Leases in the retail sector: Service charge
This series of articles explores key issues to be considered when agreeing heads of terms and negotiating the provisions of leases, with a focus on the retail sector.
In leases, a service charge typically applies where the tenant is leasing part of a property rather than the whole building. If a tenant is leasing the entire property, it’s unlikely that they will be required to pay a service charge for shared services. However, in multi-tenanted buildings or estates, service charges are common and can vary in structure and complexity.
Service charges can be structured as either an ad hoc contribution or as a more structured account, where the tenant makes regular monthly or quarterly payments, with a balancing payment at the end of the service charge year.
Retail tenants should ensure that the lease clearly outlines the landlord’s obligation to provide the necessary services that allow the tenant to properly occupy and operate from the premises. The services typically covered by a service charge include:
- Repair and maintenance of common areas (e.g. corridors, lifts, restrooms).
- Lighting and heating of common parts, ensuring areas like malls, entrances, or communal corridors are adequately lit and heated.
- Provision of essential services, such as air conditioning, refuse collection, security, and building signage.
These services must be relevant to the specific needs of the retail tenant and their ability to operate their business effectively within the premises.
Excluded costs
Retail tenants should also ensure that certain costs are explicitly excluded from the service charge to prevent unexpected liabilities. Common exclusions might include:
- Costs directly relating to another tenant (e.g. a shop fit-out for another retailer).
- Shortfalls in the cost of services due to special concessions or discounts given to other tenants.
- Any costs for which the landlord is already reimbursed (e.g. from insurance).
- Initial costs related to the original construction or design of the building or estate, as these should not be passed on to tenants.
- Costs associated with any future development or improvements to the building or estate, except where items are beyond economic repair.
- Service costs due to damage or destruction of the building, whether insured or not.
- Repair costs for defects in the property that were present before the lease was signed.
A tenant should also consider negotiating a service charge cap in the lease. This cap will limit the amount the tenant is required to pay, protecting them from unexpected increases in service charge costs.
Typically, the cap will be reviewed annually in line with inflation indices like RPI (Retail Price Index) or CPI (Consumer Price Index).
Landlord’s perspective
From a landlord’s viewpoint, it is crucial to ensure that the service charges are structured in a way that allows for the full recovery of the costs associated with providing these services. If the landlord fails to recover all appropriate costs, they could be left with a financial shortfall. However, landlords should also be mindful of costs associated with the renewal or future development of the property, which may not be recoverable through service charges. Additionally, if there are unlet spaces in the building or estate, the landlord will need to absorb those costs until the space is let.
RICS Professional Statement
The Royal Institute of Chartered Surveyors (RICS) has published a Professional Statement titled "Service charges in commercial property, 1st edition" which became effective on 1 April 2019. This document sets out the best practices and mandatory obligations for managing service charges in commercial property. For tenants, it's important to be aware of the following key points:
- Improved standards of transparency and fairness in the management and administration of service charges.
- The timely issue of budgets and year-end certificates to ensure tenants are kept informed about costs and any potential adjustments.
- Guidance on dispute resolution, reducing the likelihood of disagreements over service charge costs.
- Best practice in negotiating and drafting lease provisions related to service charges, helping tenants and landlords avoid disputes over what is included or excluded from the charge.
Although the RICS Professional Statement applies primarily to its members, it represents best practice for any landlord or managing agent involved in the administration of service charges. Tenants should ensure their lease complies with these standards to guarantee fair and transparent service charge arrangements.