UK: Cap That: Dilapidations Cap Under Scrutiny

These post-recessionary times are fascinating for a number of reasons but perhaps one of the lesser talked about developments is the management of the end of the landlord and tenant relationship. We are not talking break rights or surrenders; no, the point of interest here is the question of dilapidations and where we are following both the introduction of the current (and potentially more potent) protocol and a number of key cases focussing on the damages cap imposed by section 18 (1) of the Landlord and Tenant Act 1927.

For the uninitiated (and as a refresher for those familiar with this topic) section 18(1) creates a cap on damages for dilapidations in the following terms;

Casting our mind backs to prior to the credit crunch, litigation under section 18(1) was relatively rare and the fundamental aspects of the assessment of damage relatively secure until the seismic shift that was PGF II SA v (1) Royal & Sun Alliance Insurance Plc (2) London & Edinburgh Insurance Company Limited [2010] EWHC 1459 ("PGF").

PGF II SA v (1) Royal & Sun Alliance Insurance Plc (2) London & Edinburgh Insurance Company Limited

In the case of PGF, the claimant landlord of a 6 storey building in Lime Street, City of London issued two claims following the expiry of two leases. The first defendant, the headlessee, took a lease of the subject property in 2007, and with the consent of the landlord, sublet the majority of the property to the second defendant. Following the expiry of both the headlease and the underlease, the tenants vacated the property without carrying out any works and the landlord, having spent £5million refurbishing the building, sought to recover £4million plus interest (including a substantial loss of rent claim).

The landlord issued a claim for damages against the first defendant for breach of repairing, decoration and reinstatement covenants, and against the second defendant for damages for disrepair and for breach of the reinstatement covenant. The first defendant brought a claim against the second defendant for damages for disrepair and failure to reinstate the premises.

Following the expiry of the leases, a revised schedule of dilapidations was served as it had been decided that the cladding in the building needed replacing.

It was accepted that the landlord had carried out works which went beyond the scope of the works which either the headlessee or the underlessee would have been obliged to carry out in the event that they had complied with their covenants prior to the expiry of the leases. Further, the Defendants argued that (i) the building was worth more to the landlord refurbished/developed that it was in full repair (i.e. the latent development value); (ii) that the rules of supercession applied; and (iii) that they had no liability for the cladding replacement as this superceded the Defendants' obligation to repair and could have been repaired for substantially less cost.

Dealing with the more tame part of the judgment first (that of the diminution question), the Court held that in assessing damages under the Landlord and Tenant Act 1927 section 18(1), the first consideration is the common law value of the cost of putting the premises in repair (and which, in accordance with the decision in Ruxley Electronics v Forsyth (1996), needed to be reasonable and not out of proportion to the detriment suffered). The second stage is to apply a cap limiting the amount of recoverable damages to the diminution in the value of the reversion.

Irrespective of the extent of the works carried out by the landlord, the landlord was entitled to recover, subject to the cap, damages which reflect the actual loss suffered, which is to be assessed at the date of the termination of the lease. In order to ascertain the amount of damages, one has to consider the works which ought to have been carried out by the first and second defendants and then deduct the cost of works carried out by the landlord which has superceded the repair work which the tenants would have carried out in compliance with their covenants.

That was all relatively straightforward. However the Court then fundamentally changed the way in which the section 18(1) cap would be looked at from that point on. The Court started uncontroversially by concluding that when assessing the operation of the section 18(1) cap, the starting point was the landlord's intention at the expiry of the lease (hence the latent development value defence falling away) and that the damages should reasonably compensate a landlord for its loss. When assessing the supercession question this meant that a landlord should not be able to claim costs rendered valueless by its refurbishment.

Where the judgment became controversial, however, was in the Court's approach to assessing the landlord's intention. The Court concluded that, where a landlord had not decided what to do at lease expiry but there was only one reasonable option open to it, the Court could assess compensation on the basis that the landlord intended to pursue that option. In PGF this meant that, although the landlord itself had not elected which path it would follow on the date the lease expired, the Court decided that the landlord would not have replaced the cladding had it been in repair; therefore the landlord could recover the costs of reasonable repair but not replacement.

