also considered it relevant that the excess accrued in the same account as the annual service charge payments and not in a separate reserve or sinking fund account.

[For details of this case, see PLC Property, Legal update,Landlord to return excess service charge upon tenant exercising break (Court of Appeal)].

The Service Charge Code looks at the way these funds should be operated, in an attempt to avoid the uncertainty that arose in the Brown's case. The Service Charge Code recognises that there are some situations where it makes sense to spread the cost of major expenditure over several years, but provides that:

Sinking and reserve funds must be held in a designated account, in trust for the tenants, with interest accruing to the account.
Landlords must contribute to any sinking or reserve fund for void premises.
Landlords must be reasonable in estimating the fund contributions, and these must relate to specific items of expenditure (not just a general fund), taking into account the realistic life of the item.

Whether acting for a landlord or a tenant, you will need to draft the lease carefully if a sinking or reserve fund is being created, and ensure that the lease clearly states whether the fund is to be kept by the landlord at the end of the lease term or returned to the tenant.

In practice, larger tenants are often reluctant to contribute to sinking funds, as they prefer to incur larger annual service charge payments as and when costs arise, to avoid the risk of paying advance monies into an inefficiently managed fund. The Service Charge Code seeks to address this concern, but whether or not it will lead to an increased willingness among tenants to accept such funds, remains to be seen.

Sometimes a tenant's reluctance to contribute is dealt with by a side letter allowing a personal concession for that tenant. The Service Charge Code suggests that the landlord would be required to contribute on that tenant's behalf in those circumstances, which may make landlords less willing to agree to such arrangements going forward.

"Going green" - a potential future issue

I would also like to touch on one more issue which could increasingly be a problem in the future and this is the question of "going green".

There is a trend for businesses to be increasingly concerned about their impact on the environment and a move to operating commercial properties in a way that promotes sustainability and social responsibility.

One example of this is Energy Performance Certificates, which are being introduced in 2008. [For information, see PLC Practice note, Energy performance certificates.]

Who is to pay the cost of Energy Performance Certificates? As they are needed to enable a landlord to complete a letting, it is arguable that they are a matter between the landlord and the individual tenant and, accordingly, this cost shouldn't form part of the service charge. But is this extra expense going to be acceptable to landlords or are they going to try and put it through the service charge?

What about providing the services to the property in a more environmentally friendly way? Can the full costs of these services be recovered through the service charge even if that cost is higher than if the services were provided in a more conventional way?

The Service Charge Code restricts service charge to "reasonable costs" but is providing greener services at a higher cost reasonable? Obviously tenants will have different approaches and views.

From a landlord's point of view, if he wants the flexibility to recover the cost of providing greener services he will need to be very clear in the lease drafting that this is how he is to operate the carrying out of the services and the charging of them. We are beginning to see drafting along those lines in some leases but it is still relatively rare.

Summary

In summary, the Service Charge Code makes clear the importance of:

Transparency.
Communication.
Value for money.
Quality of management.
Cost and standard of services.
"Fairness".

If the landlord has acted reasonably and openly both in the setting up of the parameters of the service charge, and in the way it operates it, then the landlord is likely to have complied with the Service Charge Code. But the Service Charge Code is only guidance, it does not avoid the need for professional advisors to look at all the circumstances and try to achieve what is reasonable for both landlords and tenants. If leases are to be Service Charge Code compliant over a period, it is going to be very important that their service charge provisions have sufficient flexibility to allow them to be operated in a way that is most fair to all tenants and will lead to as few disputes as possible.

PLC Property Lease Code Seminar: Service Charges | Practical Law