Jessica Waters and Jack Lightburn take a look at services charges in commercial leases and breakdown the key points to consider both at the drafting stage and during the term of the lease.
A service charge is a sum charged by a landlord to a tenant to cover the landlord’s costs of providing services under a lease. Although this sounds straightforward, operating a service charge can be very complicated, particularly in large shopping centres or developments. As a result, the charging and collection of service charges can give rise to significant disputes. In many cases there is a tension. Landlords will want tenants to cover all of the costs they incur in providing the services, whereas a tenant's main concerns will be to ensure that all necessary services are provided and they are not over charged. In certain circumstances tenants may want sums removed from the service charge, for example where they don't directly benefit from a service or where they consider a service charge cost has been unreasonably or improperly incurred.
Whereas service charges for residential premises are subject to broad statutory regulation, the same limitations don't exist for commercial leases. Therefore, commercial landlords and tenants are free to negotiate service charge terms as they see fit without any statutory interference. Having said that, the Royal Institution of Chartered Surveyors (RICS) members and firms are regulated more generally by the RICS 2018 Professional Standard, Service charges in commercial leases (the ‘RICS Standard'), which is essentially a statement of good practice in the operation and management of service charges in commercial leases. When reviewing service charge clauses in a commercial lease, regard should be had to the relevant lease provisions and the requirements and recommendations set out in the RICS Standard as appropriate, although the terms of the lease will always take precedence.
This article only considers service charges in a commercial context.
What services will be provided?
The services to be provided by the landlord and paid for by the tenant will be set out in the lease. Depending on the wording of the lease, even if the tenant is obliged to pay for a service, this does not necessarily mean the landlord is required to provide that service. Often a landlord will be under an obligation to 'use reasonable endeavours' to provide the services, rather than it being an absolute obligation. This excuses the landlord for any temporary interruption of services caused by matters outside of its control.
Generally, the definition of 'Services' will include maintenance and repair of the exterior, structure, roofs, foundations and other common areas in a building or development. It may also include other services necessary for the proper operation of the building or development, such as lighting, security, a reception desk and the supply of utilities to common parts. It is also likely to include services which the landlord may choose to provide at its discretion, for example costs incurred in the interests of good estate management, such as promotional or management fees. It could also extend to the costs of improvement works, although this is more likely to be a point of contention and resisted by a tenant.
The service charge provisions in a lease may set out specific excluded service costs which are not to be charged to tenants. These may include the cost of remedying inherent defects, enforcement costs relating to tenant breaches, rent collection and any service charge costs associated with empty units. There may be provision for sums to be credited to the service charge account for facilities which generate an income for the benefit of the building, for example, public car parks. Where this is the case, any associated costs (such as repair and maintenance of the car park) are likely to be charged to the service charge.
Landlords should act reasonably and properly when incurring costs in providing the services and in accordance with the terms negotiated between the parties in the lease. This does not mean that landlords must always spend as little as possible on services or choose the cheapest quote. However, the RICS Standard does encourage competitive tendering for services and value for money should be achieved for tenants. Although the RICS Standard cannot override the lease terms, its members and firms should have due consideration to its key principles and best practice recommendations relating to the provision of services that form part of the service charge.
How much will a tenant pay?
For a tenant to be liable to a landlord for a share of the costs incurred in providing the services, there must be a specific provision in the lease requiring it to pay. Service charges are often charged separately to the principal annual rent, although it's possible to have 'inclusive' rents, which typically aggregate the rent, service charge, insurance and utilities costs (and sometimes also business rates) into one global sum.
The lease should set out how much the tenant is required to contribute to the service charge and any caps or limitations that apply. This could be a fixed or variable sum. Fixed service charges are less common as they are inflexible and won't guarantee that a landlord recovers all its costs. Where a fixed service charge applies, it will often be index linked or subject to stepped increases throughout the term.
