Section 18(1) and diminution in value

When a tenant vacates a building at the end of a tenancy, it is likely to find an obligation in the lease requiring the outgoing tenant to return (or yield up) the premises to the landlord in a state compliant with the lease terms. Where the lease is held on full repairing terms, this would mean it is to be returned in full repair, in good decorative order and with any tenant alterations reinstated and made good.

Any breach by the tenant of these obligations forms the basis of a dilapidations claim at common law.

The heads of a landlord’s dilapidations claim at common law usually extend to include the following:

• the cost of the works (including repair, decoration and reinstatement);
• contractors' preliminaries, overheads and profit;
• professional fees for supervision of the works;
• VAT (where appropriate);
• professional fees for preparation and service of the schedule;
• professional fees for negotiation of the claim;
• loss of rent (mesne profits);
• loss of empty rates; and
• loss of insurance premiums and service charge.

The common law claim is prepared by a building surveyor and summarised in a quantified demand.

The outgoing tenant then has a choice whether to undertake the dilapidations work either prior to the termination date of the lease or afterwards, with the landlord's prior agreement. In many cases, however, tenants prefer to settle claims after leases expire in the form of a financial payment in lieu of damages. This is to allow time to fully understand whether its financial liability is limited by a statutory cap as imposed by section 18(1) of the Landlord and Tenant Act 1927, as explored below.

The statutory cap

Notwithstanding the common law claim, where the tenant is exposed to a claim in damages, section 18(1) of the Landlord and Tenant Act 1927 provides for a cap on the amount that a landlord can recover from an outgoing tenant in dilapidations, being the diminution in value of the landlord's reversionary interest. In other words, the landlord cannot recover more than the loss or reduction in value of its interest (whether that be freehold or long leasehold interest) owing to the breaches of the repairing covenant by the outgoing tenant under the terms of its lease at its expiry date.

By way of example, where a landlord sought to dispose of a freehold asset valued at £1m but could only achieve a sale price of £900,000 at the lease expiry date owing to the breaches of covenant of the outgoing tenant, it would be said the value has been diminished by £100,000, being the reduction in the sale price. The diminution figure is then compared to the common law claim and the lower of the 2 figures forms the correct measure of damages. If the lower figure is the diminution valuation, the claim is said to be to capped by the application of section 18(1) and common law principles.

Section 18(1) technically only deals with repairs. It does not cover breaches of decoration or reinstatement covenants that are otherwise covered under  common law, which apply a similar cap. For example, a landlord has a duty in law to mitigate its losses and, applying the concept of mitigation, it may be considered inappropriate to recover the cost of decorations or reinstatement that are found to be disproportionate to the benefit that would have been obtained.

The assessment of diminution should be undertaken by a specialist valuer who has a knowledge of dilapidations and is experienced in undertaking section 18(1) valuations. It is preferable that the valuation surveyor is involved from an early stage, although it is not always possible as many dilapidations instructions are instigated without recourse to specialist valuation advice and it can be difficult to predict when their input will be required.

Which party is required to provide a section 18(1) valuation?

In accordance with the Dilapidations Protocol, and prior to the issue of proceedings, the landlord should quantify its loss by providing either a formal diminution valuation or an account of actual expenditure (or a combination of both) where it would be reasonable to do so. From this, it may be there are situations where it would be reasonable not to procure a diminution valuation. One such circumstance would be where the landlord has carried out, or has the intention to carry out, the works.

The Dilapidations Protocol does not give any other examples of situations where a diminution valuation might not be required, but it could be argued that a compulsion for the landlord to provide a diminution valuation may not be justified:

• in low-value claims, simply because they can cost as much or more than the preparation of the detailed schedule, and in smaller claims there is a risk that the costs of preparing a claim may become disproportionate to the value of the claim. Of course, where the case escalates, it would then be up to the court to decide what is reasonable or unreasonable in the light of the specific circumstances of the individual case;
• where it is obvious the breaches of covenant are giving rise to a significant loss, and where a straightforward statement that a valuation is not going to be prepared as a result of this will be sufficient. This is not to say such a defence should not apply to claims of this nature, but rather that it would be unduly burdensome on the landlord to prepare a valuation on every occasion, if it is going to be of little relevance.

In these cases, where a tenant pleads diminution as a defence, it is for the tenant to prepare a diminution valuation as part of the defence to the claim, as indicated in the Dilapidations Protocol.