In this article, our commercial property solicitors discuss what service charges should cover, how service charges are calculated and what you should do if you have a service charge dispute.
- What are service charges?
- What will service charges cover?
- How are service charges in a commercial property lease calculated?
- How are service charges paid?
- What is the service charge code?
- Can service charges be limited or capped?
- VAT on service charges for commercial property
- What is a sinking fund and how does it work?
- What to do about a service charge dispute?
- What happens if a tenant fails to pay the service charge?
What are service charges?
Anyone considering renting part of a multi-let commercial building or development should be aware of service charge provisions and how they will affect their lease. Service charges are sums charged by a landlord to a tenant under a commercial lease for the delivery or supply of common services. A service charge is charged in addition to normal rent payments and 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 shared areas and facilities on a multi-let sites and buildings.
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 areas and facilities and significant associated upkeep costs.
As part of the service charge mechanism within a commercial lease, the tenant usually agrees to pay a service charge fee. In certain cases, the landlord will, in return, be obliged to provide certain services (these might be critical items, such as insuring and 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
- Repair and maintenance of the structure of the building
- Lighting and heating
- Regulatory compliance (such as fire extinguishers and other emergency equipment)
- Security and risk management
- Estate staff
- Insurances of common parts
- Ongoing costs associated with complying with building safety duties
- Structural repairs for a new build where a landlord can recover these costs via their collateral warranty
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’s ability to negotiate the service charge provisions in a lease of a major retail, office or mixed-use complex is often very limited as a landlord will require a degree of consistency.
Care should be taken to establish what services the landlord is obliged to provide, and what additional services the landlord can choose to provide. A tenant will likely wish to ensure that the Landlord is obliged to provide certain essential services, but that certain costs are expressly excluded from the service charge, albeit in some cases still requiring such a service to be provided.
From a tenant’s perspective, the Landlord’s obligations might include an obligation to provide essential services, such as repair and maintenance of the structure of the building, plant and any common areas and supply of water and other utilities.
Below are examples of specific costs the tenant might want to exclude:
- Costs of inherent defects in structures
- Lost income relating to empty units in a complex
- Costs and fees relating to the Landlord’s investment interest, such as rent collection, cost of letting units and matters between the owner and an individual occupier (e.g. enforcement of lease covenants, dealing with landlord consents for assignments, sub-letting, alterations and rent reviews)
- Costs of the construction of the building or development, including initial costs incurred in relation to the original design and construction of the fabric, plant or equipment
- Any breaches or negligence by the landlord or managing agents employed by them
- Certain development costs – e.g., improvement costs above the costs of normal maintenance, repair or replacement
- Costs of improving the energy efficiency of the building or development, unless the tenants have expressly agreed to those works and/or the landlord reasonably believes that the improvements will benefit the tenants of the building/development. Tenants may want a cost-benefit analysis carried out to justify improvement costs such as the installation of energy efficient plant.
How are service charges in a commercial property lease calculated?
The lease should define how the service charge is to be calculated, including how it will be divided up between all of the tenants. The basis and method of apportionment of the service charge should be fair and reasonable, reflecting the availability, benefit and use of the services as between the occupiers of the building or development. The general principle of a service charge is that the landlord should not profit from the tenant contributions.
When deciding how to divide the total service charge between multiple tenants in a building or on a development, a landlord may simply split the service charge equally by the number of tenants in occupation (e.g. if there are five tenants then they each pay 1/5). Alternatively, 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. For example, a tenant located on the ground floor of a multi floor building will not need to use the lifts as often as a tenant located on the top floor; as such, the top floor tenant may be required to pay a higher proportion of the service charge.
Apportionment of the service charge might be calculated based on one of the following methods:
- A fixed figure each year. This method might be particularly helpful for short leases where the property or the costs, standard and level of services provided, are unlikely to vary significantly. However, there is no flexibility for the landlord, and a tenant may end up paying more or less than the landlord actually incurs in providing the services.
- What is determined by the landlord to be ‘fair’. This will depend on the nature of the building but can be vague and provide potential for dispute.
Formulaic – often based on floor space. The standard floor-area apportionment is the ratio the premises bear to the total lettable parts of the building or development.
