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The hidden costs of lease settlements

UPON penning their legendary punk rock ballad, Should I Stay or Should I Go, it is unlikely that The Clash were vexing over the ramifications of not renewing a lease of business premises. However, it is a matter of significant importance to finance directors.

Upon vacating business premises at lease expiry – either consolidating or relocating – settlement of the dilapidations claim commonly leaves a significant dent in the balance sheet. For the FD informed in the principles of the statutory cap available, the proper settlement figure can be substantially reduced.

It is estimated by the Royal Institution of Chartered Surveyors that about 90% of UK companies lease their business premises. With bank borrowing still tight and businesses keen to meticulously manage cashflow, this preference over ownership is likely to continue for the foreseeable future.

It is however the case that the length of leases has shortened, a trend that had begun pre-recession, but which has accelerated during it. According to the British Property Federation, more than 80% of new leases granted in 2012 were of 1-5 years in length. The sheer number of short leases means that the average lease length of commercial premises now stands at 5.8 years.

This is trending towards a spike in lease expiries over the next five years, due both to expiries of the short leases taken during the recession, as well as expiry of historically longer (20-25) year leases.

It is also the case that many leases taken in the past 5-10 years have incorporated (usually tenant only) break clauses. So long as these are ‘unconditional’ (on certain or all terms being performed at the break date), such is the same as lease expiry.

Exaggerated costs
Business leases are customarily ‘full repairing and insuring (FRi)’, in that the tenant is responsible for all repairs and insurance. Absent any initial Schedule of Condition (often minefields in themselves) the tenant is contractually obliged to hand the premises back in fully repaired and decorated order (with alterations reinstated). This can be the case, even if the premises were in poor condition at the start of the lease.

At or about the lease end, the landlord sends the tenant a ‘Quantified Demand’ (Schedule of Dilapidations). Usually prepared by a chartered building surveyor, this schedule (usually costed) itemises the alleged breaches of repairing, decorating and reinstatement of alterations clauses in the lease.

Those costs are often exaggerated, especially by a landlord aggrieved at a tenant not renewing their lease, to which is then added about 30% for fees and contingencies, plus loss of rent & rates – and service charge if applicable – for the claimed repairs period.

The usual process is that the outgoing tenant appoints its own chartered building surveyor to negotiate and ultimately agree a settlement figure, based on tendered contractors’ costs for agreed works. This will however often result in an unwittingly excessive settlement figure.

For at law, the purpose of dilapidations is to compensate landlords for their true loss caused by the tenant’s repairing breaches. As such, the compensation will be the lower of the cost of the remedial works, or the impact on the freehold capital value.

If premises are likely to be demolished or substantially altered so that many or all of the works – if the tenant had done them – would have been destroyed, then the compensation settlement can fall to little or nothing.

‘Cost’ and ‘value’ are not the same thing.
Much case law recognises this distinction, as do the Ministry of Justice in the ‘Dilapidations Protocol’ in noting at its paragraph 4.3 that ‘…the landlord’s likely loss…is not necessarily the same as the cost of works to remedy the breaches.’

This might seem obvious, but the distinction is often overlooked, or confused. I will often refer to the perhaps crass analogy of considering if one adds a £50,000 oak conservatory to a 3-bed semi-detached ex-Council house, have you added anything like that amount to value?

By way of real world examples in commercial property, an older industrial building with minor dents to cladding, faded and scraped paint on floors and columns etc. would be no more lettable – hence no more valuable – if rendered immaculate. Yet the cost of carrying out those repair works can be quite substantial. The ‘law of diminishing returns’ commonly applies, especially on older buildings. One reaches a point in expenditure on repairs, decorations etc. beyond which one could keep spending to achieve perfect compliance with the leasehold covenants, but no more is added (protected) in terms of freehold value. There is no value to be gained from ‘gilding the lily’.

For high street shop, few retailers require much on-site storage these days, due to modern stock control management. So several vacant and superfluous upper floors – whether immaculate or tatty (albeit wind & watertight) – will be unlikely to make any difference to lettability, hence value.

For older offices, modernisation is often the only way of having any chance of reletting. As such, much of the claimed repairs may well – after close scrutiny of what is actually happening to similar properties in the local market – prove superfluous as the likely upgrade works would override them in any event.

The Doomsday scenario is for a settlement to be reached on a costs basis between building surveyors and then, several months later, to drive by your former premises to find that they have now been demolished. Had the diminished value (section 18) cap been applied, the settlement figure would have been at or about zero.

So the building surveyors negotiate to narrow agreement on necessary repairs and their costs. It is then for the chartered valuation surveyor well versed in the specialism of preparing diminution valuations (commonly termed section 18 valuations) to advise if, and to what extent, the impact upon capital value of the agreed repairs is less than the cost of precise costed compliance.

Paul Raeburn is the founder of Raeburn Consulting

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