Testing the rent review system: report

Chapter 7: Residential Surplus

7.1 Description of Model

7.1.1 The following model of assessing the rent for surplus residential accommodation is considered to be in-keeping with the 2016 Act taking account of Standard Labour Requirements ( SLR) and excluding accommodation occupied by the tenant:

7.2 Issues arising from the model

7.2.1 The main elements to be considered prior to determining a property as surplus and subject to a separate rental assessment are:

7.2.2 Is the property surplus in terms of the labour units required for the farm?

7.2.2.1 Proposed Answer: First it must be determined, using the proposed hypothetical farming system and with reference to SAC handbook labour units, whether there is surplus residential accommodation. If there is, then we believe it is possible to rentalise residential accommodation by the amount it is surplus. For example if the labour requirement is 1.2 and a farmhouse and cottage are supplied with the tenancy then 80% of the Cottage rental value can be considered. In terms of the legislation the Farmhouse which is occupied by the tenant cannot be considered as surplus residential accommodation whether part of it is considered to be surplus in terms of the holding or not. However, generally there may be scope to consider this as part of the overall fair rent calculation. Where a Farmhouse is surplus, or an element of it is surplus, and no part of it is occupied by the tenant, it can be considered as surplus residential accommodation.

7.2.2.2 Where a property is actively being sub-let by the tenant and this has been consented to by the landlord, then the effect of that consent on the rent will remain unchanged by the 2016 Act. The Team consider that where sub-letting is prohibited, the parties should be free to come to separate agreements in terms of the split of the rent for cottages whether considered as surplus or not. Where sub-letting is taking place with consent but there is no agreement on how the rental income from the sub-let is to be dealt with, we consider that our recommended approach, as set out on the following page, should apply.

7.2.2.3 Alternative Approach: An alternative approach to this is to make a judgement on whether a property is surplus based on the labour units required. For example if a holding required 1.2 labour units it would be reasonable to consider the provision of two houses with the holding as being surplus to requirement and for 0.2 of a labour unit the tenant would not employ additional labour on a housed basis and may instead contract in some additional labour from time to time. In this case it is likely that up to 0.5 labour units would not require to be housed and therefore any housing over this amount could be considered as surplus. On the other hand, for anything over 0.5 of a labour unit there could perhaps be an argument made for having an employee and providing them with a house so housing within this allocation may be considered to be required for the holding and not available for a surplus charge. This approach is considered to be subjective in its application and more open to dispute than the previous option.

7.2.2.4 We consider that a more scientific approach is less likely to disadvantage the parties involved as the actual labour requirement reflects the proportion of rent which can be charged. Also, through worked examples by the time the improvements, compliance requirements and annual maintenance costs are accounted for there is very little left to apportion to rent where the full property is not considered to be surplus. Within the ten sample farms there was not an example where the tenant housed more labour than was required for the holding; in the majority of cases the actual labour housed was less than the SLR. This of course may indicate that the SLR rates need to be revised.

7.2.2.5 Recommended Approach: Further research and a review of the SLR data produced by SAC is required along with further regulations to formalise the use of the scientific approach in determining the surplus residential accommodation capable of being rentalised within an agricultural holding.

7.2.3 Is the property able to be sub-let in terms of the lease?

7.2.3.1 Proposed Answer: If the property is considered as surplus but the lease prohibits sub-letting, the surplus accommodation cannot be rentalised unless sub-letting has been consented to through written consent or past evidence of sub-letting being undertaken and accepted by the landlord. For the avoidance of doubt, where residential accommodation is considered to be surplus, acceptance of sub-letting by the landlord can be proven by acknowledgment at previous rent reviews or a knowledge of the sub-let and no evidence of an objection to it being issued. Where a property is considered surplus in terms of the labour units and is occupied by family members, retired employees or family friends this would be assumed to be sub-let as there is evidence of third party occupancy and the property is surplus to the needs of the agricultural holding.

7.2.3.2 Recommended Approach: No specific allowance for seasonal workers, retired employees or family members is necessary as this is only relevant to the actual tenant's business. Surplus residential accommodation should be based on the SLRs required for the holding and the tenant should only be charged a surplus rent on the proportion of accommodation provided over and above what is required for the holding.