If the building is multi-let, then the service charge will need to be apportioned between several tenants. The method of apportionment can vary but the lease should state the amount to be paid by the tenant or how it is to be calculated. For example, a fixed proportion, a "fair and reasonable" proportion or a proportion based on the floor space occupied. A fixed proportion is likely to be favoured by a tenant as it provides certainty, but may be resisted by a landlord as it is inflexible and doesn't allow for variations if the landlord wishes to extend or downsize the development.
If the landlord has exercised an option to tax the premises, VAT will be payable on the service charge. If no option to tax has been made, the landlord should be able to include in the service charge any irrecoverable VAT it has incurred in providing the services.
When will a service charge be payable?
The lease terms will dictate when the service charge is to be paid. Fixed service charges are typically paid on the same payments dates as the principal rent. Most modern commercial leases allow for a variable service charge as it provides a greater degree of flexibility, particularly in longer term leases where the costs of providing services are likely to increase over the term and cannot be easily predicted.
Variable service charges are typically payable by the tenant in advance based on estimates provided by the landlord setting out what it considers it will spend on services in the coming service charge year. These on account payments of service charge will be charged to and paid by the tenant at intervals set out in the lease, usually quarterly in advance on the same payment dates as the principal rent.
At the end of the service charge year, the landlord is required to set out in a statement what it has actually spent over the year. Subject to the requirements of the lease, the landlord should prepare this reasonably promptly and the RICS Standard suggests the statement should be issued within four months of the end of the service charge year. If the landlord has underestimated the costs, the tenant is then required to pay a balancing charge. If the landlord has overestimated, depending on what is set out in the lease, the overpayment is either credited to the tenant's service charge account for the next year or returned to the tenant.
The statement of actual expenditure will usually need to be certified. Typically, this will be done by the landlord’s accountant or surveyor, but tenants will want the statement to be certified by someone appropriately qualified and independent. How this tension is resolved will depend on the relative bargaining strength of the parties, but tenants should ensure the terms of the lease allow them to audit and challenge the statement if it is not independently certified. The RICS Standard indicates that tenants should be given the opportunity to question and dispute the sums set out in the certificate.
The lease will also often state that the certificate of account is 'conclusive, final and binding on the tenant, save for clear errors' or similar wording. A recent decision of the Supreme Court (Sara & Hossein Asset Holdings Ltd v Blacks Outdoor Retail Ltd [2023] UKSC 2) considered the meaning of "conclusive" in this context. In that case, the landlord argued that the certificate of service charge account was 'conclusive' in relation to both the costs and sums payable. The tenant disagreed and argued that the certificate was only 'conclusive' in relation to the costs incurred by the landlord and not the actual sums payable by the tenant.
However, the Supreme Court rejected both arguments and came to a different conclusion. It decided that the certificate was "conclusive" as to the sum payable by the tenant but not necessarily its liability to pay under the terms of the lease. Therefore, following this decision, if tenants wish to dispute the amount of their service charges, they are encouraged to make prompt payment of any service charges and "argue later" about their liability to pay.
Some landlords also operate a reserve or sinking fund, which is a fund held on trust for the tenants as a whole to cover large periodic items of expenditure (such as painting and decoration) or large one-off costs like replacement of a substantial item of plant and machinery (such as a lift or heating system). These have become less common in recent years as the taxation of such funds has become increasingly complex.
Dispute resolution
As you can see, there is considerable scope for disputes between landlords and tenants in relation to the charging and recovery of service charges. Many service charge issues will involve detailed analysis of the construction and interpretation of service charge provisions in the lease. Legal advice should be taken when negotiating service charge provisions in a lease and at the earliest opportunity during the lease term where a dispute arises. Many modern commercial leases contain provision for the determination of disputes by a professional expert, arbitration or mediation before being referred to court.
The above is intended only as a general overview of service charge provisions in commercial leases. If you have any questions on the above or require specific advice in this area, please contact our real estate team.
Jessica Waters
Jack Lightburn