Diminution in the value of the reversion in dilapidations: Some misconceptions
For other articles, expanding on the issues discussed here, see:
- Diminution valuation in dilapidations cases
- Diminution: a plain vanilla case explained by Peter Beckett and Terry Davis
Diminution in the value of the landlord’s reversion is a loss of value in a landlord’s property as a result of a tenant’s failure to comply with covenants.
This concept causes a lot of muddled thinking. Most of the trouble arises like this. The state of repair of a property represents a small proportion of its value, at least in high value locations. In central London, for example, the value of the site may represent two-thirds of the value of a property: the state of the building may therefore have rather a small effect on value. Furthermore, margin of error in valuation of property is several percentage points – some say 10-15% either way. This often leads even experienced property people to suppose that the state of a building, being often within that margin of error, has no real effect on value. They think there can therefore be no diminution.
One example of diminution is found in s18(1) of the Landlord and Tenant Act 1927, relating to repair:
Damages for breach of a covenant …… to keep or put premises in repair during the currency of a lease or to leave or put premises in repair at the termination of a lease …… shall in no case exceed the amount (if any) by which the value of the reversion (whether immediate or not) in the premises is diminished owing to the breach of such covenant ……
All that s18(1) does is express an attractive proposition – that a landlord cannot recover more than he has lost. It deals only with repair but, not surprisingly, the principle usually applies to all breaches of covenant.
In looking at misconceptions about diminution, I start with the most naïve (of which my reader is never guilty, I’m sure), passing to the most sophisticated.
It is a purely personal view, but I think an overriding misconception is that judges look favourably on tenants who ask, in effect, to be relieved of their covenants. On the whole, judges are a bit unsympathetic to parties who come to the Court to be relieved of contractual obligations freely and solemnly entered into. Of course, the judiciary will apply the law with complete objectivity, but it is inevitable that somebody who wants to be relieved of a contractual obligation is at a disadvantage in a finely balanced case.
Misconception no 1: outgoing tenants are rarely liable
Where the building is going to be demolished, or drastically altered throughout, tenants are normally relieved of their covenants on expiry. Landlords can hardly claim for a tenant’s failure to repair (or to comply with any covenant) if the subject building is to be demolished. In the more common case – where no demolition or structural alteration is intended – full relief is rare.
In a typical building, it’s unlikely that the walls of the building will cease to be of use. If they are in a poor state of repair, they’ll have to be repaired. The cost will be the measure of diminution, as far as those walls go, and the landlord will be compensated for it (assuming the tenant’s covenants covered the walls, of course). Further, the roof, gutters and downpipes will usually survive any change in the building. If they are in a poor state of repair, they’ll have to be repaired or replaced. It’s even a relatively rare case for all the windows and doors in the external envelope of the building to be replaced if they are in good repair. External redecoration may have to be carried out. So, even if the landlord wants to make quite significant changes inside the building, works will have to be done outside if the outgoing tenant has not already done them. The measure of diminution is the cost of rectifying any such breaches of covenant.
Even inside it’s actually quite a rare case for diminution to be zero. In most cases, much of the interior survives and must be placed in a good state of repair, if the landlord is not to lose by it.
In short, if the building is in disrepair, it’s likely that the landlord will have suffered loss. If there is such a loss, the cost of repair (plus consequential losses) is often the diminution, and he can sue for it.
Misconception no 2: the valuer doesn’t need the schedules
To understand why this is a misconception, you need to remember that, to assess diminution, you need two valuations. You are valuing the property as it actually was at the date of expiry. You then compare that figure with the value the property would have had, if the tenant had complied with his covenants. So it’s immediately apparent that the schedules of dilapidations are part of the valuation, and a first stab at diminution. That’s not just my view. To quote from Shortlands:
In most cases the cost of repairs is a good guide to the difference in value of the reversion.
Of course, if the valuer is able to produce comparables that demonstrate it, he is entitled to say that, in this case, the market is not logical and that the repairs don’t figure. Any such evidence would have to be very compelling, and he would have to explain how such an illogical situation arose.
