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When are service charge costs ‘reasonably incurred’?

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14th August 2023

Recent decisions shed fresh light on the reasonableness expected of landlords.  Nicola Muir investigates.

Lessees of residential flats are not fully in control of how or when expenditure to their buildings is incurred. However, when it comes to the calculation of their service charge, thankfully they have the benefit of numerous statutory protections to ensure they only pay what is fair. In particular, section 19 of the Landlord and Tenant Act 1985 provides that relevant costs are only payable to the extent that they are “reasonably incurred”. But what does that mean and how far can the First-tier Tribunal interfere with the landlord’s decisions as to what money is spent on?

These questions arose in two recent cases – Assethold Ltd v Adam and others [2022] UKUT 282 (LC); [2023] EGLR 5 and Fairleigh and others v St George South London Ltd and others LON/00AY/ LSC/2019/0338 and LON/00BJ/ LSC/2019/0330.

The starting point in both cases was the seminal decision in Hounslow London Borough Council v Waaler [2017] EWCA Civ 45; [2017] EGLR 19. In Waaler, the Court of Appeal said the question of whether costs have been “reasonably incurred” has to be determined by reference to the objective standard of reasonableness, not by the lower standard of rationality. There are two stages. First, the landlord must show that it adopted a reasonable decision[1]making process. However, in addition, the outcome of that decision must be a reasonable one. There may be more than one reasonable course of action and it is not for the court or tribunal to impose its own decision as to what should have been done, provided the course adopted was reasonable.

The first decision

Assethold concerned fire safety works. The landlord had engaged a firm called Hydrock, which carried out an intrusive inspection of the walls of the block and provided a report in September 2020, concluding that the construction of those walls did not present a significant fire risk. However, in January 2021, Hydrock carried out a second inspection of different walls, using different processes. This time its report concluded that combustible materials were present in the walls and presented an “intolerable” risk, with the potential consequences of fire being “extreme”. Not surprisingly, the report was met with incredulity by the landlord, but Hydrock insisted that its later report was correct. Faced with this risk, the landlord duly hired a waking watch at a cost of £28,000 per month and sought to recover the cost via the service charge. Horrified by the cost, the lessees obtained their own report, which found that the waking watch was completely unjustified. Armed with this new information, the lessees argued the waking watch costs could not have been “reasonably incurred”. The FTT agreed – the Hydrock advice was simply wrong and the costs were unnecessary.

On the landlord’s appeal, the leaseholders argued that it should be the landlord, not the tenant, who bears the risk of professional advice being incorrect; it is, after all, the landlord who bears the risk of the cost or quality of the works being unreasonable. The Upper Tribunal (Lands Chamber) disagreed. Judge Cooke considered the two-stage test in Waaler and said that, faced with a report from a reputable company saying that the fire risk was intolerable, the landlord could not be said to have acted irrationally by putting interim measures in place pending further reports or remedial work. Even though the Hydrock report was ultimately found to be “wrong”, the first test was therefore met. When it came to the outcome, Judge Cooke said that what the FTT had to decide was whether, at the time the cost was incurred, it was objectively reasonable for the landlord to have put a waking watch in place. Instead, the FTT had relied on hindsight. The cost of putting interim measures in place pending works to remove the fire risk was therefore recoverable.

The second case

Fairleigh was heard by the FTT, but involved no fewer than eight counsel – including three KCs. The question before the FTT was deceptively simple, but had potentially far-reaching consequences. In essence, the leaseholders of two very large mixed-use developments argued that, due to an HMRC exemption (ESC 3.18), VAT of approximately £500,000 pa charged on staff costs could have been avoided if those staff were employed by the landlord direct rather than by the managing agents. There was much debate about what ESC 3.18 actually means, whether the proposed tax avoidance scheme would be acceptable to HMRC, what it would cost to set up and the practicalities of employing staff direct on a complex estate with multiple landlords. Ultimately, however, the FTT found that the lessees had failed to show that their alternative scheme was realistically capable of being implemented.

In reaching that decision, again the starting point was Waaler. In considering the reasonableness of costs found to be contractually/statutorily payable, the relevant considerations would include an assessment of whether the risks inherent in making a fundamental change to the employment structure would be outweighed by the benefit of implementing that structure in terms of costs saved. The FTT found that both the management and tax risks involved in changing the arrangements for the employment of staff were such that it was not unreasonable for a landlord to refuse to adopt the leaseholders’ proposed alternative scheme.

The lesson

Interestingly, both cases considered risk. In each case, it was found that the landlord is not required to embark on a risky course of action which might save costs in the long run. Provided the decision to incur the costs is a reasonable one which leads to a reasonable outcome, the costs will have been reasonably incurred.

 

This article first appeared in the Estates Gazette.

If you would like more information, please contact Alex Southern.

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