In the second part of their assessment of the new energy efficiency law, Nicholas Dowding QC and David Gilbert consider its impact on alterations, repairs and rent reviews.
The first of these articles looked at the provisions of, and background to, the Energy Act 2011 (the Act), including the Green Deal. It analysed some of the implications of the Act for commercial property, with particular reference to mortgage securities and service charges. This second article looks at the possible impact of the Act on alterations, repairs and rent reviews.
Tenants are increasingly likely to want to implement energy-efficiency improvements to the demised premises, either because they wish to reduce their overall energy consumption (and take advantage of the Green Deal in doing so), or in order to be in a position to sub-let on or after 1 April 2018, or both. The Act does not override what would otherwise be the legal rights of landlords and tenants as against each other (although it does provide that regulations may include exemptions relating to any necessary permissions or consents). The position will therefore be governed by the terms of the relevant lease and the general law. The first step will be to consider carefully to what extent the tenant’s proposed works require the landlord’s consent under the terms of the lease. If they do, then the position will depend on the form of the covenant against alterations. If the covenant imposes an absolute prohibition, the landlord will be under no obligation to grant consent if he does not wish to.
However, this is subject to Part I of the Landlord and Tenant Act 1927 (the 1927 Act), which is frequently overlooked in practice and confers on tenants of premises used wholly or partly for carrying on a trade or business an entitlement, in certain circumstances, to carry out improvements “anything in any lease of the premises to the contrary notwithstanding”. In many cases, the relevant energy efficiency works may be such as to enable the tenant to take advantage of the statutory procedure under Part I. Where the covenant against alterations is qualified (ie, it provides, either expressly or by virtue of the term implied by section 19(2) of the 1927 Act, that the landlord’s consent cannot be unreasonably withheld), the question will be whether it is reasonable for the landlord to withhold consent. That will ordinarily turn on whether a reasonable landlord in the particular circumstances might regard the works as damaging to his property interests in some way (see generally Iqbal v Thakrar  EWCA Civ 592,  3 EGLR 21). In practice, one particular matter that may be of concern to a landlord is where the tenant proposes to fund the works under a Green Deal plan for a period that will extend beyond the remaining term of the lease. In such a case, once the lease expires, then unless the tenant renews, the landlord will become liable for the Green Deal payments (via the energy bills for the property), until he can re-let to a new tenant who will be responsible for the energy bills. One possibility to consider in such a case is to grant consent on terms that will provide the landlord with an indemnity if this happens, although whether that would be held to be reasonable remains to be seen, given that the landlord will have obtained the benefit of the relevant works. The Act may also have another impact on alterations: namely, where a tenant wishes to carry out works that will or may have a detrimental effect on the energy rating of the property. In such a case, depending on the circumstances, it may be reasonable for the landlord either to refuse consent, or to grant consent on terms that the works are done in such a way, or such additional works are done, as to preserve the existing energy rating.
As 1 April 2018 approaches, landlords are likely to become increasingly aware of the need to carry out the necessary works to bring non-compliant buildings up to standard so as to be in a position to re-let them when they fall vacant. Two issues in particular are likely to arise as regards repairing liabilities.
The first is whether and to what extent such works fall within the tenant’s covenant to repair, such that (i) the tenant is liable to carry them out, and (ii) if he fails to do so, the landlord is entitled to enter and do them under a Jervis v Harris clause (see  1 EGLR 78). On the face of it, this seems very unlikely.
