UK: SME - Beyond repair.

It is no good for small businesses to cross their fingers and hope for the best. Buildings wear out and tenants can face hefty repair bills. Think ahead.

It is all too easy for a powerful landlord to prey on small business tenants and to take advantage of their ignorance and trust. Tony Danaher, managing director of Tamesis, a London-based marketing consultancy, learnt the hard way. The company took a lease on offices in London's Docklands and gave the landlord a deposit of £5,000 or three months' rent to hold against 'dilapidations' (a term covering the condition of leasehold premises and both parties' repairing obligations under a lease). Recently, when the lease came to an end, however, the landlord withheld the deposit claiming that Tamesis had failed to maintain a kitchen area in good decorative order and internal doors had been damaged.

'It was quite unjustifiable,' fumes Danaher. 'The kitchen had never been in good condition and the doors had suffered a bit of wear and tear that pre-dated our tenancy.' The problem was that Tamesis had no proof. 'We should have taken photo-graphs when we moved in, or got an independent inventory,' says Danaher, ruefully. 'We contested it but to no avail. Frankly, unless you are prepared to throw money at the problem and employ lawyers, you end up getting had. We just wrote it off.'

Tamesis was lucky - at least the figure was low enough that it could afford to. With the odds seemingly stacked in favour of commercial landlords, few landlord and tenant disputes cause as much rancour as dilapidations.

Yet, says John Woodman, a senior partner with chartered surveyors Malcolm Hollis, repair obligations are rarely 'deal breakers' in the initial stages when the lease is being signed. 'Rent and lease term are seen as more important but there is a danger in overlooking such an onerous, open-ended liability, especially as the costs can far exceed the annual rent,' he warns. Most surveys commissioned by tenants during the lease negotiation stage do not go into sufficient detail about the issue of liability and life-cycle costs during the lease. 'Wear and tear redecorations alone can run into thousands of pounds,' he says.

Buildings are no different from other consumer goods - they wear out.

Different parts wear out faster than others and require maintenance and repair. Liability is not always clear-cut but often small business occupiers ignore or overlook the small print of a lease and later pay the price.

Others fail to protect their position and do not take professional advice.

Leases fall into two main categories. A 'full repairing and insuring' lease is one where the entire property is let and the tenant is responsible for all repairs - to the interior, exterior and structure. The second category is 'multi-let' properties, where a tenant is responsible only for the interior of the part of the building that it has rented. The landlord is then responsible for the upkeep of the main structure, roof, exterior and common parts, and recovers the cost through a service charge.

The system appears straightforward but leases can be complex and open to interpretation on the issue of liability. That is why it is usually a good idea to seek professional advice from property lawyers and valuation and building surveyors. 'Occupiers need to under-stand the terms they are entering into and the conditions of the property relative to those terms, which means taking proper advice at the outset,' advises Mike Tiplady, a partner with chartered surveyors Jones Lang Wootten. 'Professional advice is also necessary at the end of the lease to ensure that what the landlord is demanding is fair and reasonable. Money spent on lawyers and surveyors is usually money well spent.'

Andrew Smith, a director at surveyors DTZ Debenham Thorpe, agrees. 'Tenants who plan a strategy in advance often get favourable results,' he says. Adds Woodman: 'Much expense and heartache can be avoided if tenants take on leases with the benefit of a full report, addressing future obligations and not just the condition of the building at the beginning of the term. They need to understand what the ongoing liabilities are, which obviously differ from property to property.'

Basically, occupiers have to hand back the premises in good repair. Like Danaher, if tenants take on property that is in bad shape, they immediately assume a repairing liability - unless of course, they agree something to the contrary with the landlord.

With a short-term lease, it may be possible for tenants to limit their liability by agreeing a 'condition schedule' with the landlord, says Tiplady. This is prepared by a surveyor at the outset, and the tenant then undertakes to hand back the property in no worse condition than it was in at the start.

