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Service charges in a commercial property lease

Services charges in a commercial property lease are commonly payable by the tenant to the landlord. This is particularly so where the property is party of a wider complex and there are shared facilities or areas.

What are service charges?

Service charges in a commercial property lease are sums charged by a landlord to a tenant under a lease, in addition to normal rent payments. They are intended to pass on the cost from a landlord to a tenant in order to recoup some or all of the landlord’s costs in respect of managing a property.

The need for, and importance of, service charges in a commercial property lease can vary dramatically depending on the nature of a property. A small property occupying a site with a single occupant may have very limited need (if at all) for services provided or procured by the landlord. Conversely, a major retail, office or mixed-use complex may have multiple shared facilities and significant associated upkeep costs.

As part of the service charge mechanism within a commercial lease, the tenant usually agrees to pay a fee. In certain cases, the landlord will, in return, be obliged to provide certain services (these might be critical items, such maintaining main structures in a shared facility). In other cases, the landlord may have the option (but not necessarily be obliged) to provide the services and, in the event that they are provided, the tenant will have to pay for them (these might often be softer services such as cleaning or gardening).

What will service charges cover?

Service charges in a commercial property lease can often be negotiated. What it covers very much depends on the type of property, the extent of the repairing obligations of the tenant under the lease and the respective bargaining powers of the parties to negotiate.

It would be common to see any of the following as categories of service within the service charge:

  • Outside maintenance (gardening, paths and roads)
  • Cleaning and repair work to common areas
  • Lighting
  • Lifts
  • Regulatory compliance (such as fire extinguishers and other emergency equipment)
  • Estate staff
  • Insurances of common parts

In addition to any specific service specified in the lease, a provision will often be included which allows the landlord to provide any additional service which they decide are necessary. A tenant, if they are prepared to accept such a clause, would normally wish to see this linked to some level of ‘reasonableness’ so as to avoid the landlord carrying out extensive works which the tenant may think are unnecessary.

The RICS 2018 Professional Statement (which we refer to in more detail below) provides that such ‘catch all’ clauses should not be used to offer protection for services which have been forgotten in drafting. A landlord should ensure that the definition of the services is drafted as widely as possible and, therefore, removing the need to rely upon the ‘catch all’ clause.

A tenant will likely wish to ensure that they exclude certain items from the service charge, albeit in some cases still require such a service to be provided. Specifically, this might include:

  • Costs of inherent defects in structures
  • Lost income relating to empty units in a complex
  • Upfront costs in developing the complex
  • Any breaches by the landlord
  • Certain management agency fees

How are service charges in a commercial property lease calculated?

Often the lease will define how the service charge is to be calculated. This will include how a service charge is to be divided up if the property leased is part of a larger site with multiple tenants.

If one tenant on a site receives a proportionately greater benefit, the lease may include some weighting factors to pass more cost on to this tenant.

Apportionment of the service charge might be calculated based on one of the following methods:

  1. A fixed figure each year
  2. What is determined by the landlord to be ‘fair’
  3. Formulaic – perhaps linked to floor space

A fixed apportionment is where any apportionment is expressly stated in the lease and is fixed. It does not provide for any flexibility but does have the benefit of being certain.

A ‘fair’ determination relies upon a process of reviewing what is fair in the circumstances. It is more flexible but can provide potential for dispute.

A formulaic apportionment can potentially provide a rational basis for sharing costs, but it is important to be well defined as complexities or uncertainties can cause dispute.

What is the service charge code?

The Royal Institute of Chartered Surveyors previously operated a ‘Code of Practice’. This was replaced in April 2019 with a ‘Professional Statement’ (the RICS 2018 Professional Statement).

The statement sets out best practice for RICS members but, importantly, also included mandatory requirements. In the event that a member fails to adhere to the Professional Statement, it can be used as an indication of negligence in any management duties. That said, the Professional Statement is not automatically incorporated into a lease, so a landlord will not be bound by it, unless it is expressly covered by the lease.

In addition to the RICS 2018 Professional Statement, the Lease Code 2007 also includes some limited provisions relating to service charges. The Lease Code 2007 is not wholly inconsistent with the Professional Statement. However, a renewed Lease Code has undergone consultation.

Can service charges be limited or capped?

It is possible for service charges to be limited or capped.

  • Limits - Certain legal cases have indicated that a landlord may be limited in its ability to recover large service charges from a tenant to the extent that the lease is short term and the service relate to major structural costs. Landlords should be wary of relying on their ability to recover in such circumstances, as it may face legal challenge.

A landlord should also be aware that if they own mixed use properties which include residential tenants, then more restrictive procedures will apply to any residential service charges.

  • Caps - It is not uncommon for a tenant to seek to include an express cap within the lease to restrict the amount of service charge in each year.

    Tenants should take into account that often index linked increase provisions within a lease can also cover service charges. Therefore, even though a service charge may be the subject of a cap, that cap may rise year on year over the course of the lease (in line with a specified increase mechanism, which may run higher than actual inflation).

    One other issue to be aware of is that a cap is not confused for a fixed payment.

VAT on service charges for commercial property

HMRC treats payment of a service charge as further consideration for the supply of the property by the landlord. This is the case regardless of whether the charge is specified to a ‘service charge’ or an additional rent. As a consequence, the service charge will be treated, for VAT purposes, in the same way that the rent is. If the landlord has elected the option to tax on the property, VAT will be chargeable on both the rent and any service charge.

In addition to VAT payable on the service charge, a tenant may be required, under the lease, to pay additional VAT that the landlord has not recovered in respect of the delivery of the services.

The tenant’s own VAT will determine whether it is able to recover any VAT paid on the service charge.

What is a sinking fund and how does it work?

The terms ‘sinking fund’ and ‘reserve fund’ are commonly used interchangeably. Both are terms used to describe a sum put aside for substantial or ‘one off’ capital expenditure not provided for within the service charge. There is, however, a distinction and it is important for parties to be clear on what they are agreeing to and that the lease clearly reflects the intentions.

A tenant who is occupying a property for a few years may be, understandably, reluctant to agree to pay for a service charge for repairs that will take place long after it has left the property.

A sinking fund is designed to address any major repair costs which the parties can reasonably envisage will need to be paid for within the term of the lease. This might be large expensive equipment, for example, air conditioning systems.

A reserve fund although similar is normally used for more regular, but nevertheless, major expenditure. For example, this may be treatment of perimeter fencing or external building decoration. Money held in a reserve fund can reduce the risk of large one-off payments hitting a tenant.

What to do about a service charge dispute?

Normally a lease will include a process for dealing with disputes, including disputes relating to service charges. A common approach is to involve external experts to be appointed by the parties in agreement. If no agreement can be reached as to the expert, then they defer to an appropriate body to appoint on their behalf (this might, for example, be RICS).

Indeed, the RICS 2018 Professional Statement (as referred to earlier) specifically recommends that disputes in respect of service charges are resolve by following an alternative dispute resolution process (a process which is not referred to the courts to determine). In particular, the statement suggests expert determination and mediation (where a third party is involved in discussions, on a non-binding basis, to facilitate agreement).

What next?

If you are planning on entering into a new commercial lease, a service charge is one aspect of many important issues that need to be considered as part of a commercial lease. Our commercial property solicitors can help. Call us on 0800 689 1700 or fill out the short form below with your enquiry.

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