Creating iron-clad contracts on service charges

To understand how the recovery of service charges affects you as a landlord, it is important first to understand exactly what a service charge is.

The Royal Institution of Chartered Surveyors’ Code Of Practice document states, quite simply, that “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.”

The charges should apply to services provided to common parts of the building only, or to services enjoyed by all occupiers in common. The costs which might be enjoyed exclusively by an individual occupier should generally be met directly by that occupier. While the initial cost might be borne by the landlord, any recharge should be directly to the occupier concerned, and not shared by other occupiers.

It is important to note that service charges should be implemented solely to recover the cost of keeping buildings maintained and, where necessary, repaired. Capital expenditure on major improvements should generally be excluded from service charges, and should be recovered through the implementation of a separate sinking fund.

Where major improvements or the full replacement of major items will be required at some point, landlords should implement a sinking fund to recover the cost from occupiers in advance over a period of time. Contributions made by occupiers must be held ‘in trust’ by the landlord until utilisation of becomes necessary.

The advantage of a sinking fund is that occupiers will generally contribute to the larger replacement costs over a period of a few years instead of facing a one-time, potentially considerable charge, from the landlord at the point of replacement. The disadvantage, from an occupier’s perspective, is that the lease might expire before the sinking fund needs to be utilised, but the landlord is not generally obliged to return any of the contributions which the occupier may have made to the fund.

If a sinking fund is operated by a landlord, the contributions towards the fund should be recovered separately from the service charges, to avoid any confusion over what the contributions relate to.

Service charges should, wherever possible, be applied and recovered on a non-profit/non-loss basis. This does not mean that individual service suppliers, such as MEP maintenance contractors, cannot make a profit on the services they provide. It means the landlord should not profit by recovering contributions from occupiers which exceed the annual operational costs, nor should a landlord suffer financial loss by recovering less than the annual operational costs.

Typically, across the Middle East, the method of calculation of occupiers’ service charge contributions will fall 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; or

• A fair and reasonable proportion.

The percentage of rent and fixed rate methods are the most common in the Middle East. Both involve fixing occupiers’ service charge contributions at a specific rate for the entire lease term, and both are attractive to landlords and occupiers alike because it allows them to budget, at the commencement of the lease.

The disadvantage to landlords is the potential for them to bear a proportion of the operational costs if these exceed recoverable contributions, and their general inability to increase contributions throughout the term, until a lease is renewed. The exception, of course, being where rents increase at a midterm rent review.

The disadvantage to occupiers is they may effectively overpay for services where operational costs are less than the contributions they have made.

The capped method is similar to the previous two, with the main difference being that while landlords will bear a proportion of operational costs where those costs exceed the recoverable contributions from occupiers, occupiers will have the right to receive reimbursements or credits if their annual contributions exceed the actual operational costs.
The fully recoverable method is arguably the most reasonable for landlords and occupiers alike — for the simple reason that it is a transparent, non-profit/non-loss method of recovery. The key principle is that as the occupiers are (usually) the sole beneficiaries of services provided to a building, they must pay the full cost of those services, with no shortfall being met by the landlord.

With this method, provisional service charge contributions would be made by the occupiers throughout the year. These would be calculated on the basis stipulated in the leases, with arguably the fairest method being that occupiers’ contributions are calculated by way of reference to their floor area as a percentage of the gross leasable area.

The general rule is that if an occupier has, say, 10 per cent of the gross leasable area, it should pay 10 per cent of the annual operational costs. Naturally, there are always exceptions — for example, in shopping centres where anchor stores, typically having larger floor areas, might either pay reduced service charges or none at all.

At the end of the year, the operational costs and service charge contributions would be reconciled. If expenditure exceeds the recovered contributions, the landlord would have the right to levy additional charges against the occupiers to meet the excess.

If the contributions exceed the operational expenditure, the landlord must return the difference to the occupiers, either by way of on-account credits against the forthcoming year’s contributions, or (more common only if tenants are in their final year of occupation) actual reimbursement.

The main advantage to the landlord of employing the fully recoverable method of service charge recovery is that, if operated correctly, there should be no shortfall attributable to the landlord, as all costs will be met by the occupiers.

The exception to the rule of full recovery is where a building contains vacant units. If a unit remains vacant, the landlord should be responsible for any costs that would normally be attributed to that unit if it were occupied.
For example, a building may contain five units, each having 20 per cent of the gross leasable area and, therefore, each having 20 per cent of the operational costs attributed to it. If one of those units is vacant, the landlord should be responsible for meeting the costs attributed, as it would be unreasonable to expect the other four occupiers to meet the costs attributed to a unit that the landlord is unable to let.

Source: Simon Nash, Special to Gulf News

The writer is Partner — Property Asset Management at Knight Frank UAE.


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