7.2.4 Has the property been declared as redundant in terms of the lease or through agreement with the landlord?

7.2.4.1 Proposed Answer: If the property has been considered as redundant or has been written off as neither party having ongoing obligation through an agreement between the parties, it should not be taken into account when considering the surplus residential accommodation on the holding. If the tenant has thereafter brought the property up to a rentable standard and is actively sub-letting it should not be considered in the rental assessment.

7.2.4.2 Recommended Approach: Properties declared by both parties as 'redundant' or 'no obligation' should be excluded from any surplus residential accommodation calculations.

7.2.5 How should the assessment consider the different legislation for residential letting?

7.2.5.1 Proposed Answer: The fact that residential tenancies are governed by different legislation and impose different obligations on Landlords and Tenants should be taken into account in the rent assessment process. Surplus residential properties may be let by tenants under Regulated, Assured or Short Assured tenancies currently (in the future they will be let under Private Residential Tenancies). In terms of the Housing (Scotland) Acts, these types of tenancy all have different security implications and means of calculating the rent. When considering whether or not to consent to a sub-let the landlord should consider the implication of the sub-let on the agricultural tenancy as a whole.

7.2.5.2 In terms of the rent determination the specific tenancy is not a valid consideration when assessing the rent from surplus residential property. It should be noted that this may disadvantage some tenants where they are only able to receive a fair rent for the property as the sub-tenant has been in occupation prior to the implementation of the Housing (Scotland) Act 1988. This is likely to apply to a very small amount of tenancies, if any. All types of residential tenancy are however governed by the Repairing Standard and as such the current cost of meeting the compliance elements of the Housing (Scotland) Acts should be annualised and discounted from the Market Rent whether they have been undertaken by the actual tenant of not.

7.2.5.3 Alternative Approach: An alternative approach is to consider the property as supplied by the landlord, black patching all tenant's improvements. In terms of compliance in many cases, the tenant may be sub-letting or allowing the property to be occupied by a third party without undertaking the necessary compliance works. We believe the occupation of the property suggests it is in use and can therefore be considered as lettable, subject to the necessary costs of bringing the property up to a modern lettable standard are met. In terms of the fairness approach, it would be unreasonable to propose a surplus rent could not be charged on a property which was being actively used or had the ability to be actively used subject to all necessary costs being deducted.

7.2.5.4 Recommended Approach: Deductions to account for the requirements of the repairing standard should be based on what is required - not what has been carried out by the actual tenant. Further regulations should ensure that compliance costs can be accounted for and discounted rather than a black patch approach being undertaken.

7.2.6 How should the assessment account for tenants improvements?

7.2.6.1 Proposed Answer: The requirements for a surplus property to be let under the Housing (Scotland) Act will be considered as has been discussed above. For property improvements it is necessary to value them out of the property's rental value. New kitchens, bathrooms, central heating should be treated this way. The cost of these can be discounted either through analysing their impact on the rent through an analysis of comparable evidence or annualising their current cost and deducting them from the rent. This allows rents to start from reference to comparable evidence with tenant's improvements then discounted from this. This method is considered to be the most scientific and fair way to rentalise surplus residential accommodation.

7.2.6.2 Alternative Approach: An alternative approach would be to completely black patch the property and consider the open market rent without any tenants improvements. This does not work for a number of reasons as follows:

• It assumes that the landlord would supply all the compliance measures to make the property fit for sub-letting. The landlord has different obligations for residential property if let as part of an agricultural tenancy in comparison with a direct residential tenancy. The cost of such measures must be considered for the surplus rent as a landlord would have to assume that the tenant was sub-letting the property in a compliant condition. By black patching these elements consideration of a market rent is not possible, which in turn should mean that sub-letting the property is not possible. It is likely landlords would withdraw consent for sub-letting if they were unable to achieve any rental benefit by permitting it.;
• black patching tenant's improvements such as new kitchens, bathrooms and central heating makes the analysis of comparables very difficult as it is impossible to consider what was initially supplied by the landlord ( i.e. what was taken out in order to put the improvement in). This leaves the determination of open market rent of an improved property open to debate due to a shortage of comparables. A more objective approach is to analyse market rent based on the property as it is, cost the tenant's improvements through contractor costings and adjust the rent. Annualising these improvements through using a likely lifespan provides an objective means of making deductions to the rent. Through the use of current costs the inflation element these improvements attribute to the rent is also taken into account and deducted.

