Hot topics in service charge negotiation
With pressure on businesses to keep costs down and the continuing upheaval to our world from Brexit, Covid and the Ukrainian conflict, service charges are now sharply back in focus and there are new issues to wrestle with.
Service charge caps
With more flexible leases becoming the norm, occupiers wish to have greater certainty as regards costs and one way to do so is to agree a service charge cap. This is attractive to occupiers and can be a shortcut to get the service charge provisions agreed.
The intention of caps was rarely seen as a way for occupiers to avoid costs they should rightly pay. Rather, they were intended to limit a tenant’s exposure to cost and to ensure that a landlord kept a close eye on costs or risked paying them itself. The cap was settled at an appropriate level which the landlord believed gave enough scope to cover its proper costs for the year. It was usually subject to annual review by reference to a recognised index so that it kept up with genuine increases in cost.
Setting a cap with sufficient headroom for the landlord to be confident that it will not have a shortfall is increasingly difficult and limits by reference to percentage increases look bold in light of the recent movement in inflation as well as RPI and CPI.
Looking at the last three years’ accounts and adding 10% for comfort no longer works. Landlords face spiralling costs in terms of supply contracts from service providers who themselves need to pass on the increases in the costs of doing business, including staffing challenges.
Even where a landlord had made sensible hedging provision around its utilities contracts, there are huge spikes in the cost of gas and electricity supplies – a particular concern for office and retail schemes with big lighting, cooling and heating bills.
We are also seeing the need for urgent and expensive repairs to the buildings themselves after two years of landlords holding back expenditure on buildings works during the pandemic – this seemed the right approach at the time to limit costs to occupiers who were hugely impacted by the pandemic. But, in some cases, the repair bill is now much higher than it would have been.
The likelihood is that service charge caps will need to be set higher above running costs for landlords to agree to them. Even then, the caps may be exceeded.
One proposal is to carve out utilities costs from a cap so that any cost fluctuations are passed on to the occupiers. The service charge cap applying to the remaining service costs would need to be set carefully and occupiers are unlikely to want a managing agents’ fee applied to utility costs.
Or will a fixed service charge contribution or all-inclusive rent become the norm? A risk-sharing exercise may be more palatable as property directors convince their boards to commit to bricks and mortar, while landlords seek to fill the space and cover the costs and rates bills, which would otherwise fall to them in the event of voids.
This is a key issue at the moment and something that will form a crucial part of lease negotiations, at least in the short term.
Are you really a short term occupier?
There is a distinction between an occupier who is in a property only for a short period and one which renews and regears over a long period of time by way of shorter leases and breaks. Should both benefit from a concessionary position such as a service charge cap?
Arguably, a tenant who frequently renews a short lease is benefitting from repairs to and investment in the infrastructure of a scheme in the same way as a tenant who commits to a 10 year lease from the outset. If this is right, should both occupiers not contribute equally? But what if the three year break in a five year lease is exercised? That tenant will argue that it shouldn’t contribute as much as those committed for 10 years.
This is all down to negotiation and both parties are free to take advantage of the market from time to time but there is a point of principle to consider.
Welcoming people back
Much has been said regarding working from home and encouraging people back to leisure and retail schemes and we have yet to see what will be the much-anticipated “new normal”.
In the retail and leisure context, people have to be drawn back from clicks to bricks and that means that these spaces have to offer the consumer something which they cannot achieve in the comfort of their homes. They must feel safe and happy; shopping and dining out must be pleasurable and fun. It’s all about the experience.
While occupiers need to achieve this within stores and restaurants, the communal spaces, and this applies equally to office schemes, have their part to play. To the extent that this costs money, will landlords be prepared to fund that investment, or will the tenants be prepared to contribute?
Making the space more enticing to visit – whether aesthetically or by experience – makes the scheme more profitable. This, in turn, should increase rents and make the investment stronger – therefore, to many occupiers, these costs should be for the landlord to pay. However, if the rent isn’t turnover based, most landlords will want a tenant, who should benefit, to contribute.
The question becomes, why is the customer visiting? A large retailer is likely to invest significantly and have a sophisticated approach to its own advertising - it might argue that it generates its own footfall and does not receive much benefit from scheme marketing and entertaining costs.
This is not a new issue, but the circumstances are, and the debate is ongoing.
Mixed use schemes
One aspect of the push to bring people back to stores is the increase in hospitality and residential space featured in new schemes. This is welcomed by most, but one impact is that a scheme may be open for longer hours. If the lights stay on until late in the evening or all night to provide for restaurants and passageways for residential flats, should a retailer who is open from 9am to 6pm contribute equally towards this cost?
Where should the cost lie? This depends on one’s perception of who benefits.
Ask occupiers and they will say that they are already meeting the costs of their own businesses in achieving their sustainability, green and social agendas. The landlord’s business is to provide a building for which it will receive a rent. Surely, satisfying their investors and shareholders of their green and social credentials should be a cost for the landlord?
Ask landlords and they will say that they want to conduct their business with a social conscience, and this requires the buy-in of the occupiers who use the property. So why shouldn’t those occupiers help them to fund initiatives which benefit everyone – investing in green technology and recycling as well as supplying data and participating in forums to make the world a better place?
Where the landlord needs to comply with legal obligation as regards common facilities, the occupiers seem to be prepared to meet the costs. However, beyond that, landlords will need to show actual benefit to the occupiers before they can justify passing the expenditure on.
Finding a resolution to this debate may actually be assisted by the exposure to utilities costs felt as a result of the Ukrainian conflict. Green technology was previously seen as having too long a payback period to be worth the capital investment. The ability to be more self-reliant as regards power paired with the ESG agenda may mean that the arithmetic has a different result. But there is still an upfront cost and, at present, it isn’t agreed who should pay for that.
At the end of the day, the message from occupiers is cost versus value. If an occupier receives a benefit, it will pay the cost. If not, there will be push back. For landlords, they need to balance the needs and concerns of different types of occupier who may hold leases of varying lengths. As a result, some flexibility is required to enable landlords to manage effectively, for the benefit of all tenants.
This article was first published in EG on 21 May 2022.
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