ESG, EPC and MEES considered alongside dilapidations
In recent years, Environmental, Social, and Governance (ESG) criteria have become a crucial factor for investors, tenants, and regulators in the commercial property sector. Concurrently, the issue of dilapidations—referring to the condition of a property at the end of a lease—has gained prominence. Adding to this, the importance of Energy Performance Certificates (EPCs) has risen, acting as a critical metric for evaluating a property’s energy efficiency. Understanding the intersection of ESG considerations, EPC ratings, and dilapidations is essential for property owners, investors, and tenants aiming to navigate the evolving landscape of commercial real estate.
Our team of building surveyors are often asked to assess the condition of buildings, including the level of dilapidations and repairs. Where landlords plan to carry out work to improve their EPC rating to a minimum of an E, it may not make sense for a tenant to carry out remedial work as part of their exit. Most leases do not require the tenant to improve the energy rating (EPC) and with the landlord’s intent to improve could result in the tenant undertaking abortive work and costs.
What is ESG?
ESG stands for Environmental, Social, and Governance, representing a set of standards for a company’s operations that socially conscious investors use to screen potential investments. In the context of commercial properties:
- Environmental criteria consider how a property interacts with the environment, including energy efficiency, carbon footprint, waste management, and sustainability practices.
- Social criteria examine how the property affects people and communities, including factors like tenant well-being, community engagement, and health and safety standards.
- Governance criteria focus on the management and oversight of the property, including compliance with laws and regulations, transparency, and ethical business practices.
What is an EPC?
An Energy Performance Certificate (EPC) provides a rating of a building’s energy efficiency, ranging from A+ (most efficient) to G (least efficient). It includes:
- Energy Efficiency Rating: A numerical score and letter rating indicating the property’s overall energy efficiency.
- Recommendations: Suggested measures to improve the building’s energy performance.
- Environmental Impact: Information on the property’s carbon dioxide emissions.
EPCs are legally required when properties are built, sold, or leased, and play a significant role in assessing a building’s environmental performance. The importance of possessing a valid EPC has increased in the wake of the Minimum Energy Efficiency Standards (MEES). First introduced in 2018 but made more stringent in 2023, properties must possess an EPC with a rating of E. Landlords are prohibited from letting substandard (EPC F or G) properties without an exemption. It is anticipated that MEES will become stricter, requiring an EPC C in 2028 and EPC B in 2030, with any substandard properties becoming unlettable. As such, it is not enough to have a valid EPC. Landlords must now plan a forward-looking energy efficiency improvement strategy to adhere to increasing regulatory requirements.
What are Dilapidations?
Dilapidations refer to the repairs and maintenance that a tenant is required to undertake, or pay for, during or at the end of a lease to return the property to its original condition. This process involves:
- Repairs: Fixing any damage caused during the lease.
- Redecoration: complying with the lease clause – often for redecoration to be undertaken in the last 12 months or 3 months of the lease.
- Reinstatement: Removing any alterations made during the tenancy and reinstating the property’s original features.
The aim of dilapidations is to ensure that the property is returned to the landlord in a suitable condition, set out in the lease, which often in simplistic terms means able to be re-let or sold without impact on its value as a consequence of the tenant’s occupation/actions..
ESG and Dilapidations: The Intersection
1. Environmental Considerations
With increasing regulatory and market pressure to improve the environmental performance of buildings, ESG principles significantly impact how dilapidations are managed:
- Sustainable Repairs: Landlords are now more inclined to use sustainable materials and eco-friendly processes when addressing dilapidations, These enhanced materials and processes may not be recoverable costs under the terms of the lease.
- Energy Efficiency: Dilapidations can involve upgrading to more energy-efficient systems, such as lighting, heating, and cooling, which align with ESG goals.
- Waste Reduction: Managing dilapidations with minimal waste, through recycling and reusing materials, is becoming standard practice.
2. Social Implications
The social aspect of ESG emphasizes the well-being of occupants and the community:
- Health and Safety: Ensuring that dilapidations include updates to health and safety[DV1] standards can contribute to a better working environment for future tenants.
- Community Impact: Properties maintained to high standards contribute positively to the surrounding community, promoting economic and social benefits.
3. Governance Factors
Strong governance practices ensure that both landlords and tenants adhere to legal and ethical standards:
- Transparency: Clear communication and documentation throughout the dilapidations process foster trust and accountability between landlords and tenants.