7.2.6.3 Recommended Approach: Tenant's improvements which are required to meet the Repairing Standard, meet a basic standard for letting or have been taken into consideration when analysing comparables should be valued out of the rent on the basis of the additional rent a tenant would pay for their inclusion. Tenant's improvements not falling into these categories should be black patched. Wherever possible tenant's improvements should be black patched and relevant comparable evidence used to calculate the open market rent applicable.

7.2.7 How should the surplus rent following deductions be split between the landlord and tenant?

7.2.7.1 Proposed Answer: It is common practice for surplus cottages to be rentalised on the basis of a third of the rent to go to the landlord or half the rent following deductions being made for higher maintenance obligations and an allowance for voids. The Mortgage Advice Bureau suggests average voids for rental properties are 3 weeks per annum; as such 5% of the annual rent should be deducted to account for this with an additional 5% for management and 10% for the higher maintenance obligation not accounted for in the compliance and improvements deductions already made. This 10% is in line with the figure HMRC use as an allowance for buy-to-let income calculations and was discussed with a number of banks as being realistic. Discussions with banks also provided clarity on what they would expect their buy to let clients to budget on. It was suggested, due to the recent increases in compliance required for residential property, it is now expected that 30% of the rental income is set against voids, management and maintenance, so debt servicing is based on 70% of the total income. Interestingly the model adopted is considered to be consistent with the 30% figure once the compliance measures are taken into account. The standard percentages within the models are therefore considered to be robust but capable of being adjusted to reflect market demand and proximity to services. The remaining surplus rent should be split 50/50 between landlord and tenant.

7.2.7.2 Alternative Approach: The industry standard has been to apply 1/3 or 33% of the rent to management, maintenance and voids and split the remaining rent 50/50 between the landlord and tenant. This option is considered to be less scientific and less open to adjustments. It also doesn't specifically take compliance measures into account. A second alternative is to split the surplus rent in line with the percentage of capital invested by the landlord and tenant but as previously discussed this can lead to rents being heavily weighted in the landlord's favour which can be seen as unfair.

7.2.7.3 Recommended Approach: Rather than the standard 1/3, 1/3, 1/3 model, a more rational approach taking account of actual business budgeting techniques is recommended with an adjustment where evidence is available of the actual costs experienced in relation to voids, maintenance and management. A valid sense check of this would be the industry practice approach ensuring deductions made for compliance, management, maintenance and voids come to approximately 33% (banks use 30%). The surplus rent should then be split equally between the Landlord and Tenant.

7.3 Worked Examples

7.3.1 In order to show how the recommendations work in practice, we have used one of the sample farm examples to illustrate the possible results.

7.3.2 Example: Holding with a small acreage and two farmhouses one of which is occupied by the tenant.

Step 1 – Exclude the farmhouse occupied by the tenant.

Step 2 – Calculate the labour units required for the farm = 0.28 labour units.

Step 3 – Consider whether there is a prohibition in the lease to sub-let or whether there has been consent to the sub-let in writing or through knowledge and acceptance in practice.

Step 4 – Consider what the surplus residential accommodation is = 100% of the farmhouse which is not occupied by the tenant (additional property). It is irrelevant who is occupying this farmhouse.

Step 5 – Consider the condition of the property defined as surplus. If classified as redundant it should not be rentalised.

Step 6 – Calculate the market rent of the property black patching tenant's improvements wherever possible.

Step 7 – Deduct the cost of all compliance measures required to meet the repairing standard.

Step 8 – Deduct the cost of any tenant's improvements considered when calculating the market rent i.e. new kitchen, central heating (if possible these should be black patched if comparable evidence is available).

Step 9 – Deduct 20% of the annual rent to account for voids, management and a higher maintenance obligation. Adjustments should be made to this to account for aspects particular to the holding i.e. proximity to market, proximity to services and contractors etc.