Remember that we are not speaking here about a property due for demolition, so it’s likely that some of the wants of repair, to put it no higher, will have to be rectified by an actual or hypothetical purchaser. The landlord can claim damages for that rectification. There may be areas of the building where you can say that no damage has occurred for a specific reason, such as supersession, which is discussed below. It’s most unlikely that not a single breach of covenant inside or outside the building has any effect on the mind of a purchaser.
In the real world, it is rare for comparable evidence to prove such a counterintuitive proposition. You will have to go very close to the perfect standard of comparable evidence to prove the point. You will need two physically very similar properties, very close to one another and to the subject property, sold in the open market at more or less exactly the valuation date. One of these would have to be a property in a comparably poor state, and the other in a good state. Such perfect, open market, evidence is most unlikely to be available, and you will therefore be thrown back on arguing the logic. If you are arguing that disrepair makes no difference to the bid of a purchaser, and you can give no specific reason for that (such as one of the reasons discussed later), you may have difficulty convincing the Court of your proposition.
Misconception no 3: tenants in breach don’t have to pay much
The first port of call for diminution is the cost of works. Particularly where the landlord carries out those works and pays for them, it may be very difficult to say that he did not lose to that extent. In such a situation, it is hardly worth doing a diminution valuation at all – see Jones v Herxheimer . All that such a valuation will reveal is that the property, worth £x in good order, is worth £x minus the cost of works (and consequential costs), or thereabouts, in poor order.
In principle, this is so even if the landlord doesn’t do the work. The first and most obvious estimate of diminution is the cost of the works to which he is exposed by the tenant’s failure to carry them out. The diminution valuation may only be a check that no special considerations have been left out of account. In Shortlands, what was effectively a residual valuation approach was approved by the Court, and appended to the judgement. There were two valuations: one assuming compliance with covenants; the other assuming the actual situation. The difference between the two valuations was little different from the cost of works (over and above the cost of works the landlord would have been put to anyway), adjusted for consequential considerations.
In many simple situations, the difference between the value the property would have had if the tenant had complied, and the value it actually had, is the cost of works plus consequential costs.
The diminution is to be assessed as at the lease expiry date. It involves two valuations of the landlord’s interest. The first is on the assumption that the premises were then in the state that they would have been in if the tenant had performed his covenants. The second is of the premises in their actual state and condition at that date. …… the purpose of the exercise is to isolate the effect on value of the tenant’s failure to do the relevant works, from which it follows that the only variable between the two valuations is the works. All other factors are constants.
Misconception no 4: let the landlord make the running
Surveyors rarely seem to realise that, in litigation to recover damages, the tenant is normally paying both sides’ costs. Until the tenant makes a payment into Court, a Calderbank Offer or a Part 36 Offer, he has not even begun to protect himself against costs. If the Court finds that the tenant’s liability is greater than zero, it will often make the tenant pay the costs until the time he makes a payment or an Offer. As I have suggested above, the case where a diminution valuation will reduce the tenant’s liability to zero is a rare case, so the exposure to costs is real.
Once a payment into Court or Part 36 Offer is made, much more careful judgment has to be made on both sides. The landlord has to beat that payment or Offer, otherwise he will be paying the tenant’s costs from 21 days later.
So letting the landlord make the running is dangerous: it’s far better for the tenant to take some action. Often, the best action a tenant can take is to do the work that appears to be needed before the end of the lease. There are two reasons:
- It places the landlord in the position of having to argue, not about whether work has or has not been done, but about standard of the work. No judge is going to be thrilled by an argument about adequate standards. By contrast, if the work hasn’t been done at all then, on the face of it, that is a breach of covenant pure and simple, and the landlord will be more sympathetically received.
- The preparatory, administrative work can be done while the tenant is still in occupation. The tenant will face a claim for loss of rent, service charge, void rates etc, if he leaves it to the landlord. Before physical work can be done to a building, the party doing it needs to know exactly what is required. The landlord can’t know for sure until he recovers possession. He then instructs a surveyor; the surveyor inspects, and prepares a specification; the specification is sent out to contractors; the contractors have to be given time to respond; the successful contractor will have to be chosen; and the contractor given time actually to appear on site. Until that moment, not a stroke of physical work has been done.
The tenant is in a position to all carry out all those preparatory stages, lasting weeks if not months, while he is still has the lease and therefore the right to do them. If he doesn’t do so, the landlord may be able to claim loss of rent and outgoings during the period in which the property is lying fallow.
