A guide to understanding service charges

A guide to understanding service chargesSimon Nash

The Royal Institution of Chartered Surveyors' (Rics) Code of Practice states, ''Service charges enable an owner to recover the costs of servicing and operating a property from the occupiers as well as any others who benefit from and use the services and facilities provided.'' In short, they are charges levied by landlords on occupiers to recover the cost of maintaining buildings and facilitating repairs.

Recovery methods

So what are the most common methods of service charge recovery? Such charges should be applied and recovered on a non-profit/non loss basis, wherever possible.

This does not mean that individual service suppliers such as mechanical, electrical and plumbing maintenance contractors cannot make a profit on the services they provide. It means the landlord should not profit by recovering contributions from occupiers that exceed the annual operational costs, nor should he suffer financial loss by recovering less and having to meet the shortfall himself.

Typically, across the Middle East, the method of calculating occupiers' service charge falls into one of the following categories:

• A percentage of rent

• A fixed rate applied to the occupier's floor area

• A capped rate applied to the occupier's floor area

• A reasonable proportion

The percentage of rent and fixed-rate methods are the most common in the region. Both involve fixing occupiers' service charge contributions at a specific rate for the duration of the lease and are attractive to landlords and occupiers alike because they allow budgeting for the entire term of the contract.

The disadvantage to landlords is the potential bearing of a proportion of the operational costs if they exceed recoverable contributions and the general inability to increase contributions until a lease is renewed. On the other hand, the disadvantage to occupiers is they may overpay for services where operational costs are less than the contributions they have made.

The capped method is similar to the previous two methods, with the main difference being that while landlords will bear a proportion of operational costs where they exceed occupier contributions, the occupiers will have the right to receive reimbursements or credits if what they pay exceeds the actual operational costs.

The fully recoverable method is arguably the most reasonable for landlords and occupiers as it is a transparent, non-profit/non-loss method of recovery. The key principle is that since the occupiers are usually the sole beneficiaries of services provided to a building, they must pay the full cost with no shortfall being met by the landlord. Provisional service charge contributions, calculated on the basis stipulated in the lease, would be made by the occupiers throughout the year. Arguably, the fairest method would be for contributions to be calculated in terms of occupiers' floor area as a percentage of the gross leasable area. At the end of the year, the operational costs and contributions would be reconciled.

If total expenditure exceeds the recovered contributions, the landlord has the right to levy additional charges to meet the excess, while in case of the contributions exceeding operational expenditure, the landlord must return the difference to the occupiers, either by way of account credit against the forthcoming year's contributions or actual reimbursement — common for final year tenants.

The main advantage of employing the fully recoverable method for the landlord is that if operated correctly, there should be no shortfalls.

What works best

While the most appropriate method for each landlord must be considered on a case-by-case basis, Knight Frank's view is that when structuring leases for new lettings, landlords should at least include provisions to allow for operational costs to be recovered fully at some point in the future, if not from the outset.

This allows them to monitor the initial method of recovery (if rent-pegged, fixed or capped) or adapt it to enable a more viable alternative The adoption of this method can also help landlords attract better tenants. Most international clients will be familiar with this method of service charge recovery and may even insist on it as a condition of taking up rooms in a building.

Finally, having a lease structure that permits the adoption of a fully recoverable service charge method can offer better prospects to buyers, should the current owner wish to dispose of the asset.

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Source: Simon Nash, Special to Property Weekly

The writer is Partner – Property Asset Management at Knight Frank Dubai. He has more than 12 years' experience in property management and has worked in the Middle East for over seven years, with specialization in commercial and retail property


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