Step 10 – Cross check deduction made for compliance, voids, management and maintenance against 33% industry standard.

Step 11 – Split the surplus rent 50/50 between the landlord and the tenant.

Table 13: Example

Property	Market Rent	Propor-tion lettable	Comp-liance costs per annum	Tenants Improv-ments costs per annum	10% Maint	10% Voids & Mgt	Rent	50/50 split	% MR
Farmhouse	£6000	0%	£0	£0	0	0	£0	£0	0
Additional Property	£6000	100%	£482.67	£966	600	600	£3351.33	£1675.66	27.9

7.3.3 The above table applies the following standard costs which have been compiled through reference to contractor's quotes and would be used as the starting point for negotiations. These would need to be updated at each rent review so long as the improvement was being taken into account when calculating the open market rent.

Table 14: Compliance Current Costs

Maintenance Provision	£ inc VAT	Renewal (yrs)	£/annum
EPC	£78	10	£7.80
EICR	£300	5	£60.00
Smoke Detectors	£144	10	£14.40
Heat Detectors	£144	10	£14.40
CO alarms	£48	10	£4.80
Replace Battery on CO Alarm	£20	5	£4
Landlord Registration	£11	3	£3.67
Boiler service (annual)	£90	1	£90
Water Filtration System annual service	£220	1	£220
Legionella Risk Assessment	£36	1	£36
Empty Septic Tank	£276	10	£28
TOTAL	£483.07

Table 15: Tenant's Improvements Current Costs

Tenants Improvements	£ inc VAT	Renewal	£/annum
Kitchen	£7000	20	£350.00
Double glazing	£5400	25	£216.00
Central Heating	£6000	15	£400.00
TOTAL	£18,400	60	£966.00

7.4 Common issues arising from the sample

7.4.1 Issues with standard cost data:

• There are various methods of pricing works. These can be done on comparables using hourly rates plus material costs, quotes from contractors or by using building price books.;
• hourly rates vary depending on the size of the company and how they price works. Labour rates can vary from £20/hr to £35/hr.;
• if the works are to be 'wrapped' up into one contract and dealt with by one main contractor, 15% should be allowed over and above the total construction cost to cover the 'on site' element, such as CDM, insurance, office, toilets, site fencing and travel i.e. the cost of prelims. If the site is really isolated or difficult to access with machines etc. this percentage may rise. This may need considered if tenant's improvements are to such an extent that a complete renovation was undertaken.;
• it is standard to base budget costings on previous examples and Prelims with caveats. It would seem reasonable to use this as a starting point for negotiations.;
• lifespan is based on materials/products specified. Lifespans can be adjusted following negotiations. Information on standard lifespans can be easily obtained from discussions with local contractors.;
• as a sense check to standard costs, it should always be considered how much extra rent a tenant would pay for an improvement being present compared to where it was not. Often for elements such as central heating and double glazing it is difficult to determine differences through analysing comparables but general rules of thumb can be drawn. For example, from a broad analysis of comparables in the Aberdeenshire area it would seem that central heating would perhaps justify an additional £10-£25 per month of rent. However these figures do seem low so it should be noted that care should always be taken when determining such rules of thumb as often there are other specific factors involved which cause rents to differ (it would be rare to find an example of two identical properties, one with central heating and one without).

7.4.2 Issues with where a farm does not have enough acres to justify a house.

The Act specifically lists accommodation occupied by the tenant of the holding as being disregarded in terms of surplus residential accommodation. This does present an issue where holdings are small and would not justify a whole labour unit. The below table shows what the rent would be if the farmhouse that the tenant occupied could be considered as surplus using the proposed model:

Table 16: Example

Property	Market Rent	Proportion lettable	Compliance costs per annum	Tenants Improvements costs per annum	10% Maint	10% Voids & Mgt	Rent	50/50 split	% MR
Farmhouse	6000	72%	482.67	1000	600	600	1637.33	818.66	13.6
Additional Property	6000	100%	482.67	966	600	600	3351.33	1675.66	27.9
Total	12,000	2,494.32							20.75