When assessing the practical implication of this conclusion, the Court decided that the standard of repair had to take account of the locality of the building and the type of tenant that would take such a letting but, also, that it was limited to the works that a reasonable tenant would undertake to make the property reasonably fit for occupation. This was vastly different to the sum claimed by PGF and resulted in its claim being reduced significantly. It also had a fundamental impact on the loss of rent claim as, given that the Court decided that PGF would carry out the works in any event, it was only entitled to very limited loss of rent at approximately one sixth of the amount claimed. Not a good day for the landlords of this world. The Current Protocol This of course all came before the current version of the dilapidations protocol was formally enshrined in civil litigation practice in January 2012. What is clear from the current protocol is that the s.18(1) cap (whether in terms of diminution of value or supercession) remains as relevant now as it did in either 2010 or 1927 (please see our March 2012 article on some of the main changes introduced by the current protocol at http://www.charlesrussell.co.uk/userfiles/file/pdf/property%20litigation/BriefingnoteTheChangingFaceofDilapidations.pdf ) . This has been followed through in two significant cases which, in tandem with the PGF decision, help us have greater clarity as to how the Court approach the questions presented by section 18(1).

Sunlife Europe Properties Limited v (1) Tiger Aspect Holdings Ltd (2) Tiger Television Ltd

The first is the case of Sunlife Europe Properties Ltd v (1) Tiger Aspect Holdings Ltd (2) Tiger Television Ltd [2013] EWHC 463 (TCC).

In our last edition of the property litigation update we included a detailed summary of the judgment of this case. This can be accessed at http://www.charlesrussell.co.uk/UserFiles/file/pdf/Property/The_Diminution_Question.pdf . The question for this article is the lessons that we can learn in terms of how section 18(1) is to be applied.

In that case, the premises had been fitted out to a high standard in 1970 with high quality mechanical and electrical installations. On the expiry of the leases in 2008 the landlord prepared a schedule of dilapidations claiming the sum of £2.1m for remedial works and associated costs.

The tenant contended that the cost of the works it ought to have carried out in order to comply with its covenants amounted to £700,000, and that it had no obligation to replace the mechanical and electrical installations with modern equipment of a similar standard to that originally installed. Further, the tenant argued that the landlord's claim was subject to the statutory cap contained in section 18(1) of the Landlord and Tenant Act 1927.

The Court considered whether, assuming that the tenant had complied with its covenants, the landlord would have been in a position to let or sell the building at the expiry of the lease without any discount to reflect the state of the building. If the answer to that question was yes, then the value of the landlord's loss is either the cost of putting the building back into the condition it ought to have been in had the tenant complied with its obligations, or the difference in the value of the building in its actual state and the state in which it ought to have been delivered up by the tenant, whichever was the lower figure.

In terms of the landlord's works, the question was not whether the landlord acted reasonably in carrying out the works, but if the works went beyond the scope of the works which the tenant would have been obliged to carry out had it complied with its covenants, the landlord cannot recover the cost of that additional work. To the extent that the additional work would have superceded the work which the tenant ought to have done, the landlord has suffered no loss, and cannot recover any damages in respect of that breach.

If the cost of works carried out by the landlord was greater than the cost of work which would be sufficient to put the building into the condition it should have been left in by the tenant, then landlord is limited to recovering the costs of the latter.

Again, like PGF, this was all relatively straight forward and uncontroversial and the eight principles of dilapidations claims highlighted in our previous article will undoubtedly assist the formulation and assessment of dilapidations disputes in the future. However, also like PGF, the controversial element was to come.

When the Court came to calculate the loss sustained by the landlord, it used all of the discretion that is open to it and departed from the traditional approach to evidence. Akin to the majority of substantial dilapidations disputes, there were appointed experts on both sides in accordance with Part 35 of the Civil Procedure Rules. Both had provided their views as to both the cost of works and the questions posed by section 18(1) but only the evidence of the landlord's expert was before the Court at Trial.

However, the Court was not satisfied with the quality of the evidence before it when it came to the section 18(1) issues. The Court therefore assessed the costs of works using the landlord's expert evidence and arrived at a total figure of £1,353,254 as the total costs incurred by the landlord (which was broken down as £1,312,076 for the costs of work, £37,663 for the valuation report and £3,515 for the costs of preparing the schedule of dilapidations).

When it came to comparing this figure with the damage to the landlord's reversion, on the other hand, the Court was unsatisfied with the level of detail in the landlord's expert evidence and, in the light of this, the Court did not consider that it was in a position to adjust the expert evidence to reflect the Court's decision on the costs of work.

The Court therefore noted that the tenants had also obtained expert evidence that had been referred to by the parties to the dispute albeit that this valuation was not part of the expert evidence before the Court save for the diminution in valuation calculation itself.

The Court was however satisfied with the level of detail in this calculation and decided to use that calculation rather than the valuation before the Court at Trial. It is unlikely that this calculation will have been scrutinised by the parties as closely as the expert evidence that was before the Court and was a surprising move to say the least.

