It is the form of the new rules now embodied within a Professional Statement (which provide RICS members and regulated firms with mandatory requirements rather than simply guidance around best practice) that distinguishes it from previous incarnations and is raising eyebrows. This promotion follows a recent trend in upgrading of various other RICS Codes to Professional Statements including those on agency, measurement and conflicts of interest.
The new Statement’s core principles:
- Recoverability: Owners and managers must seek to recover no more than 100% of the proper and actual costs of the provision or supply of the services unless the lease of the property gives them the explicit right to do so.
Comment: As a matter of good estate management, to the extent that the cost of such item/stream is funded by the service charge, income received should be credited to the service charge pot and as such this requirement should be uncontentious.
- Budgets and audited accounts: Owners and managers must ensure that service charge budgets (including appropriate explanatory commentary) and subsequently a signed statement (showing a true and accurate record of the actual expenditure) are issued annually to all tenants.
Comment: the vast majority of commercial leases will already provide for this so it is unlikely to cause ripples but anecdotal evidence suggests that the approach to auditing has often fallen short particularly around timings and the professional ability and qualifications of the auditor – the new Statement sets clear expectations around those.
Notwithstanding any specific requirements of the lease, the certifier will need to be an appropriately qualified, competent person with experience in dealing with service charges. The certifier will have a duty of care to both owners and occupiers to act with professional care, diligence, integrity and objectivity.
Where the lease specifically refers to an ‘audit’, this should be carried out in accordance with ISA 800 (UK), and should be performed by a registered auditor. If the lease is silent or the audit is optional, an external audit shouldn’t be carried out without consent from the occupiers.
Best practice is for annual statements to be certified by the manager and then reviewed by an independent accountant in line with the ICAEW Technical Release (TECH 09/14BL).
- Apportionment: Owners and managers must ensure that a service charge apportionment schedule for their property is provided annually to all tenants. Rateable values are no longer recommended as an appropriate method for calculating apportionments as they do not generally reflect a reasonable assessment of the benefit and use of common services. Where possible such apportionments should be changed to other recognised methods of apportionment consistent with the aims of the Statement. Where rateable value apportionments do exist (given they are subject to appeal and so could fluctuate through the year), best practice is to use the values in the rating list at the service charge year end date. The date of the rating list and rateable values used should be clearly communicated to occupiers.
Comment: ratings based apportionments are rarely seen so this is unlikely to cause major headaches. Where they exist in a lease which does not allow a different method of assessment, moving away from ratings based apportionment would necessitate a deed of variation. Given the recent spate of ratings cases this would seem to make commercial sense but note there is flexibility in this principle (through the “where possible” drafting) which should at least give landlords a defence to making an amendment mid-term.
More problematic is the apportionment of service charge in mixed use buildings – the Statement doesn’t deal with those in any detail but refers back to the 2012 RICS guidance note on “Managing mixed use developments” (available only on subscription). Any split between commercial and residential units should be clear, open and transparent and demonstrably fair and reasonable to ensure that individual occupiers bear an appropriate proportion of the costs that reflects the availability, benefit and use of the services. Wherever possible, it is recommended that the costs to each type of occupancy are separately identifiable and apportioned by way of separate schedules.
- Lease compliance: All expenditure that the owner and manager seek to recover must be in accordance with the terms of the lease.
Comment: on the face of it this would seem a fair position – the fine print suggests that this signals the death toll for sweeper clauses – or at least using sweeper clauses for heads of costs that were anticipated at the date of grant and left out either purposefully or in error. The shift in the market towards greater protection for commercial tenants (in line with the increased statutory protection for residential tenants) would suggest that it is no longer commercially acceptable to roll out the same lease for every asset. In order to protect a landlord’s service charge recoverability rate a lease should be synced with the service charge regime at the building/estate. All items that are anticipated should be listed or referenced within groups of service cost heads (there is a list of standard industry cost classifications in Appendix B to the Statement). Conversely a tenant looking to dispute a service charge payment will have a stronger hand under the new regime where the lease is not aligned and there has been no effort from the landlord’s side to align.