Whichever method is used, the Landlord should ideally provide a full apportionment matrix to all occupiers within the building or development. This should clearly show the basis and method of calculation of the service charge, and the total apportionment for each unit within the property or development.
How are service charges paid?
The usual process is as follows:
- Landlord issues a service charge estimate before the start of each service charge year, which sets out a budget for the coming year’s anticipated expenditure. The budget should include an explanatory commentary and apportionment matrix.
- The tenant will be required to pay this estimated service charge (either monthly or quarterly) in advance.
- At the end of the service charge year, the landlord should reconcile the costs it actually incurred in providing the services against the budget and provide each tenant with a service charge statement setting out the costs actually incurred. This statement should be provided within a reasonable time of the end of the service charge year (e.g., within 4 months).
- If there is a shortfall in the payments made by the tenant over the course of the service charge year, the landlord will require the tenant to make a balancing payment.
- If there is an overpayment, the landlord will set this against the tenant’s service charge payments for the coming year (or, in the final year of the lease, repay the excess to the tenant).
- It is preferable for tenants that the lease contains an obligation on landlords to have end of year service charge accounts certified or audited by an independent accountant, particularly on more complex developments where service costs can be high. Ideally tenants should also have the right to inspect receipts and invoices evidencing the service costs.
What is the service charge code?
The Royal Institute of Chartered Surveyors published a ‘Professional Statement’ on Services Charges in commercial property (the RICS 2018 Professional Statement) effective from April 2019, which sets out best practice for RICS members but, importantly, also includes 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 2020 also includes some limited provisions relating to service charges. As with the Professional Statement, the Lease Code 2020 does not bind landlords who are not regulated by RICS (unless its provisions are incorporated in the lease). However, the RICS 2018 Professional Statement and the 2020 Lease Code provides a helpful reference for tenants negotiating service charge provisions in a lease.
Can service charges be limited or capped?
Tenants will often try to negotiate an expressly limited or capped service charge liability. It is important to ensure that this agreement is reflected correctly in the lease.
A service charge cap is often linked to the Retail Prices Index (RPI). Tenants should note that 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 the RPI increase, 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.
Where there is no express provision for limiting or capping the service charge in the lease, the service charge will fluctuate each year in line with what costs the landlord has incurred in providing the services. However, 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 services 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.
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’ 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 or lifts. A landlord should take accounting advice if it wishes to set up a sinking fund. There are various ways in which a sinking fund arrangement can be put in place, with potentially different tax consequences.
A reserve fund is formed to meet anticipated future costs of maintenance and upkeep to avoid fluctuations in the amount of service charge payable each year (for example, for external cleaning and redecorations). Money held in a reserve fund can reduce the risk of large one-off payments hitting a tenant.
In the case of both sinking and reserve funds, both landlord and tenant should ensure that the following issues are considered:
- the ‘ownership’ of the money
- the purpose for which the fund is being accumulated and its timescale; and
- what will happen to it at the end of the lease?
- will any unused funds be returned to the tenant?
What to do about a service charge dispute?
It is vital that the service charge provisions in a commercial lease are correct as this is one of the most common areas of dispute in commercial property.
Normally a lease will include a process for dealing with service charge disputes. 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 resolved 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).
If a lease requires a landlord to consult its tenants before carrying out any major works, the landlord cannot recover any service charges from the tenant if the works were carried out without consultation. Again, this is a very common area for dispute when dealing with service charges.
What happens if a tenant fails to pay the service charge?
A tenant will fall into arrears if it fails to pay the service charge, at which point a landlord can rely on the forfeiture provisions in the lease and take back possession of the property. Please refer to our forfeiture article for a more detailed insight into how the forfeiture provisions work in practice.
Service charge mechanisms in commercial leases are complex and often a cause for dispute. It is important that you legal seek advice before agreeing to the service charge provisions in a commercial lease in order to avoid any unnecessary disputes during the lease term. Our commercial property solicitors can advise both landlords and tenants when negotiating service charge provisions. Please do not hesitate to contact our team and we would be happy to talk you through the process and ensure that the service charge provisions work in your favour.