Shining a light on the ‘dark art’ of diminution valuations in dilapidations claims: a response to COVID-19
Paul Raeburn, Chartered Surveyor, RICS accredited mediator, arbitrator and head of specialist diminution valuation consultancy, Radius Consulting, examines the fundamentals of section 18 Diminution Valuations (DVs) and their significance during the Coronavirus pandemic.
What is a diminution valuation?
Under section 18(1) of the Landlord and Tenant Act 1927, DVs are a mechanism by which dilapidations damages recovered by landlords from tenants in England and Wales can be capped. Every landlord or tenant will be concerned with dilapidations at some point during, and at the end of, a lease. The cap can result in a significant reduction in the tenant’s dilapidations payment to the landlord and whilst a valuable tool, DVs are often overlooked by those advising on dilapidations.
Generally, a chartered building surveyor prepares the schedule of dilapidations, that sets out and costs the covenants in the expired lease which the tenant has allegedly breached in terms of repairs, decorating and reinstating alterations. This forms the basis of the landlord’s dilapidations claim against the tenant.
However, as the actual impact on the property’s open market value is often far less than the tenant building surveyor’s assessment of costed repairs, section 18(1) provides that the damages should be the lower of the two. Assessing the impact on the property’s value is the specialism of a chartered valuation surveyor (Valuer), rather than a building surveyor.
Landlords can require DVs too; for example, to rebut a tenant’s, or to comply with the Dilapidations Protocol requirement to provide one (at its paragraph 9.4) when the remedial works are not actually being done.
COVID – 19
Despite the business implications of Coronavirus and the Government’s attempts to ease their economic impact, leases will continue to expire, or have break clauses operated, so landlords will continue to have to make timely claims. It is likely that even more dilapidations claims will arise as properties are vacated at lease expiry or break due to tenants’ inability to occupy and operate; or following a strategic decision to pivot their businesses online; or having more staff working from home.
Despite continuing restrictions caused by the pandemic, DVs can still be readily and comprehensively prepared through a combination of pre-existing location knowledge, desk- top research, online comparable portals and exit photographs. Professional advisers such as building surveyors and solicitors, as well as commercial property owners and tenants direct, can therefore readily and quickly access DVs in the prevailing climate.
Why DVs matter
DVs can potentially be an easily overlooked lifeline to both commercial tenants and landlords. Professional advisers for each should have a detailed understanding of them in their toolbox for the benefit of their clients for the following reasons:
For tenants
To maintain momentum on any ongoing dilapidations negotiations by using the DV report to show the tenant’s common law (Cost of Works) position as still at, or above, the true level of loss (Diminished Value);
To send to the landlord with a (higher) Calderbank/Part 36 offer, so as to make a more compelling case for its acceptance;
Diminution Assessments (Accounting FRS 102) to reduce Corporation Tax liability to assist cashflow and make advance provision;
Ultimately to save valuable cash reserves in the current climate by establishing if the statutory cap is likely to reduce their dilapidations payment to the landlord.
For Landlords
Again, to keep any ongoing dilapidations negotiations moving when ‘the works’ have not been (fully) done (pursuant to paragraph 9.4 of the Dilapidations Protocol);
To rebut a section 18 basic ‘no loss’ approach by an opportunistic tenant;
To underscore any common law (Cost of Works) Claim already made.
The legal framework
Based on common law and section 18(1), the general principle is to assess the diminution in value (if any) of the landlord’s reversionary interest in the premises. The diminution in value would then represent a cap on the damages payable.
If the diminution in value to the reversion is more than, or equal to, the cost of the works (and related valid items), then the cost of works negotiated between opposing building surveyors will be the damages. Conversely, if the valuation surveyor’s assessment of the diminution in value of the reversion is less than the cost of works, then this lower figure will be the damages. Commonly, the impact on value is far less.
The paradigm of a Section 18 (1) appraisal, requires two valuations:
Valuation A
The value of the landlord’s interest assuming that the premises are in their covenanted condition on that date; and
Valuation B
The value of the landlord’s interest in its actual condition on the valuation date.
These two valuations can only be made independently of one another if the valuer has access to open market comparable evidence of similar properties in each distinct condition.
Generally, this is straightforward for the covenanted condition, being any evidence from similar properties let on full repairing and insuring leases. However, such valuations are near impossible in practice for the actual (dilapidated) condition at lease expiry, as this would require evidence from transactions involving physically similar properties with all but precisely the same breaches as to repair, decoration, and reinstatement.
Valuers tend to arrive at Valuation A by gathering and analysing comparable transactional evidence but then, in the absence of any true comparables for the dilapidated state, deduct the aggregated cost of works from Valuation A, to arrive at Valuation B.
This ‘two valuation approach’ could therefore be considered at best impractical, and at worst, superfluous, when what is actually sought, is the amount of the sum deducted from Valuation A. This is the amount of Diminution in Value. It comprises of two key elements. First, the cost of claimed works which ‘survive’ two so-called ‘filters’ the valuer applies as informed by open market transacting experience as follows:
Supersession – To remove items which are known will be, or open market knowledge informs will likely be, destroyed, or overridden, by the likely hypothetical purchaser’s works of upgrading, modernising and otherwise altering the property to evolve it to best meet modern open market demand; and
Items ‘Not Value-Affective’ – Under this second ‘filter’, the valuer applies open market transacting experience to objectively judge which costs are, and which are not, likely to be ‘Value-Affective’ by reference to the condition and presentation the local market requires, and expects of similar properties. In other words, having regard to the property’s ‘age, character and locality’[1] and likely ‘calibre’ of prospective tenant, to objectively conclude which items are likely to contribute, and which are not, to recovering the full value required and expected of similar properties. This will take into account local market trends such as evolving changes of use to meet modern demand.
When looking at the likely impact on value of the breaches, it is first necessary to contemplate the likely type of hypothetical purchaser (such as an investor or owner-occupier) of the landlord’s interest at the Valuation Date, and how their bid would be affected, if at all, by the disrepair. The property’s likely evolution to best meet modern uses and demand is therefore key.
The second key element in calculating the Diminution in Value (if any) is Loss of Rent, and other mesne profits (e.g. Void Rates, building’s insurance etc.) directly attributable to the dilapidations. However, if the valuer can evidence that the property is likely to have its marketability maximised by alterations and improvements in any event, which works would take a similar time to, and could run concurrent with, the (surviving) dilapidations works, this element of claim might be weakened.
Conclusion
The specialist skills of both the chartered building surveyor and the valuer must therefore be unilaterally deployed to achieve the best results in terms of DVs and dilapidations generally.
As chartered surveyors and dilapidations specialists, Paul and the Radius Consulting team’s focus is on debunking the ‘dark art’ of DVs and highlighting their importance in ensuring dilapidations disputes are resolved fairly. Facing the potentially catastrophic economic impact of Coronavirus, it is more important than ever that those advising landlords and tenants are aware of the value of DVs to their clients.
To help demystify dilapidations generally, the Radius team has developed a Dilapidations App, Dilapps that can be downloaded free from either the App Store or Google play. This provides a ready ‘mind map’ through various dilapidations scenarios for both landlords and tenants, as well as real world case studies, and explanations of the distinctions between how dilapidations are pursued in the various jurisdictions around the UK & Ireland.
For further details or questions visit www.radius-consulting.com, email paul@radius-consulting.com or call 0845 673 3009.
[1] Proudfoot -v- Hart [1890] L.R.25 Q.B.D. 42, CA