• It is difficult to assess the rental value of the farmhouse of a very small holding in the productive capacity of the farmland or through the fixed equipment generally.;
• it could be argued that the reference to 'in particular' within the Act could allow the presence of the farmhouse to be considered when calculating the fair rent as another consideration outwith the productive capacity, the residential surplus and the non-agricultural use. Additional considerations such as these are outwith the remit of this report and would be for the Land Court to determine whether justified or not.;
• we do however note that this is a contentious issue and acknowledge there is an argument for a farmhouse being automatically included as part of an agricultural tenancy where it is utilised by the tenant in order to work the holding. ;
• there does appear to be an anomaly within the legislation in terms of the existence of joint tenants and the potential for the legislation to prevent two properties from being considered within the surplus residential accommodation calculation. However we believe this is addressed within the Explanatory Notes (March 2016) through reference to 'the sole farmhouse occupied by the tenant'.;
• Hamish Lean advises that the legislation relating to surplus residential accommodation is explicit in terms of the farmhouse which is occupied by the tenant and cannot be changed without an amendment. As such we cannot comment on it in terms of further regulation.

7.4.3 Taking account of voids and maintenance

We believe the percentages used are valid in terms of being recognised by banks, mortgage companies and HMRC as averages. However we accept adjustments may need to be made to account for the following:

• Remote areas are likely to be vulnerable to longer void periods and higher maintenance costs so the percentages should be increased to account for this.;
• high rent demand areas which are less susceptible to periods of voids.;
• it could be argued that a number of maintenance costs have already been accounted for in the deductions made e.g. annual boiler services. 10% should therefore be considered as a full maintenance consideration and should only be adjusted upwards if there are significantly higher than normal maintenance costs. This would need to be evidenced by the tenant. In more rural locations it may be more appropriate to agree an actual annual figure rather than a percentage of the rent as rents are often lower and repair/maintenance costs higher.;
• adjustments made to decrease these percentages would also need to be fully justified but may be relevant in situations where the lease or a post-lease agreement dictates that the landlord is responsible for an element of the renewals.

A cross check with the industry practice model is shown below as another means of considering management, voids and maintenance costs.

Table 17: Example

Property	Market Rent	Proportion lettable	Compliance costs per annum	Tenants Improvements costs per annum	33% Voids & Mgt	Rent	50/50 split	% MR
Farmhouse	6000	0%	0	0	0	0	0	0
Additional Property	6000	100%	0	966	1980	3054	1527	25.45

• The difficulty with this method is that it does not adjust for compliance only for tenant's improvements actually carried out. This prevents full consideration of required costs for letting to be taken into account. It is also less flexible to changing compliance costs, for example it did not change to reflect the higher electrical inspection obligation now applicable and will not be able to cope with changes in energy efficiency standards going forwards. This system would benefit tenants who are letting out non-compliant properties and therefore disadvantage tenants who had undertaken all the works involved in making properties compliant. ;
• although simplistic and easy to follow in its application, it is considered overly rigid when considering the variety of different scenarios present on tenanted farms. ;
• this method discourages investment in surplus properties and is not recommended as the best means of calculating the rent going forwards. However it could be used as a sense check to the previous model where there is uncertainty on the costs used. It determines that the landlord should be able to achieve roughly one third of the open market rent of the property following the exclusion of improvements.

7.4.4 Splitting the surplus rent according to capital invested.

• A 50/50 split of the surplus rent has been considered to be fair in practice and has been used as an industry standard generally ( i.e. a deduction for maintenance then a 50/50 split or split a 1/3 for maintenance, a 1/3 for the tenant and a 1/3 for the landlord).);
• the following table looks at what would happen to the rent if the split was based on the percentage of capital investment present ( i.e. the cost of renewal annualised through reference to the expected lifetime of the element being assessed) within the property i.e. the landlord's share is based on the property itself and the tenants share is based on the improvements they have made to the property.