Leaving it to the landlord actually increases the cost, both in terms of standards and consequential losses.
Moreover, the legal costs of a dilapidations case are formidable: it’s not uncommon for the combined costs to exceed the amount of the claim. So costs should loom large in the minds of both parties. Where a tenant leaves the matter to the landlord, without making a payment into Court or a Part 36 Offer, the tenant’s costs will soon escalate out of hand.
Misconception no 5: you can’t value the property accurately
There is a “margin of error” around any valuation. It’s not possible to put “a” value on a property; there is always a uncertainty. The margin of error varies but, as mentioned at the beginning of the note, it’s often something like 10-15% either way. This means that a property valued at say £1,000,000 could sell for anything between £850,000 and £1,150,000. This 30% band could be wider.
If property cannot be valued more accurately than this, some say, surely the effect of dilapidations is lost in that margin? I’ve heard this described as the “practical man’s approach.” It’s actually just a misunderstanding. The two valuations – one assuming compliance with covenants, and the other the actual situation – must be done on a consistent basis. The job is to value the property as it actually was, and to compare it with exactly the same property, as it would have been had the tenant complied with his covenants to repair. Whatever assumptions are made in the “compliance” valuation, must also be made in the “actual” valuation. Margin of error has got nothing to do with it.
Misconception no 6: the property is difficult to let
Limb 2 of s18(1) makes it clear that, if the property is to be destroyed, there’s no claim. One can envisage some cases where the property is not to be demolished but where, nonetheless, the breaches of covenant have no effect. Logically expressed, this is the case where the property has no value even if it is in compliance with the tenant’s covenants. There probably are industrial buildings which are completely unlettable in any state, but where the market is such that one cannot justify demolishing them. Even there, we must consider the effect on the mind of the “Least unlikely purchaser” . If the property has any kind of non-zero value, then breaches of covenant can reduce it, and the valuer will have to identify the diminution resulting.
The reverse of this is the idea that, if a landlord let the property at a good rent after expiry, there was no diminution. The property belongs to the landlord; if he lets it for better than valuers expect, it’s more likely that the valuers were wrong than that the condition of the property is irrelevant.
Misconception no 7: cost of works doesn’t matter much
The terms “supersession” and “superseded” (sometimes spelled “supercession” and “superceded”) are not used in s18(1), but they are helpful in thinking about diminution, and the idea has begun to creep into judicial decisions- see Latimer v Carney  and PGF for examples.
The easiest way of explaining this concept is by way of example. Suppose that two rooms are due to be amalgamated. The lease has a provision that the whole of the demise, including its internal walls, must be fully repaired and decorated. Suppose further that the plaster is blown, the wall is cracked and it needs redecoration. What would be the purpose, from the landlord’s point of view (let alone the tenant’s), of doing that work? If the wall is to be demolished, what possible point would there be in repairing and redecorating it before it’s demolished? It would be pointless, and the landlord can’t lose by its not being done. We therefore say that the work of repair and redecoration to that wall is superseded by the landlord’s intention to demolish it. He has lost nothing by the tenant’s breach of covenant; he can recover nothing from him on that account.
It only requires brief acquaintance with “supersession” to realise that the schedule of dilapidations has to be examined item-by-item to establish the extent of supersession. This will only not be necessary in a case where the landlord’s intentions, short of demolition, are nonetheless so all-embracing that it is obvious that every repair will be superseded – a rare case, I would think, and hard to imagine it short of Limb 2.
Misconception no 8: diminution doesn’t need to be explained
When the valuer presents his valuation to the Court, he may have to explain why diminution differs from the cost of works. Indeed, in my opinion, it is probably necessary to go through the Scott Schedule (the document which sets out the parties’ positions on the items in the schedule of dilapidations) and identify the items affected by supersession, and those that are not.
For example, in the case of a well-located shop, all internal repair might be bracketed and annotated “superseded by the incoming tenant’s shop fitting”. Again it might be noted, against some works of repair to a bathroom soon to be changed to a kitchen, that the works will be “superseded by conversion to a kitchen.” If an item cannot be said to be superseded in this way, it is not easy to see why it should not figure in the calculation the valuer is doing. After all, the valuer will have to allow for the cost of repairs in his valuation – cost for which a purchaser of the property will make an allowance. It will affect value; it will enter into diminution because it would not be included in the compliance valuation.
