Mind your F’s and G’s

August 3, 2017

Rob Molyneux, director of energy and property services at Stroma, explains why the Minimum Energy Efficiency Standard is vital in protecting the properties that lenders lend on. In April it will be illegal to let out properties with an energy rating below E

The Energy Efficiency (Private Rented) Property Regulations 2015 set out a Minimum Energy Efficiency Standard (MEES) for all privately rented properties in England and Wales. From April 2018, it will be unlawful to let out commercial properties with an Energy Performance Certificate (EPC) rating of F or G, unless exemptions apply.

The onus for compliance lies with owners and landlords of commercial properties (as well as domestic lets), but lenders have a significant role in supporting and influencing the compliance process for properties on which they lend.

What are EPCs?

In a nutshell, the government currently defines the energy efficiency rating of a building or dwelling with a rating defined from the Energy Performance Certificate. This rating ranges from A (most efficient) to F (least efficient) and advises lenders, buyers, owners and tenants of a property’s energy efficiency through the grade rating.

Under the new legislation the minimum standard of energy efficiency for a rental property will be set at E, preventing any rental which is rated at either F or G. From 1 April 2018, landlords cannot renew (including extensions) or grant tenancies on a property if it does not meet the MEES regulations. Beyond 1 April 2023, the continued private rental of all buildings failing to meet the minimum standard will be outlawed entirely.

More about MEES

The Minimum Energy Efficiency Standards regulations will apply to all privately rented properties with tenancies over six months and less than 99 years which are required to have an Energy Performance Certificate.

Exemptions

Properties in breach of the regulations must undertake permissible, relevant and cost-effective energy efficiency improvements to meet the minimum standard, unless an exemption applies.

A commercial landlord may be exempt when the improvements required to meet the minimum standard are not cost-effective, for example, when the simple payback is greater than a seven-year period. An exemption may also apply when it is proven that improvements may decrease the property’s value by 5% or more, or where upgrades may damage the property, for example, the potential risk of cavity wall installation damaging the building. In addition, an exclusion to the regulations may apply where third party consent cannot be obtained, for example, a tenant, superior landlord or lender; or where all improvements have been made to a property, but it still fails to meet the minimum standard.

It is worth noting that new landlords can apply for a temporary exemption for six months from the date of taking ownership of a property. All other exemptions are valid for five years as the regulations will apply to all privately rented commercial properties from 1 April 2023, including where a lease is already in place, or currently occupied by a tenant.

Wherever non-compliant properties are proven to be exempt from the regulations, landlords must register the exemption along with necessary evidence to the PRS Exemption Register, if they wish to continue leasing the property. Landlords or owners of properties who fail to register an exemption of a non-compliant property will be in breach of the MEES regulations, which may result in penalties and enforcements.

If a landlord or owner is found to be in breach of the regulations, they could face a substantial financial penalty of up to £160,000, along with a public notification of their non-compliance. Enforced by Local Weights & Measures Authorities, penalties can also be enforced for failing to record an exemption with the appropriate evidence to the PRS Exemption Register.

What are the risks and challenges to lenders?

There is a substantial new risk to lenders in the event that a property fails to meet MEES, as an owner or agent is therefore prevented from letting a property, which may result in potential financial losses.

A report by Arbnco stated that 19% of commercial properties in England and Wales may not meet the minimum energy efficiency standard and could potentially see their capital value decrease by as much as 10%. In terms of collateral value, a negative impact in the value of an asset, i.e. the property, could affect the loan amount and rental value. This may result in an inability of the borrower to make repayments on a mortgage or loan, and in extreme circumstances could lead to a default on their mortgage which may result in repossession.

As the regulations require properties to meet the minimum standard by undertaking improvements to meet the minimum EPC rating of E, borrowers may be required to lend additional capital expenditure to meet MEES, resulting in lenders further loaning funds to fulfil improvements.

EPCs have a validity of 10 years. With requirements for EPCs for non-domestic properties having been introduced in 2007, many of the EPCs are nearing expiry or will expire prior to the introduction of MEES in April 2018.

Many changes have been made to the current methodologies behind EPCs during the last 10 years, and many buildings have themselves been altered, meaning that more buildings may be at risk of non-compliance.

Considering that the assessment for an EPC is performed for each individual tenanted property (for example, one occupied floor in a multi-let office building), it is possible that a property wishing to secure a loan could have more than one EPC. To effectively manage on-going loan books, a lender needs the capability to add EPC data for each tenanted property to oversee risks.