Under well-established principles, an obligation to repair is not engaged until the occurrence of physical damage that requires remedying (see Post Office v Aquarius Properties Ltd  1 All ER 1055), and even then, the tenant is not required to carry out works that go beyond the ambit of what can properly be called repair as distinct from improvements. On this basis, free standing works to improve energy efficiency (such as the replacement of existing plant which, although energy inefficient, is nonetheless functional and in repair, with new energy-efficient plant) will not qualify as repair. However, the position may be more arguable where disrepair has occurred, and it can be shown that any reasonable person would adopt a method of repair that takes advantage of modern energy-efficient designs and materials, as opposed simply to replicating the existing energy in efficient fabric or plant. In its current form, however, the Act does not impose an obligation to carry out the energy-efficiency improvements provided for by the regulations; it says that the property cannot be let until such obligation has been complied with. For this reason, it may be difficult either to rely on the general principle that the disrepair must be remedied in a manner which complies with applicable regulations (see Lurcott v Wakely  2 KB 905), or to say that the tenant is liable to carry out the work under the conventional form of covenant to comply with statutes and regulations. The second potential issue concerns the quantum of damages for terminal dilapidations, and in particular the assessment of the diminution in the value of the landlord’s reversion caused by the relevant disrepair. Where the remedial works for which the tenant is liable include energy-efficiency works for which Green Deal funding would be available, the tenant may argue that the cost of such works should not form part of the diminution in value, because any buyer would be able to obtain Green Deal funding to carry them out.
Also, supersession issues will inevitably arise where the buyer of the reversion in repair would undertake energy-efficiency improvement works over and above the repair works, and those works would render valueless some or all of the relevant repair works.
The vast majority of commercial leases provide for the reviewed rent to be fixed by reference to the conventional hypothesis of an open-market letting of the demised premises on the relevant review date between notional willing parties on specified assumptions and disregards. The Act does not impose any restriction on letting prior to 1 April 2018 (or such earlier date as the regulations come into force) and landlords may be keen to complete lettings prior to that date to avoid having to incur substantial expenditure. After that date, however, the landlord cannot let until either he has complied with the obligation to make the energy efficiency improvements provided for by the regulations, or (on present indications) carried out the maximum package of measures fundable under the Green Deal or Energy Company Obligation. How does this translate into the hypothetical scenario to be assumed for review purposes? There will be no difficulty in principle where the review date falls before the date on which the regulations come into force, because reality and hypothesis will coincide. Nonetheless, it may be argued on behalf of tenants that the hypothetical landlord would be prepared to accept a discounted rent so as to be certain of achieving a letting before the relevant date. However, this argument may fail to give sufficient weight to the assumptions (which are express or implied in almost all rent review clauses) that the hypothetical landlord is a willing landlord, not a forced seller, and that the property has been properly exposed to the market in advance of the review date. The position is potentially more complicated where the review date falls after the date on which the regulations come into force, and at the time the property falls below the level of energy efficiency obligation provided for by the regulations. In such a case, a literal application of the review hypothesis would produce the apparent consequence that the hypothetical letting is unlawful. A possible way round this would be to argue that the property must be assumed to meet the requisite level of energy efficiency.
However, that would have the unattractive consequence of the tenant having to pay rent for notional works that do not exist in reality. A better way would be to invoke the well-known reality principle that “in the absence of clear contrary words or necessary implication, it is assumed that the hypothetical letting required by the clause is of the premises as they actually were, on the terms of the actual lease and in the circumstances as they actually existed” (Co-operative Wholesale Society Ltd v National Westminster Bank plc  1 EGLR 97). In the real world, the actual letting will not be unlawful, because it will have been effected before the date on which the regulations came into force. The same assumption should therefore be made in relation to the hypothetical letting. Other energy- or Act-related points likely to come up on review will be the extent to which the property being hypothetically let is energy-efficient; if it is not, what effect that may have on value (particularly bearing in mind the potential ability of the hypothetical tenant, with the landlord’s consent where necessary, to fund energy efficiency improvements through the Green Deal); and the extent to which the terms of the hypothetical lease oblige either party to carry out energy efficiency works.
The ability of commercial rent reviews, and indeed property law generally, to generate new points as market conditions change or the legal framework alters is legendary. No doubt many other issues will crop up as the Act, and energy issues generally, come increasingly into mainstream focus. While there is uncertainty until we see the regulations, owners, lenders and tenants of commercial property all need to start considering the likely implications now.