Heads of Terms: Service charge and insurance provisions (Part 5/8)

Our eight-part series highlights the important aspects of negotiating Heads of Terms in a commercial lease and what tenants and landlords should consider and why.

Read the full series:

1. What are they, and why are they important?
2. Negotiating a commercial lease 
3. Alienation and transferability of the lease
4. Rent-free periods and break clauses
5. Service charge and insurance provisions
6. The tenant's covenant to repair
7. Making alterations to the property
8. Final boilerplate provisions in a commercial lease
   
    

Service charge and insurance provisions

Service charge and insurance provisions are potentially one of the most misunderstood areas when considering a commercial lease - and one of the most crucial because of the opposing positions of the landlord and tenant. 

What is a service charge?

The service charge is the mechanism within the lease allowing the landlord to recover its service and maintenance costs from the tenants. 

Where there is a multi-let building or series of buildings in an estate, the landlord will wish to ensure that they can recover the service charge from the whole area from the different tenants. For the landlord, this is known as achieving a “clear rent”, as they do not then need to spend any of the rent money on maintenance expenses.

The tenant’s point of view is more balanced. Whilst they want to limit their liability to pay for works to other parts of the building or estate, they would also wish to maintain the overall appearance and condition of the building. 

The important point for the tenant is to remove from the service charge any items that it thinks should be supplied and paid for by the landlord or for which other tenants should be responsible. 

As there are limited statutory restrictions on the service charges in commercial leases, the parties are free to negotiate whatever provisions they would like. 

Therefore, the final service charge and insurance provisions will largely depend on the bargaining power of the parties.

What is covered by the lease provisions?

Let’s look at the main elements of what should be included in the service charge clause:

1. Firstly, the clause must contain a list of the services for which the landlord can charge the tenant. These will usually include a number of matters which the landlord is obliged to provide by covenant and a number of matters which the landlord is not obliged to provide, but for which the tenant must contribute if they are provided. Despite the tenant being required to pay for these, the landlord is not necessarily required to provide them (Russell v Laimond Properties (1984) 269 E.G. 947). As the tenant, these are the items for which you will be responsible for contributing the agreed proportion. You must remember that this relates to the whole of the building or estate and not just the lease of your part. The obligation to insure can also be included here as one of the services or can be included separately within the lease. This important point is that if included here, the remaining provisions will apply to insurance charges. Another point to consider is management costs. These are often included in the service charge if the landlord employs a managing agent. The tenant may wish to impose a cap on what can be charged here, whilst the landlord will wish to recover as much as possible from the tenants.
   
    
2. Secondly, the clause will place an obligation on the tenant by a covenant to contribute towards the total service charge cost for the building or estate. In a larger estate or even in a multi-let building, it is important for the landlord that the service charge provisions of each lease are exactly the same. It can therefore be difficult for a tenant to negotiate the standard provisions in these circumstances. The exact proportion that an individual tenant will pay can be fixed in the lease by a percentage, but whilst this provides certainty, it can also result in an unfair result if there are any changes in the future. The other common option is for the proportion to be based on a fair proportion. This method is more flexible when there are changes to the building or estate but can also lead to disputes over what constitutes a fair proportion.
   
    
3. The third element of the service charge provisions is an obligation on the landlord to provide the services, which usually forms part of the landlord’s covenants. From the tenant’s point of view, they will want to ensure that the covenant is a full obligation on the landlord to provide the services, whereas the landlord is likely to try to limit their obligation by stating they must only use their ‘reasonable’ or ‘best’ endeavours to provide the services.
   
    
4. The final key part of the service charge provisions is the operative parts, e.g. how the mechanism for payment will work. The service charge will usually be calculated by reference to a given service charge year. There must also be a provision for a statement of account to be prepared, and this should then be certified independently. Importantly, there must also be a timescale for the preparation of the service charge accounts, which should occur promptly after the end of the service charge year. If there is any delay, there may be problems for the tenant on assignment as there could be sums outstanding after the assignment. The landlord may also validly be able to reject an application for a licence to assign if such sums are outstanding. This ties in with the matters discussed in part three of this series on alienation.

Service charge and insurance provisions: What should the landlord consider?

There are some important issues that the landlord should consider when negotiating a new lease:

1. It is common for the lease to provide for advance payment of service charge, usually paid monthly or quarterly, to allow the landlord to have sufficient cash flow to undertake the services for which they are obliged. It is important in this situation for there to be provisions dealing with any overpayment or underpayment when the service charge accounts are finalised. From the landlord’s point of view, any excess service charge payments should be set off against future service charge costs.
   
    
2. It may be useful for the landlord to be able to vary the services that they are to provide. Particularly in larger developments, circumstances may change, and so there could be a need to alter the services that are provided at any given time under the service charge provisions. Tenants may be reluctant to agree to this, but without such a right in the lease, the landlord would not be able to vary the services that they are obliged to provide should the need arise.
   