Regardless of whether another landlord or agent was able to acquire the property, the regulations would still affect the ability of the property to be let until such time as the EPC rating was raised to meet the minimum standard. The risk still remains and it could lead to a vicious circle of non-compliance and mortgage defaulting. Key to the role of lenders will be the opportunity to mitigate risk on their lending in order to protect the investment.

How can lenders mitigate risks?

There are a number of measures a lender can take to reduce the impact of MEES on their property investments. For new lending decisions, a lender may ask a borrower to provide details of the property’s EPC to assess its risks against the minimum standard; this may involve gathering EPC data such as certification and expiry dates. Lenders may also wish to carry out their own independent assessment as it is possible for an energy performance rating to vary through a new assessment; this will ensure the validity of data when making informed lending decisions.

In regards to making well-versed lending decisions, assessing and underwriting MEES risk is an important process within mortgage lending and determining loan terms. To give lenders a better representation of a borrower’s intentions and to understand the associated risks, they may request to seek further information such as proposed length of leases, which may be affected by MEES time-scales. Furthermore, understanding if a borrower is planning upgrades to the property and how they plan to acquire funds; this includes timescales and whether the upgrades could affect the properties energy performance.

To further mitigate risks, any commercial impacts should be underwritten, especially if a lender is concerned about a specific MEES risk which has been identified following an assessment. This may be accompanied by a lender requesting a structure to loan repayments and documentation to protect their rights as consumers.

For existing loans, a lender is advised to start obtaining EPC data to assess and manage MEES risks in relation to a borrower securing an existing loan against a property. A lender may also include the EPC data they’ve obtained with any MEES risks identified when monitoring and managing existing loan book portfolios to highlight ‘at risk’ properties, or organise properties by EPC expiry dates.

It is also important to undertake a thorough review of loan documentation to examine whether the borrower is responsible for meeting the minimum energy standard if a property becomes non-compliant, and if relevant energy improvement costs to the property can be passed on to the current occupiers, for example, the tenants.

To minimise potential effects of MEES on mortgage lenders, it is vital to assess MEES risks surrounding your investments through in-depth energy assessments of properties, particularly ones which have been identified as ‘high risk’; this will ensure risks are identified at the earliest opportunity and mitigation plans can be formed to reduce potential threats of non-compliance.

Additionally, lenders have a legal and moral responsibility to inform borrowers of the risks surrounding MEES and the effects a non-compliant property can have on their investments. By providing sound advice and support and ensuring risks are underwritten and included in relevant documents, ensures borrowers are fully aware of their responsibilities and associated MEES risks when borrowing.

In conclusion

Assessing a customer’s capability to make loan repayments on their mortgage is top priority for lenders, so it’s vital that MEES risks are managed and practical solutions are implemented to minimise risks.

There are a number of processes lenders can implement to reduce the threat of non-compliance surrounding their property investments. This includes assessing EPC data, underwriting MEES risk within the lending process, understanding a client’s business plan and how they will meet the minimum standard, structuring loan repayments effectively and revising loan documentation to ensure responsibilities are clear and concise.

A lender may also wish to carry out their own independent MEES assessment to establish any potential commercial impacts, particularly for properties which have been identified as ‘high risk’. Additionally, for due diligence, monitoring existing loan book portfolios and managing EPC data including expiry dates will ensure ‘at risk’ properties are highlighted and strategies can be applied promptly to mitigate any risks early.

Furthermore, the regulations will largely affect property owners and potentially their financial investments. Lenders have a legal and moral responsibility to inform their customers of the risks surrounding MEES and any potential impacts it could have on their property portfolios.

Stroma Tech is working with the rental market to support the process of MEES compliance. Our energy consultancy team has developed a four stage lifecycle approach to compliance which enables landlords and property agents to manage their portfolio. By following this process, properties can be brought up to standard in advance of the deadline and the risk to mortgage lenders is reduced:

  • MEES Risk Assessment – Using a lookup database we can analyse property portfolios and assess potential EPC risks against the new regulations
  • Individual Property MEES Assessment – Bespoke assessments for each ‘at risk’ property can be completed.
  • MEES Compliance Summary, Improvement Plan and Funding Assessment – A summary produced to include a portfolio wide summary of works required to become compliant with the regulations
  • PRS Exemption Register Management – Assistance with exemption management for properties which do not meet the regulations

If lenders analyse their property stock against the risk of non-compliance of MEES they will be in a much better position to reduce commercial impacts to themselves and their clients.

 

Source:  Mortgage Finance Gazette Mind your F’s and G’s