As a result of this approach, the Court concluded that the in repair valuation of the property was £5.870 million. From this figure the Court deducted the actual condition valuation prepared by the landlord's expert of £4,462 million leaving a damage to the reversion of £1.408 million. As this figure exceeded the already determined costs of repairs, Judgment was given for £1,353,254 plus interest at 3% per annum and costs. Interestingly this figure was not far from being half way between the figure contended for by the landlord and the figure offered by the tenants.

Hammersmatch Properties (Welwyn) Limited v Saint-Gobain Ceramics and Plastics Limited (2) Saint-Gobain Abrasives Inc

Finally, we come to the most recent case of the three; Hammersmatch Properties (Welwyn) Limited v Saint-Gobain Ceramics and Plastics Limited (2) Saint-Gobain Abrasives Inc [2013] EWHC 1161 (TCC).

This case, if nothing else, shows the danger for landlords of the PGF decision and does nothing to quell the concern that the approach adopted in the Sunlife case may also be applied in the future.

The Court found that the total cost of the works which the tenant should have carried out under the lease (including costs) amounted to £3,087,712. The majority of this cost had been agreed by the parties before Trial.

The Court considered whether and to what extent the breaches of covenant resulted in a diminution in the value of Hammersmatch's freehold reversion on the term date. The starting point was the value of the property in repair. The costs of the works in this case was found to exceed the value of the property in repair.

The principal issue which the Court considered was the ability of the claimant landlord to recover the costs of the works and fees, or whether the statutory cap would apply. In order to establish the appropriate standard of repair, the Court was entitled to take into account the age, character and locality of the building. The Court noted that a tenant's obligation is not to return the premises to the condition that they were in at the start of the lease. The Court considered what a "reasonably minded tenant of the relevant user class" would reasonably have required at the start of the lease, in order to render the building fit for occupation for the purposes contemplated by the lease.

This required an analysis of the expert evidence and it is clear from the judgment that the evidence of the tenant was generally considered to be more cogent, detailed and better thought out. Therefore, when the Court came to calculate the diminution in value, it generally sided more with the tenant's figures than the landlord's.

Taking all of the valuation evidence into account, including making an assessment of the refurbishment works necessary to be able to re-let the premises, the Court then concluded that the "in repair" valuation was £3,061,251. This is of course less than the figure stated as being the costs of the works (£3,087,712).

The Court then assessed the site value.

There was again a dispute between the parties as to what the site value was. The tenant contended for a site value of £2,950,000 against an "in repair" valuation of approximately £3,050,000. This would result in a diminution of value of £100,000 on the tenant's analysis. The landlord however contended for a site value of £2,100,000; it was this valuation that was accepted by the Court.

This then brought the Court to the point at which it needed to determine (i) the intention of the landlord and (ii) the appropriate basis for determining the diminution in value.

The Court followed the principles set down by the PGF case and made its own assessment of the landlord's intention. Despite the landlord having made it clear in preaction correspondence that it intended to carry out the works when it had the financial ability to do so, the Court concluded that the evidence did not show any clear intention one way or another but was more an approach of keeping options open pending the proceedings (this came from a number of emails between the landlord and their agent that contradicted the position put forward by the landlord in the proceedings). On that basis, the Court decided that the landlord did not intend to carry out the dilapidations that it claimed.

Further, when assessing the appropriate basis for determining the diminution in value question, the Court accepted the tenant's submission that once the resulting figure for the costs of the works falls below the site value, then the diminution in value is the difference between the "in repair" value and the site value.

In the instant case, the effect of the limitation of the landlord's damages by section 18(1) meant that the landlord was limited to recover only £900,000 as against an assessed figure for the works of £3,087,712. It also prevented other consequential claims such as loss of rent.

It did however mean that at least the landlord got something out of a building that was likely to require significant refurbishment if it was to be re-let at all (although this is no doubt scant consolation to the landlord, particularly when it comes to the assessment of the parties' costs).

Where are we now?

Where we are is a difficult place, particularly for landlords.

It is clear that the Court considers PGF to be good law and is prepared to apply the principles of that case to future dilapidations disputes, particularly when addressing the issue of landlord intention.

The Court has also shown a willingness to use the evidence available in as flexible way as possible to resolve the dispute even if that means using unconventional methods. It also shows that tenants will still usually be liable for the cost of repairs which ought to have been carried out (subject to the operation of the section 18(1) cap).

Accordingly, it is now more important than ever, whether a landlord or a tenant, to take the question of dilapidations seriously and prepare for the end of the tenancy with the utmost rigour. Any dilapidations dispute could become protracted and both the flow of communications (even between a party and their own advisers) and the preparation of the evidence need to be handled with the utmost care and attention if the parties to such disputes are to avoid nasty surprises.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.