- Accounting: Service charge monies (including reserve and sinking funds) must be held in one or more discrete (or virtual) bank accounts. All interest earned on service charge accounts – or where separate accounts per property are not operated, a proper and reasonable amount of interest calculated on normal commercial rates – must be credited to the service charge account after appropriate deductions have been made.
Comment: the provisions around sinking funds, reserve funds and depreciation charges seek to protect tenants both from nasty surprises (ie a hefty unexpected service charge bill) and from contributing to costs that are not incurred until after their lease has expired. In reality these mechanisms are far less commonly seen in practice (even if in theory the lease would allow them to be used).
- Disputes: Where acting on behalf of a tenant, RICS members must advise their clients that if a dispute exists any service charge payment withheld by the tenant should reflect only the actual sums in dispute. Where acting for a landlord clients must ensure that following the resolution of a dispute any service charge that has been raised incorrectly should be adjusted/reimbursed without undue delay.
Comment: Most leases will not allow a right of set off so any dispute is likely to be around the fact that the money was not properly due as a service charge item in the first place and therefore payment should not be made. The statement should make it clear that any right to withhold relates only to the extent the sum is in dispute, for example if the tenant disputes the cost of replacing the windows where the landlord has charged £10,000 and the tenant claims the true cost should have been £5,000 the amount withheld should be the difference between the two figures and not the full £10,000 claimed.
What does it mean in practice?
What happens after 1 April 2019 where there are existing non-compliant leases?
The Statement will not automatically override the position stated in the lease. If an element of the lease is in explicit conflict with the Statement the parties could seek a mid-term variation to ensure compliance or look to do so on renewal, if they do neither, the lease will continue as before. In reality, the aim of the Statement is to promote visibility and accountability and a tenant is unlikely to complain to its landlord if either of those improve, provided that they don’t come at a cost to the tenant itself. Likewise a surveyor would have a defence to a claim that they were acting in conflict if they had genuinely sought to remedy that conflict whether or not successful.
What are the implications if a landlord fails to comply with the Statement post 1 April 2019 on the grant of new leases
A flagrant breach of the Statement could result in a professional reprimand for the surveyor(s) involved and potentially a fine for the landlord client in addition to reputational damage. Perhaps more worrying is that even a perceived breach of the Statement (intended or otherwise) may widen the opportunities available for those entities in the market seeking to ambulance chase – that is to encourage tenants to allow them to look for holes in lease compliance and then exploit them for financial gain even where the tenant itself is not suffering any real issues.
What happens if there is a mis-match of service charge regimes within a single building/estate?
This will depend on the areas of the Statement which conflict. The Statement suggests that renewal leases could contain both the ideal service charge provisions and the status quo allowing the landlord to switch off the status quo once all other leases had been brought into line. In reality, an amendment requiring a variation to the lease itself would be better rolled out at once, if commercially acceptable. Some leases, for example, will already contain provisions allowing the landlord to change the method of apportionment.
How does the Statement affect procurement and managing agents’ fees?
Under the Statement, managing agents’ fees must be set on a fixed-price basis (subject to annual review or indexation) rather than being calculated as a percentage of expenditure. This shouldn’t limit the agents’ ability to charge an appropriate commercial fee for the work done especially where that work meets the requirements of the Statement. However, where there are caps in the leases this could, in theory, result in a shortfall for the landlord. Some of that “overspend” may arise from the agents following procurement rules to ensure the tenants’ services are good value for money – the backbone of those rules is as set out in RICS’s new statement on “Procurement of facility management” which became effective on 1 October 2018.
How does the Statement address issues around MEES and energy efficiency?
Of course, since 1 April 2018 all commercial lettings (with limited exceptions/exemptions) must carry an EPC rating of E or above. The Statement definitively states that the cost of obtaining an EPC shouldn’t normally be put through the service charge. Whether or not energy saving improvements to the building can be recharged would depend on the drafting of the lease.