CoStar: Time to get to grips with the challenges and the opportunities of energy performance legislation

Unless you’ve been living under a rock, if you’re a commercial landlord or developer you will be aware that the UK government has passed new legislation for commercial properties to reach minimum energy efficiency standards.

From 1 April 2023, the legislation has made any commercial lettings of premises with an EPC rating below an E unlawful not only in respect of new leases as had been the case previously, but now for all existing commercial leases as well.

Swathes of commercial space is now unlettable as a result, and asset owners must either invest to improve the energy efficiency of their properties or failing that, register for exemptions to buy some much needed time to plan for the investment required to improve their assets.

To give some wider context, although changes to the law were flagged well in advance, the level of transformation needed to make commercial buildings more energy efficient and align with the new MEES legislation can still be substantial. Research from BNP Paribas Real Estate estimates that nearly 8% of London’s commercial stock is stuck with an F or G EPC rating and is therefore now unlawful to let, illustrating the sheer volume of capex needed from asset owners to bring their properties up to scratch and make them lettable again.

This comes at a time when rising interest rates, changing working trends and geopolitical headwinds mean many property owners and operators are in a tougher financial position than they have been for some time. Energy efficiency requirements are also only likely to tighten further in the coming years, with a minimum standard for commercial properties expected to rise to a C in 2027, followed by B in 2030.

The cost of upgrading non-compliant properties to align with the new MEES legislation is therefore likely to be significant, both now and in the future. But commercial landlords and developers with an understanding of their options will be best place to plan, secure more time to invest and complete necessary works in the most cost-effective way possible.

Exemptions

Our conversations with clients demonstrate that many are still unaware of exemptions that may apply to them that would give them more time to invest in their commercial buildings, or make their properties exempt from complying with the April 2023 E EPC rating change altogether for a certain period of time. Although each case is different, there are seven general exemptions available on the Private Rented Sector Exemptions Register, with six of these applying to commercial properties:

• Devaluation – applies when a landlord can prove the installation of certain efficiency measures would reduce the market value of their property (or the building) by more than 5%. A report from an independent RICS valuer confirming the fall in value is required to achieve this exemption.
• Consent – an exemption relevant when certain improvements to a property’s EPC rating require third-party consent that cannot be obtained (or has been granted with conditions that the landlord cannot reasonably be expected to comply with). For example, solar panels requiring local authority planning consent, or consent from lenders.
• Seven Year Payback – applies where a landlord can prove that the cost of making energy efficiency improvements does not satisfy a seven-year payback test. An improvement will fail where the savings on energy bills expected to be achieved over seven years is less than the cost of purchasing and/or installing the energy efficiency measure(s). However, future unpredictability in energy prices may cause difficulties in making these calculations reliably.
• All Improvements Made – this exemption relates to where a landlord has already made the relevant energy efficiency improvements and the EPC rating still remains lower than an E. These improvements may include upgrading heating or air conditioning systems or replacing windows and rooflights. This may be particularly relevant for older buildings that are tougher to retrofit or improve.
• Wall Insulation – applies where a building owner can prove recommended wall insulation systems for improving EPC ratings are not suitable for their property, formal advice from a relevant professional such as an architect will be required.
• New Landlord – applies where a party has suddenly become the landlord and so it is not reasonable to expect that they will comply with the Regulations immediately. For example, if a new lease has been granted by a court order or there is a grant of a lease due to a contractual obligation.

All these exemptions last for five years, potentially giving asset owners considerably more time to make their buildings MEES compliant, and importantly maintain rental income. The only exception is the new landlord exemption that lasts only six months.

However, exemptions are registered via self-certification rather than being attached to the property so require renewal upon an asset’s sale or purchase. Therefore, parties on both sides of a proposed sale should be mindful of this and bear in mind that it could become a point of commercial negotiation.

Planning for the future

Research indicates many commercial real estate owners have a way to go to prepare for future deadlines in the MEES legislation. BNP Paribas estimates that 43% of commercial space could, under future proposed MEES regulation changes, be unlawful to let from April 2027 and further, reckons just over 26% of inner London’s commercial stock is rated C and could be unlawful to let from April 2030 when the proposed minimum EPC rating is expected to be B. It estimates just 23% of stock is currently rated A+, A, or B.

Steps we would urge commercial building owners to take to prepare for future MEES legislation include:

• Carefully consider upcoming further EPC rating (2027 and 2030) deadlines and, if required, plan necessary works and budget accordingly in advance.
• Ensure new leases include appropriate wording such that the cost of and responsibility for maintaining energy efficiency ratings at a premises is clearly defined. In particular, landlords will be keen to impose tighter obligations on tenants in respect of any initial fitout works and/or alterations during the term of the lease so as to maintain or achieve the required EPC rating (and retain the ability to step in and carry out the works in a compliant manner if the tenant fails to do so). Landlords may also seek to recover costs for energy efficiency measures at the building via the service charge – this is matter of negotiation between landlord and tenant and should be dealt with in initial agreed terms for clarity.
• Be aware that lenders may amend their policy to include more stringent conditions for adherence to energy efficiency ratings.
• Check if lenders are offering incentives for retrofitting buildings or if these can be negotiated.

Legislation that leads to commercial properties becoming more energy efficient is of course a positive step that will support the fight against climate change. Real estate owners are also set to benefit from making their properties more sustainable. MSCI research shows that London buildings with green credentials are 26% more expensive than those without.

However, upgrade works take time, and landlords with a strong appreciation of current and upcoming MEES legislation will be best place to plan investment and protect rental income.

The article was first published in CoStar on 20 April 2023: https://product.costar.com/home/news/497711182

Disclaimer: We at Memery Crystal (and our parent company RBG Holdings plc) support and encourage free/independent thinking in relation to issues which are sometimes considered to be controversial subject matters. However, the views and opinions of the authors do not necessarily reflect the opinions, views, practices and policies of either Memery Crystal or RBG Holdings plc.