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D-Day for commercial landlords

D-Day for commercial landlords

Insights & Perspectives

(Previously published in Property Week)


Many smaller landlords are still unprepared for stricter EPC requirements.

This year’s April Fools’ Day will be no joke for some in the UK’s commercial property sector. That’s because 1 April is also the date that Minimum Energy Efficiency Standards (MEES) regulations are changing.

The amended rules will effectively make it illegal, with few exceptions, to let a commercial property that has an energy performance certificate (EPC) rating of ‘F’ or ‘G’ – the two worst performing categories. The ban will apply to both new and existing tenancies in England and Wales. Landlords will no longer be able to rely on having long leases for such properties or thinking MEES are not their concern.

So, how much commercial property is about to become unlettable, and what might happen to these properties?

Research by Savills shows that around 3% of office space in England and Wales and 11% of retail space will fall foul of the new regulations come 1 April. These might sound like small proportions, but they represent hundreds of thousands of square feet of space.

According to Chris Cummings, director at Savills Earth, the firm’s sustainability advisory arm, there is also a clear split in the market, with larger, well-funded landlords better prepared for the changes compared with smaller ones. He largely blames a lack of government support for smaller landlords’ failure to get to grips with the EPC changes.

“I’ve been cynical about people’s ability, never mind motivations, to comply with these changes,” he says. “A lot of what should have been support on how to do this has fallen away, but the legislation still remains. I’m not surprised so many people and properties are left behind.”

While the majority of major landlords have been aware of the changes for some time, Jamie Barton, partner at law firm Winckworth Sherwood, points out that those that haven’t are in for a nasty shock.

“A number of exemptions exist, but are limited in scope and timeframe, and landlords who fail to either comply with the minimum rating or register a valid exemption face significant penalties.”

Subletting problem

Barton points out that many occupiers could also fall foul of the regulations if they sublet or underlet space to other companies. “Underletting is commonplace in today’s market, whether for office users adapting to flexible working or retail occupiers bringing in complementary businesses as they cut back on their own store space,” he says.

“These incidental occupier-landlords are also caught by the prohibition on letting. If properties do not meet the sufficient energy standards, tenants may not be able to sub-let or continue to sub-let, depriving them of vital revenue.”

The MEES regulations only apply to England and Wales, but Chris McLeish, partner in the real estate and infrastructure team at law firm Morton Fraser, says Scottish landlords and occupiers would be foolish to think similar rules will not follow in Scotland.

“The less stringent rules that apply in Scotland allow owners to defer the carrying out of any improvement works by instead opting to report annually on the operational energy ratings of a building,” he says.

“This allows owners to avoid the costs associated with upgrading the energy efficiency of their buildings. But this advantage might be short-lived. A new EPC regime for Scotland is anticipated once we know the outcome of the Scottish Government’s consultation [on the subject].”

Flawed system

The fact that MEES regulations are based on the EPC system raises concerns for some in the sector. Many experts consider the existing EPC system to be flawed and discussions between the industry and government are under way about a possible replacement system.

“As the market prepares for new minimum rating laws, it must be careful not to champion it as a silver-bullet solution in the push for lower emissions,” says Malcolm Hanna, sustainability manager at LGIM Real Assets.

“The reality is that the current system tells only part of the story. The fundamental issue that can’t be ignored is that there is little to no correlation between a building’s EPC rating and actual energy use. Occupier behaviour [is] one of the largest contributors to energy consumption [and is] not fully accounted for.”

Instead of seeing MEES as a regulatory obligation that ticks the sustainability box, Hanna says the property industry needs to look at the issue in the round. “If the commercial sector is to make the progress needed in its decarbonisation, a more holistic regulatory standard is absolutely crucial,” he says.

“Incremental changes in the current framework are welcome, but industry participants have long called for a rating system that accounts for operational performance, such as is offered by the [Australian] NABERS energy rating system or the government’s proposed performance-based rating scheme, which it consulted on in 2021.”