Normally the crunch comes at the end of the lease. Tenants have often fitted out new premises, or made changes during the course of the lease by putting up partitions or installing lights, air conditioning or central heating. If they have fallen foul of the lease terms ('in breach of covenant'), the financial penalty can be severe. The tenant's work over the lease term may in fact be an improvement but that sometimes cuts little ice with the courts.

The definition of 'repair' is something that has taxed the courts for 150 years and various factors come into play when trying to determine legal liability (who has to do what repairs and who has to foot the bill).

Are the works an alteration requiring the landlord's consent? What are fixtures and fittings and will those added by the tenant automatically revert to the landlord at the end of the lease? Do the changes amount to an improvement that affects the value of the property at the next rent review?

Is there an obligation to 'reinstate' the premises at the end of the lease? Is the tenant responsible for inherent defects - say, rampant dry rot - not covered when alterations are being made?

Because leases vary in the way in which repairing liabilities are imposed, a legal victory for a landlord in one case can herald a tenant's victory in another. A recent legal case will produce glum faces on the tenant side of the fence. The dispute revolved around the underfloor heating system in offices occupied by the London Borough of Hammersmith and Fulham, and whether the council could replace the system with more efficient storage heaters.

The offices had been built in the '60s and the underfloor system consisted of electrical cables embedded in heat-retaining concrete. The system started to break down and tests revealed that this was caused either by the cables breaking or by their insulation becoming damaged. Within the terms of the lease, the tenant was obliged: 'during the term ... well and substantially to repair and maintain ... the interior of the premises and every part thereof including ... all heating ... installations.' Hammersmith and Fulham Council did not dispute its liability to repair but, while the landlord Creska wanted the existing system to be repaired, the council wanted to install a more modern equivalent. It argued that replacing and redesigning the existing system was not sensible, practicable or economical.

The case ended up in the Court of Appeal, which sided with Creska. Although repairing the system would be expensive, it would not be impossible, it said. The outcome certainly seems harsh and Hammersmith and Fulham is to appeal to the House of Lords. No figures were given in the judgement and it appears that the court did not take financial considerations into account when deciding what was the sensible and practical way of dealing with the dis-repair. For now, however, Creska holds sway.

Tenants are often their own worst enemy, says Stephen Alambritis of the Federation of Small Businesses. 'Location is a priority for many companies.

They get emotionally com-mitted to a property and don't consider the ins and outs of the lease. Instead, they cross their fingers and hope for the best, rather than making a clinical judgment.'

Elliott Grant opened a hairdressing salon in the City of London four years ago. 'Position is everything in our business and sometimes you have to take what you can get,' he says. He took a 25-year lease on a ground-floor shop with basement, at an annual rent of £20,500, plus £11,500 rates, but the premises were in such bad condition that he had to spend nearly £200,000 on refurbishment. Alterations to a staircase incurred the wrath of the landlord who threatened action for breach of covenant but this was smoothed over. 'The harsh reality is that I'm maintaining the fabric of the building for the benefit of the landlord.

Technically, I could be obliged to undo the improvements I have made,' admits Grant.

Ultimately, tenants have two choices. They can either do the repairs before the lease expires and return the property in good order; or they can contest the matter when the lease is up. 'Which is the best option depends on the circumstances,' says Tony Guthrie, a partner with chartered surveyors Weatherall Green and Smith. 'If the building is elderly, the tenant may take the view that there is a good chance of the landlord redeveloping or refurbishing it, in which case it is better to do nothing.' On the other hand, with a listed building, the tenant may want to take the initiative because the cost of neglecting repairs could be considerable.

'If you are in a multi-let building, the thing to watch as the end of the lease approaches is whether the landlord is trying to make improvements at your expense - in the form of a higher service charge,' adds Guthrie. The landlord is entitled by law to seek damages for breach of a repairing covenant while the lease continues.