Table 18: Example

Property	Market Rent	Proportion lettable	Comp-liance costs per annum	Tenants Improve-ments costs per annum	10% Maint	10% Voids & Mgt	Rent	% capital investment split	% MR
Farmhouse	6000	0%	0	0	0	0	0	0	0
Additional Property	6000	100%	482.67	966	600	600	3351.33	2245.39	37.4

• Although this method is logical in practice it does tend to favour the landlord's interest due to the fact they own the actual property which is generally where the essence of the cost of renewal lies. Even if this was calculated on a value basis rather than a cost basis it still comes out heavily weighted towards the landlord - unless the tenant's improvements are to such an extent that renewal of elements of the property itself have been undertaken.;
• also due to the number of elements involved in valuing the cost of everything owned by the landlord and everything owned by the tenant there leaves an element of room for error in cost analysis and the possibility for double counting or missing out certain elements. Therefore this model for calculating the surplus rent is seen to be higher risk, more subjective and therefore more open to debate.;
• with such a high risk of this method causing conflict between the parties involved, a 50/50 split approach is regarded by the team to be the most fair. Accurate deductions can be made for tenant's improvements, management, maintenance and voids.

7.4.5 Where a proportion of a property is lettable

• We have previously discussed the justification for considering a proportion of a property as able to be considered in terms of the surplus rent in line with the SLR of the holding.;
• in terms of the calculation, the timing of when to consider the proportion let makes a difference to the surplus rental figure. For example if you consider the proportion let before considering the tenant's improvements, maintenance, voids and management, the surplus rent is less than if you consider the proportion let after accounting for these. See example of the two different results below:

Table 19: Proportion considered before deductions for improvements

Property	Market Rent	Proportion lettable	Comp-liance costs per annum	Tenants Improve-ments costs per annum	10% Maint	10% Voids & Mgt	Rent	50/50 split	% MR
Surplus Property 1	6000	72%	482.67	1000	600	600	1637.33	818.66	13.6
Surplus Property 2	6000	100%	482.67	966	600	600	3351.33	1675.66	27.9

Table 20: Proportion considered after deductions for improvements

Property	Market Rent	Comp-liance costs per annum	Tenants Improve-ments costs per annum	10% Maint	10% Voids & Mgt	Propor-tion lettable	Rent	50/50 split	% MR
Surplus Property 1	6000	482.67	1000	600	600	72%	2,388.47	1194.23	19.9
Surplus Property 2	6000	482.67	966	600	600	100%	3351.33	1675.66	27.9

• The question which should therefore be posed is: 'if only a proportion of the rent is applicable for consideration should only a proportion of the costs be applicable for consideration?'
• one argument is that if you are considering an element of a property as being surplus then you must account for all the costs in making the whole property lettable as it is impossible to only let part of a property. ;
• it should be noted that where a property is actually being sub-let by the tenant with the consent of the landlord, the rental element of that property will be defined through the agreement with the landlord rather than via chapter 5, section 10 of the 2016 Act.;
• the proportion calculation is most likely to come into play where a property is being occupied by either staff (seasonable or full time), the tenant's family or retired employees and where the labour units required for the holding equate to a proportion of one additional labour unit required.;
• with reference to the above it would seem fair that if the landlord and tenant are sharing in the potential rental income from the property they should also share in the potential costs. The potential costs will more than likely be over-inflated as they will take into account what should be done in order to sub-let rather than what has been done.

7.5 Recommendations

• An update of the SLR data contained within the SAC handbook should be undertaken.;
• surplus residential accommodation should be defined using the SAC handbook's SLR figures for a holding.;
• the open market rent should be calculated on the proportion of residential accommodation over and above what is required for the holding. Regulations and/or Best Practice Guidance must allow this to be calculated using the method outlined in paragraph 7.2.2.1 of this report.;
• clarity needs to be added to ensure that compliance with the Housing (Scotland) Act is accounted for when calculating the cost to be deducted from the open market rent.;
• tenant's improvements should be black patched wherever possible unless they are considered when analysing comparable evidence to come to the open market rent.;
• non black patched improvements should be deducted through assessing the amount of additional rent the improvement warrants through an analysis of comparables then deducting it from the market rent or spreading the current cost over the likely lifetime of the improvement and deducting its annualised rate from the market rent. The overall basis for the deduction of non black patched improvements should be to reasonably consider how much the improvement adds to the rent at each rent review and deduct it on that basis.