He adds: “In many cases, ambitious net-zero targets need to be supported by significant regulatory reform. Now is the time for public and private sector participants to actively and urgently increase the scope of energy-efficiency standards in UK real estate.”

That strikes a chord with Ronan Pigott, principle at international building engineer and consultant Introba, who points out that some clients have received improved EPC ratings without making any attempt to upgrade their buildings, due to the fact that the electricity grid in the UK is progressively relying on more and more renewables.

“EPCs are measured by a building’s carbon output,” he says. “What’s interesting is that we’ve seen some offices get bumped up the ranking based on recent assessments because there are more renewables connected to the grid now, so the power a building is using is less carbon-intensive. But clients shouldn’t rely on this or see it as an excuse not to act.”

Amo Sihra, commercial head of EPC training and accreditation body Elmhurst Energy, defends the existing EPC system, but adds that including in-use energy would be beneficial.

“An EPC is perfect for what it’s been designed for, which is all about an asset’s rating,” he says. “It is not about in-use [consumption]. But moving forward, maybe there should be a combination of the two. That could be a good thing to do.”

Future-proofing assets

It is well understood that the government is keen to resolve the issue and that EPCs are likely to be toughened up or even replaced. So for landlords, taking stronger action today is not just better for the planet, but also means they will be future-proofing their assets.

“In time, EPC calculations could start to place much stronger emphasis on operational energy efficiency, and that will require investment by asset owners in mechanical, electrical and plumbing systems and potentially the building fabric, too,” says Pigott.

“Crucially, this is also where the market is heading in terms of what occupiers want and landlords have got to ensure their leasing offer keeps pace with tenant expectations. More businesses have committed to ESG and green targets and they need to show how their office choice is playing a role in delivering them.”

Richard Shepherd-Cross, managing director at Custodian Capital and fund manager at Custodian Property Income REIT, says this trend has made his life a lot easier. “Five years ago, regulation started to be talked about, then started to come into force for commercial real estate, landlords, but didn’t necessarily apply equally to the tenants of those properties,” he says.

“When we said to tenants: ‘your EPC is low and we’d like to do something to improve it, but it will cost some money’, their response would be ‘not really our problem’. Roll forward five years, post-Greta Thunberg and in the grip of an energy crisis, and the conversation is very different. They’re aware that there is a cold, hard cost to having a less energy-efficient building and they are also feeling the pressure to be environmentally friendly.”

A business opportunity

Zac Goodman, founder and chief executive of investment and asset management firm TSP, believes that regulatory changes ought to be seen as a business opportunity. “Sustainability is the biggest value driver in the market now and EPC regulations are forcing investors, landlords and occupiers to price it into their transactions, which is a good thing,” he says.

“If we want offices and real estate more broadly to evolve as products responding to customer demands, we’ll need a period of distressed assets coming to the market, some of which will be redeemable and some of which will not. There’s huge opportunity in giving a new life to inefficient secondary offices.”

TSP is looking to do so and is not alone, according to Richard Vernon, partner at law firm Ashurst. “We’ve already seen a couple of clients who are setting up opportunistic funds to go out and find these assets and buy [them],” he says. “We’re going to see a huge amount of that. This isn’t distress caused by the global economy and everything else going on in the world.

“There’s real opportunity here for people to come in, spend the capex and take the value [uplift]. There’s a real incentive for good investment managers and property managers to benefit alongside investor clients.”

Whether or not the system ultimately better reflects in-use energy, the government has indicated that it will toughen up regulations further using the current EPC system. The most recent UK Energy White Paper proposes that the minimum lettable rating for commercial buildings will rise to ‘C’ in 2027 and ‘B’ in 2030, with fines also likely to strengthen.

“Even those who are ready for the [2023] change in legislation still need to look to the future,” says Barton. “The jump to a ‘C’ rating will not be easy for many properties. While the timetable for ratcheting up requirements has not been confirmed, it should be assumed that further increases in standards are firmly on the horizon.”

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