- Compliance: Ensuring that all dilapidations comply with local laws and regulations is crucial for avoiding legal disputes and penalties.
Quite apart from the ESG factors, a tenant should be aware of the implications of making good and reinstating the premises at the end of the lease. A tenant often thinks that their alterations and adaptations are an improvement to the property and the landlord will benefit from such improvement. An improvement/betterment for one person is not always of any merit to other and can be a hindrance to another tenant; for example installing a mezzanine might increase the net floor area and be useful for occupiers with a large office/storage of small items, it is a detriment to users wishing to store larger items or have free space for manufacture.
Tenants need to be mindful when making alterations to the heating, insulation and adaptations (and the type of systems being installed) which may affect (reduce) the EPC as many leases now incorporate specific clauses regarding the effect of alterations on the EPC rating.
The Role of EPCs in ESG and Dilapidations
EPCs play a crucial role in aligning dilapidations with ESG objectives by:
- Benchmarking: Providing a clear metric for the property’s energy efficiency, helping to identify areas needing improvement.
- Regulatory Compliance: Ensuring that properties meet minimum energy performance standards set by regulations.
- Value Enhancement: Higher EPC ratings can enhance the property’s market value and attractiveness to tenants and investors focused on sustainability.
The Future of ESG, EPC, and Dilapidations in Commercial Real Estate
As ESG considerations and EPC requirements become more embedded in the commercial real estate sector, several trends are expected to shape the future of dilapidations:
- Increased Collaboration: Landlords and tenants will need to work closely to align dilapidations with ESG and EPC objectives, sharing responsibilities and costs where appropriate.
- Technological Advancements: Innovations such as building information modeling (BIM) and smart building technologies will facilitate more efficient and sustainable management of dilapidations.
- Regulatory Evolution: Governments are likely to introduce stricter regulations around the environmental and social impact of properties, further integrating ESG considerations and EPC requirements into dilapidations.
Conclusion
Integrating ESG principles and improving EPC ratings in the dilapidations process in commercial properties is not only beneficial for the environment and society but also makes sound business sense. Sustainable practices can reduce costs in the long run, enhance property values, and meet the growing expectations of investors and tenants. As the commercial real estate sector continues to evolve, embracing ESG and EPC considerations in all aspects, including dilapidations, will be key to future-proofing properties and maintaining a competitive advantage.
Much depends on how the lease has been structured and this may be where we see some big changes. Landlords and tenants need to build in enough time for tenants to carry out repairs, and they also need to build flexibility into leases to encourage improvements and continued investments into the building especially around its efficiency and value.
To see these ideals implemented and both tenants and landlords benefit there needs to be a sidelining of the “adversarial” approach often taken by the surveyors and parties and a more transparent negotiation of liabilities and requirements. To achieve this there must be trust between landlord and tenant and for this to develop over the life of the lease.
The outcome of this can be seen in more simplistic examples such as at the end of the lease where Vickery Holman have made agreement between Landlord and Tenant for the retention of alterations until the new letting is agreed. If the new tenant requires some or all of these, the old tenant has saved the cost of removal and if the landlord had insisted on the compliance with the lease they have saved the cost of incentives for the new tenant undertaking alterations and the new tenant has saved costs. The environment has benefited from less waste. If the new tenant does not require any of the alterations the old tenant is responsible for complying with their lease covenants.
Intervention at the time of alterations and adaptations being undertaken, at the commencement or during the lease, can provide opportunity for ESG goals to be achieved by the landlord making contribution to works to improve these (particularly with services) and enhance the EPC or life expectancy of the adaptations beyond the tenant’s lease term, enabling the landlord to get back a better quality property than that initially demised.
While simple in theory, achieving a marketable property with “tenant’s improvements” in situ is not always easy. A flexible open and transparent dialogue is required.
As always, these matters can be complex and we recommend talking to one of our surveyors about your own circumstances.
Vickery Holman are the leading property consultancy in the South West, with around 80 people based out of offices in Bristol, Exeter, Plymouth and Truro. Our services include commercial agency, building surveying, development, investment, property management, business rates and lease advisory. We also have the largest team of RICS Registered Valuers in the South West for secured and non-secured valuation work.
Please talk to our Building Surveys team for more information or advice.
