Commercial leases: dealing with dilapidations

It is vital for any lease to deal clearly with the tenant’s liability for repairs, both throughout the lease and on expiry. Even so, agreeing and enforcing dilapidations claims can often end up being a lengthy (and costly) exercise. While dilapidations are often an after-thought when negotiating the terms of a lease, they can become one of the greatest expenses in taking on a commercial property.

Whether you are a landlord or a tenant, there are steps you can take to minimise the risk of unwelcome surprises at the end of lease – and ultimately a long litigation.

Here we look at:

• the purpose and nature of the dilapidations clause;
• the obligations on both sides throughout and the term of the lease;
• how to negotiate these to your best advantage; and
• why being ahead of the curve can limit your exposure.

What is the Full Repairing Obligation?

It is worth emphasising at the outset that the commercial purpose of a dilapidations clause is not to result in a windfall payment for the landlord. The purpose is to reimburse the landlord’s losses as a result of the tenant failing to put the premises back into the original condition.

The standard full repairing and insuring lease requires, among other things, that the tenant accepts the premises “in good and substantial repair and condition”. The tenant is then responsible for ensuring that the premises are maintained (and if required, renewed or replaced) to keep them in such repair and condition throughout the term, regardless of any defects present at entry, and regardless of whether any disrepair is caused by the tenant.

It’s not all bad news for tenants: the courts have also determined that the “good and substantial” repair obligation doesn’t necessitate replacements just because a part of the premises has reached the end of its economic life.

Dilapidations through the stages

Dilapidations should be considered and planned for at every stage of the lease term.

1. Commencement of the Lease

(a) The Premises

It might seem obvious, but since the tenant’s repair obligation applies to the premises only, it’s important to know what this comprises. That may be straightforward in a single occupancy lease, where the whole of the landlord’s property has been exclusively let to the tenant. The matter gets more complicated when dealing with premises comprising internal airspace within a multi-occupancy building. The lease should contain sufficient detail in the description of the premises to identify whether the internal walls, ceiling, floors and other component parts are included, and therefore covered by the repair obligation, or not.

The tenant should also bear in mind that, depending on the lease terms, any fixtures and fittings which they install may also become part of the premises, and therefore subject to the “good and substantial” repair obligation. Alternatively, depending on the nature of what is installed, it could be considered an alteration. In such a case, putting the premises back into the condition it was in at the outset may require removal of those alterations.

(b) Negotiating the Repair Obligation

Many commercially-minded tenants will try to manage the risk of a steep dilapidations claim at the outset by negotiating an appropriate reduction in rent, excluding liability for latent and inherent defects, and/or by agreeing that liability for patent defects existing at entry will be excluded by way of a schedule of condition.

If it is agreed that the tenant’s repair obligations are to be subject to a schedule of condition, it is essential that the schedule is referred to in any other lease clauses which may also ultimately require the tenant to carry out the excluded work, for example, any obligations imposed on the tenant to decorate or carry out any works required by statute, and obligations to yield up and reinstate the premises at the expiry of the lease.

It is also of the utmost importance that the schedule of condition contains high quality photographs, and that a colour copy is kept throughout the duration of the lease. A poor quality schedule of condition can be of very little use to a tenant in proving the condition at the outset.

2. During the Lease Term

A vigilant landlord may not wait until the end of the lease to serve a dilapidations notice, and it is common for the lease to reserve to the landlord a right to enter the premises, carry out any works not completed by the tenant and recharge the costs of doing so. To avoid this, the tenant should ensure that the lease gives them a reasonable amount of time to comply with a dilapidations notice, depending on the nature and extent of the works required. Ultimately, if a landlord’s dilapidations notices are not complied with during the term, it does have the option of irritating the lease, but statute only permits this where a reasonable amount of time to remedy the breach has been given.

On a practical level, regular inspection and maintenance will help to avoid a hefty claim at the end of the term.

3. On Expiry/Renunciation/Assignation

Although landlords may serve interim schedules of dilapidations at any time during the lease term, dilapidations issues are most likely to arise at the end of the landlord/tenant relationship: on expiry, assignation or renunciation of the lease.

Before agreeing to an early renunciation or assignation, the landlord will need to ensure that it doesn’t inadvertently release the tenant from existing dilapidations claims, by securing payment or preserving these against the incoming assignee.

Ahead of the lease expiry, the parties should be aware of potential dilapidations claims and try to flush these out sooner rather than later. The lease is likely to require the tenant to leave the premises in good and substantial repair and condition, including removal of any tenant’s alterations or additions unless otherwise agreed. If that’s not done, and any damage from the removal work made good, the landlord may also claim any losses (i.e. lost rent and rates), so getting clarity on the extent of the works in good time is important.

Enforcement of the Repair Obligation

Both the landlord and the tenant would be well advised to consult an experienced surveyor before agreeing either that the works in the dilapidations schedule are necessary, or the value of the works. Where agreement cannot be reached between the parties on the extent or value of a dilapidations claim, the landlord’s next logical step is to raise a court action seeking an order either requiring the tenant to carry out the works or, more likely, requiring that the tenant pay the sum in the schedule of dilapidations.

As stated earlier, the commercial purpose of a dilapidations clause is not to result in a windfall payment for the landlord. Before seeking to recover payment, the landlord will need to take steps to demonstrate that it will suffer a loss, either through the carrying out of works to the premises, or a diminution in sale value or rental yield.

Litigation provides a forum for both sides state their cases. More often than not it will focus the minds of those involved, resulting in more constructive discussion and debate. However, this course of action is notoriously expensive, and all parties involved would do well to bear that cost in mind during pre-litigation negotiations.