Few claims are made as it is difficult to prove but, says Anne Waltham, a partner of London lawyers Lovell White Durrant, a recent court ruling in a case called Jervis v Harris gives the landlord a potentially powerful weapon.

Most modern leases allow the landlord to enter the premises to inspect the state of repair and to give written notice of defects to be repaired within a given time. If the tenant fails to do the repairs, the landlord can now carry out the work and recover the costs from the tenant as a debt, rather than as damages which are harder to prove.

Tenants do have legal protection, however. First, Waltham urges, they should get advice as to the validity of the claim and, if necessary, carry out the repairs themselves before the landlord steps in and charges for all sorts of extras.

If the tenant wishes to renew the lease and remain in the building, it may be possible to negotiate away the dilapidations claim or at least postpone it until the end of the new lease.

By law, tenants can also 'protect' themselves against a dilapidations claim if the lease is for more than seven years and still has three years unexpired. 'A lot of small business occupiers don't realise they have a valuation argument that could limit their liability,' says DTZ's Smith.

A landlord's dilapidations claim will usually take the form of a schedule of repairs prepared by a surveyor. The claim will include not only the cost of carrying out the works but also professional fees incurred and loss of rent and service charge. These extras can be hefty and far outweigh the cost of undertaking the repairs.

A surveyor can help to determine which items are valid and can negotiate with the landlord. Suppose the schedule contains items relating to decorative works: if the lease contains an express requirement to decorate, then the tenant may not have a leg to stand on. Yet the extent to which the landlord is entitled to recover damages will depend on whether it intends to do the works, in which case the cost will be recoverable - but not otherwise.

The schedule will often include items of consequential loss such as fees, rent and service charge. The single most important item is likely to be rent.

To make such a claim, the landlord must have evidence that the repairs at the end of the lease will prevent or have prevented the letting of the premises for that period. If the market is very weak and the evidence is that the landlord would have been unable to let the premises, even in good repair, then loss of rent may well not be recoverable.

Landlords who want to re-market the premises often try to recover as much as possible from the tenant towards its refurbishment costs. Calculating which costs are justifiable is not easy for tenants but the law says that a claim for damages for breach of a repair covenant cannot exceed the loss to the landlord's reversionary interest (the freehold value in full repair). If it would cost £50,000 to repair a building but the difference in value between the building in and out of repair is £25,000, then £25,000 is the maximum amount the landlord can receive in damages.

Take a '60s building, says Waltham, where over the years the tenant has put up internal partitioning, suspended ceilings and so on. At the end of the lease, the landlord will want to modernise the interior in order to relet. This is likely to involve removal of the partitions to create open-plan space. If some of the internal works required by the schedule of dilapidations would survive the refurbishment, then the diminution in value may well be limited to the cost of those works. Tenants should never meekly accept the landlord's figures. They can help their cause by coming up with their own figure for 'diminution of value'.

Tenants should take advice and think ahead. As Danaher discovered to his cost, it is the 'deal-breaking' negotiations when the lease is signed that really count.

A GUIDE TO COMMERCIAL TENANCY AGREEMENTS

Andrew Smith, a director of DTZ Debenham Thorpe, says:

- Check your lease at the outset and don't sign if your repairing obligations seem too harsh. Lawyers can tell you if the wording is standard or if it favours the landlord. Most commonly, a Jervis v Harris clause will allow the landlord to serve notice on you to carry out certain repairs during your lease. If you fail to comply, it can do the works, reclaiming its costs from you as a debt.

- Commission a structural survey of the premises before signing the lease.

- Before moving in, arrange an independent inventory of the premises.

Take photographs inside and outside the building, particularly anything that is chipped or broken.

- If you are sent a schedule of dilapidations, check the figures and your lease. Landlords often include improvements outside your obligations.

Initially, a building surveyor can say if the landlord's claim is valid.

If not, professionals can negotiate the figure down.

- Know your rights. Tenants may have statutory protection or valuation arguments that reduce the amount they have to pay.