    
3. Again, there may be a need for a provision providing for provision and maintenance of a sinking or reserve fund. Given the complex tax issues and the burden of administering these funds, they have become a less popular option. However, the landlord should consider if this is required.
   
    
4. The landlord may wish to make the provision of the services conditional on payment of the service charge. In smaller multi-let developments or in single let properties, this can be an effective method for the landlord to ensure that they do have to outlay substantial funds in order to provide the services without receiving the advance service charge payment tenants. In a large multi-let development, this can be less effective as it would be unlikely that all tenants would be in arrears of service charge, and as such, the landlord would still be obliged to provide the services for those tenants who are up to date with their payments.
   
    
5. Where some parts of a multi-let development are vacant, the landlord will want to consider how payment of that portion of the service charge is covered. The tenant will be keen to ensure that they are not responsible for excess payment here, but where the service charge is by reference to a fair proportion, this will be of the whole of the service charge for the premises and will oblige the tenant to contribute.

Service charge and insurance provisions: What should the tenant consider?

Likewise, the tenants can be heavily impacted by the service charge provisions, and such they should be carefully considered. In particular, the following should be discussed.

1. The service charge may be capped, and this is something the tenant should consider negotiating with the landlord to provide them with a certainty of their expenses. This restricts the amount that the landlord can charge in each service charge year. Whether this is acceptable will largely depend on the bargaining strength of the parties. If an outright cap is not accepted, then the landlord may accept a cap that has an increase linked to the Retail Price Index or other mechanism allowing proportionate increases.
   
    
2. The landlord may try to negotiate a ‘catch-all’ clause that allows them to include additional items that they decide to provide within the service charge. Although this is not objectionable in principle for the tenant, it gives the landlord wide scope for the provision of services, and so the tenant should insist that the clause is limited so that the landlord is acting reasonably at all times. In Fluor Daniel Properties Ltd v Shortlands Investments Ltd [2001] EWHC 705 (Ch), the court said that the landlord must consider the length of a lease when acting reasonably.
   
    
3. Where statements of account are prepared, the tenant should insist that the person who prepares them is fully qualified to do so and independent from the landlord. This can add extra cost. However where the statement is to be final, it is key for the tenant to be comfortable that this accurately reflects the correct position.
   
    
4. Any guarantor of the tenant will also be providing a guarantee of payment of the service charge. For this reason, they should be aware of the costs and requirements of this. Similarly, if the tenant forfeits the lease, the guarantor could be asked to take a lease in the same format, and so they would take liability for the payments.

Insurance provisions

Commonly, the landlord will insure the building or development as a whole and then recover the cost of this from the tenants. This insurance would be in the landlord’s name, and the tenant would want to make sure that it is to the full reinstatement value. From the landlord’s point of view, this should also include cover for loss of rent for a specified period. The tenant will be prohibited from doing anything that may vitiate the landlord’s insurance.

The insurance provisions will then usually provide that the tenant is liable for repair and upkeep of the property, except where damage is caused by an insured risk. In this situation, the landlord becomes liable to claim under the policy and to apply the proceeds for reinstatement of the property as a whole.

The tenant should insist that if the property has been damaged or destroyed by an insured risk so as it so that it is no longer able to be occupied for the permitted use, that the annual rent is suspended for a set period of time.

Some important points to consider in relation to insurance provisions:

1. The landlord’s obligation to insure should not be linked to the tenant's payment of the insurance rent or service charge. This should be separate with separate remedies for breach of covenant if left unpaid. This is particularly key in multi-let buildings and developments.
   
    
2. The landlord should not accept complete liability for insurance. Where an act of the tenant has vitiated the policy, or where the policy itself limits cover, the landlord’s solicitor should ensure that there is no liability on the landlord for insurance not being in place. From the tenant’s point of view, they must include in the lease an obligation on the landlord to provided copies of the relevant document on them so that they are aware of all the restrictions.
   
    
3. There can be disagreements between parties over what should be covered by the ‘insured risks’. The normal position is that cover is provided for usual risks by reference to a list of insured risks in the definition section. Special consideration should be given in the circumstances of each lease to ensure that all necessary risks are covered.

A final important point about service charge and insurance provisions for landlords and tenants is how the payment is defined in the lease. Often the landlord’s starting position is to reserve the actual rent, insurance, service charge and interest owing as ‘rent’. A tenant should reject this because the payment of ‘rent’, or in actual fact, the non-payment of ‘rent’ can lead to forfeiture provisions being instigated. A landlord is able to forfeit the lease if a tenant has not paid ‘rent’ within, say, 14 or 21 days of demand. 

If service charge and insurance are classed as ‘rent’, the tenant must pay or risk forfeiture. This means a tenant who disputes the payment of a service charge or insurance must first pay to avoid forfeiture and only have the right to contest. We advise that only the actual rent is reserved as such, and other payments are separated as other payments.

Expert legal advice on commercial property leases

SO Legal has commercial property solicitors based in London, Brighton and East Sussex and works with clients across the UK.