In principle, every item will either be superseded or will enter into diminution. The valuer will therefore need to show which is in which category. Obviously, the valuation will not end there, but the cost of works element in the valuation will.
A proper justification of the use of the repair figures will require analysis.
Misconception no 9: diminution only affects repair
There are subtle differences between s18(1) (relating to repair only) and the general common law method of assessing loss (relating to all other breaches of covenant), but these are beyond the scope of this paper, and possibly too subtle for surveyors to worry about anyway.
The general rule at common law is that no one can claim in damages more than he has lost. In the 19th century, for reasons that are beyond me, the courts started to accept that repair was an exception to this rule . They decided that a landlord could claim for the breach of a covenant to repair, even if he’d suffered nothing by it. It was this anomaly that s18(1)was intended to remedy. The anomaly having been remedied by statute, the position is:
- in relation to repair, the correct measure of the landlord’s loss is diminution; and
- in relation to other breaches of covenant, the landlord has to show what he has lost.
In 99/100 cases, this comes to the same thing: diminution.
Misconception no 10: no diminution if value is negative
Not so. In the Shortlands case, which concerned a landlord with a leasehold interest in a bad market, the Court put it this way:
If the premises had been delivered a up in a state of good repair and decoration the premises would have had a negative value, but as they were delivered up in a bad condition, they had a worse negative value.
The diminution in value is the difference between the amount of money paid out by the willing transferor to the willing transferee:
- if the premises were delivered up in a condition in conformity with the covenants; and
- if the premises were delivered up in their actual condition.
There would be no willing “purchaser” if no money were paid to him.
(Some liberties have been taken with the layout of this quotation for ease of exposition).
Misconception no 11: if refurbishment, then no diminution
We are now getting to the more subtle kind of misconception. Suppose you act for a tenant and, a year after the tenant’s lease is up and he has vacated, the landlord utterly refurbishes the building in a style and in a manner that would have neutralised any repairs your client might have carried out. Does that prove that there was at no diminution in the areas of the building so affected?
That is the kind of situation s18(1) is designed to avoid. It would make it very difficult for the landlord to say he didn’t intend to do it. However, he might be able to convince the Court that he had different intentions at the date. Sometimes he may be genuinely overtaken by events: war breaks out in some of the cases, for example. 9/11 might be another example. The market might suddenly undergo an abrupt change. Knowing exactly how a landlord would have to go about convincing a Court of his genuine intention at the time is too difficult a legal question for me to tackle. The valuer must be alive to this possibility though – that the tenant will still be liable, because of the landlord’s state of mind at the date, even if claimed repair work was utterly superseded later. It has been established that the valuation has to be done at the expiry date.
Misconception no 12: no damage if an item is replaced
Suppose a window is damaged. Diminution is normally the cost of repairing the window: in a normal case, s18(1) has no impact on this at all. Suppose however that the landlord intends, regardless of the state of repair of that window, to replace it – perhaps to introduce double-glazing. In such a case, s18(1) removes the obligation from the tenant altogether. Even if the tenant had repaired the window to a perfect standard and handed it over in that condition to the landlord, the repair of the window would have been superseded by the landlord’s intention to replace the window. He has therefore suffered no loss, and s18(1) says he can have no compensation for any such failure.
Suppose now that the window is in an appalling state of repair, and let us say it is a single-glazed window. Suppose, further, that physical repair would be uneconomic and the landlord has to replace it. In doing so, he chooses to replace it with a double-glazed window. He can recover the cost of replacing the window, though obviously he can only recover the cost that would have been incurred by replacing it with a single-glazed window to a similar specification to the old window. For the landlord to succeed in recovering this cost, of course, he has to establish that, but for the disrepair, he would not have replaced the window.
 Shortlands Investments Ltd v Cargill plc  1EGLR 51
  2KB 106
 Mason v. TotalFinaElf UK Ltd  EWHC 1604
 See: Craven (Builders) v Secretary of State for Health 
 Latimer v Carney  EWCA Civ 1417
 PGF II SA v Royal & Sun Alliance 
 Joyner v Weeks  2 QB 31